Our typical consulting assignment is to put together a wealth transfer plan for a successful business owner. Invariably, the client brings up two critical and related operational problems: “How do I keep my top executives?” (The headhunters — usually working for a competitor — are always circling), and “How do I attract quality people?”
What to do? Almost 20 years ago, after struggling with the problem for about a year, we decided to develop an organized plan to find the answers. We interviewed our few client/owners who did not have the two problems; we also interviewed their key management people. Then came the hard part: getting permission to interview the key people at clients who were suffering with the problem.
What quickly became clear was that almost 100% of the best key people had the soul of an entrepreneur. But for various reasons they did not want to strike out on their own or couldn’t (usually because they required capital).
The answer turned out to be simple: Mimic ownership. “Give ’em the same challenges as an owner and, if successful, most of the rewards.”
Additional interviews kept reconfirming the original answers. The top (non-owner) executives wanted four core benefits of ownership:
1) A piece of the action (a share of company profits);
2) Get paid when they are sick or become disabled;
3) Receive adequate retirement pay when it’s time to leave the company; and
4) Death benefits for the family (“Like my piece of the equity if I get hit by a bus” is the way most executives put it).
Over the years we’ve created hundreds of contracts (their technical name is a non-qualified deferred corporation agreement; the non-technical name is a golden handcuff agreement) that attract and keep the kind of people you want in your company.
Let’s take a closer look at the four desired benefits:
1) A piece of the action. Typically, this is a percentage of the profits in excess of a specific dollar amount. Often, the percentage grows as the business and profits grow.
For example, Sam Topguy will get 3% of all before-tax profits in excess of $200,000 per year. Profits in excess of $500,000 will be entitled to 5%.
Say the amount earned for year one (or any subsequent year) is $18,000. Usually, Sam will get about one-third ($6,000) in cash and the balance ($12,000) is deferred. The deferred portion is invested for Sam’s benefit. When does Sam get the deferred portion and the accumulated earnings (usually called the side fund)? When the employee becomes disabled, dies or reaches retirement age (the age is usually set around 58 for younger key employees and in the 65-age range for older key people).
When the key employee becomes entitled to collect the side fund (say it is $500,000), it usually is paid out in equal annual installments (say 10 years) or $50,000 per year plus the additional investment earnings for that year.
2) Disability. The employee gets paid when sick or disabled, whether for a day or for a lifetime. This benefit is covered by long-term disability insurance. It is essential that “disability” be defined “word for word” in your agreement as the word is defined in the disability insurance contract.
3) Retirement. The side fund (described in point 1 above) supplements any regular retirement program such as a 401(k) or profit-sharing plan. Typically, the executive is allowed to direct the investment of the side-fund, which remains an asset of the employer.
Here are the tax consequences of the arrangement.
The side-fund earnings are taxable to the employer. When the employee receives a distribution, the company gets a deduction for the exact amount distributed and the employee must report the identical amount as taxable income. If the employee leaves for any reason — except because of disability, death or retirement — the entire side fund is forfeited by the employee and remains the property of the company. Hence, the name “golden handcuffs.”
4) A set amount of money at death. When an owner dies, the family can sell the business (assuming it is not transferred to the kids). A similar benefit (really a death benefit) should be given to the employee. This benefit should be insurance funded.
We have been doing these non-qualified plans for years. Done right, they work. Often, when an owner does not have a family member to pass the business to, the side fund serves as the down payment by one or more of the key people to buy the business from the owner.
Two warnings: This article does not attempt to cover every detail and the endless variations for tailoring an agreement that is perfect for your company. Always, and we mean always, work with an experienced adviser. Years of experience have proven that the right agreement will make your good people even better. And second, there is no agreement we have ever seen that will make a bad employee even a little bit better.
In a way this getting-and-keeping good people is a frustrating subject. The reason is that we have never been able to develop a cookie-cutter solution.
Yes, the four core benefits are almost always similar. But the bells, whistles and unique requirements of each situation make it impossible to write a complete report.