by Jennifer Mailhes, Shareholder, Doeren Mayhew CPAs and Advisors

Hiring and developing key employees to build your management team is essential to business growth, but what type of compensation incentives can you offer to retain them? Maintaining a strong management team is a critical component to the overall success of any company, which is why a well-structured compensation plan aligns the incentives offered to key employees with the company’s short- and long-term goals. To help structure a compensation plan that benefits your business and management team, we’ve weighed the pros and cons of some options below.

Compensation Options

Consider these factors when evaluating effective compensation strategies for your key employees:

Type Pros Cons
Direct Ownership Interest
  • Develops an owner mindset within the employee, which will inherently align their interests and create business value
  • Demonstrates a true transfer of value to the employee
  • Ties key employee to the company since they now have an incentive to stay
  • Future business sale may be difficult if owner interests aren’t aligned
  • Tax consequences of a buy-in deal; either they have to pay through a note and sale of ownership, or it is deemed compensation
  • Difficulty in determining value of a buy-in or buy-out
Stock Options/Phantom Equity
  • Provides an incentive for growth in value, as the interests are aligned with ownership
  • Easier to separate from the company if there is a change in employment status
  • Creates opportunity to combine with a bonus program to encourage near- and long-term performance
  • Limits adverse tax consequences for the employee, if properly drafted
  • Sometimes difficult to calculate and understand
  • Not commonly tied to near-term performance
  • May create tax consequences with issuance of options, as it can be considered as compensation
Bonus Program
  • Offers real-time cash compensation when it is tied to profitability  Provides opportunity to tie a bonus to a triggering event, like change in ownership
  • Creates ability to easily modify if there is a change in business strategy
  • Employee may not have a long-term focus on building business value
  • Does not create the same benefit overall due to its tax treatment at exit (usually ordinary income to employee)
  • May encourage bad behavior if not properly developed
  • Not as much incentive for the employee to remain committed to the company

Implementing a Plan

With these options in mind, here are steps to structure and implement a compensation plan suitable for your business:

  • Gather your financial data and define relevant metrics for the bonus program to develop a structure tied to your key success factors and metrics.
  • Model structure based on your current company financials, as well as from the last two years, to evaluate its impact and effectiveness.
  • Brainstorm ideas if proposed bonus program creates disincentives for creating long-term value versus short-term results. For example, you do not want your management team forgoing long-term process improvements creating value to produce short-term profit.
  • Use financial metrics to create an estimate of value and tie phantom equity program to an increase over this value.
  • Define appropriate triggering events for any plan to result in a payment.
  • Consider whether vesting is appropriate or not.
  • Create an outline for each option, gain a consensus on its structure and provide outlines to legal counsel to draft agreements and review.

A compensation plan will vary for each business. For example, a business owner may choose to combine phantom equity and a bonus plan together that aligns with short- and long-term performance goals. The bonus plan would be tied to the business’ goals outlined for the year and the phantom equity would compensate for growth in value on a triggering event, such as a business sale.

Seeking assistance with structuring a compensation package that benefits your overall business strategy? Contact our business advisors today.