Matters Column

How can family businesses retain key outsiders?

December 26, 2014
| By Jeff Nauta |
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The ability to attract and retain talented employees is key to the long-term success of any business. If you own a family business, you may be one of the lucky few that have found all of your key talent within the family. More likely, and especially as the business has grown, you’ve identified the need to go outside of the family for technical expertise and senior executives.

In West Michigan’s competitive job market, family businesses can often point to their corporate culture, family atmosphere and job security as differentiators. To hire and keep top talent though, you still need an attractive compensation package competitive with family-owned businesses and non-family-owned businesses alike. For many employees in today’s market, an attractive compensation package means some sort of equity compensation. In addition to the benefits of recruiting and retaining top talent, equity compensation is a proven motivator and can better align your employees’ interests with the growth of the company.

The rub for you as family business owner is that even though you’d like to offer equity compensation to your non-family key employees, you don’t want to offer them stock and the shareholder rights that go along with it. There are options available for a family business to share the economic value of equity, but not the actual equity itself. Phantom stock plans and stock appreciation rights can be attractive solutions for family businesses looking to share the growth of their company. 

As the name implies, a phantom stock plan awards an employee phantom or hypothetical shares, not actual shares or interests in the company. Because the employee only owns phantom shares, he doesn’t receive all of the rights of a true shareholder such as notices of shareholder meetings, voting rights, or access to books and records.

The plan is a contractual agreement between the employee and the business where the business agrees to pay the employee compensation at some point in the future based on the value and growth of the stock. Generally, in order to receive the additional compensation, the employee must remain employed for a specified period of time as the phantom stock vests.

For example, the business grants 100 shares of phantom stock valued at the time at $200 per share to Joe, creating an account valued at $20,000 (100 units X $200). The agreement states the phantom stock will vest over 10 years at which time the balance of the plan will be paid out to Joe.

In 10 years, because of the hard work of both the family and Joe, the value of the business’s stock has grown to $600 per share. The business will then pay to Joe, usually over a period of years, the value of the account or $60,000 (100 units X $600). Joe will pay income taxes on the amount received when it is paid and the corporation will receive a corresponding deduction. During the 10-year vesting period, some plans may credit Joe’s account with dividends as they are declared for the real shares further aligning Joe’s interest with that of the shareholders. Joe ends up sharing in the growth of the company while the business has retained the true equity ownership within the family. 

Stock appreciation rights, settled in cash rather than shares, are a close-cousin to phantom stock plans, the difference being they provide the right to the monetary equivalent of the increase in the value of shares. Additionally, SARS may have a vesting schedule but not a specified pay-out date and do not offer the option for dividend credits such as phantom stock plans do. 

The good thing about phantom stock and SARS plans is they are very flexible in their design — but with flexibility comes decisions. There are a number of considerations and issues for family business owners to consider when designing and implementing a plan. 

The first and perhaps most important is to decide who to benefit and how much of a benefit to provide. The amount can vary by employee and will depend on a number of factors such the value of the business today, growth expectations, and value the employee brings to the business.

In the example above, the event that triggered the distribution was a fixed term of 10 years. Other common distribution events that can be included on an either/or basis include specified date or age (often tied to retirement), death, permanent disability, voluntary or involuntary termination of employment, or change in control of the company.

The vesting schedules that can be incorporated into these plans provide a strong incentive for the non-family outsider to stick around for the long-term. In addition to these “golden handcuff” provisions, the agreements can also include provisions in which pay-outs are forfeited if the employee violates confidentiality or non-compete clauses during or after employment, for example.

The plan document should spell out how the business will be valued when calculating employee pay-outs. The value can be determined by a formula spelled out within the document or a business valuation. Each employee’s account balance is a liability of the company on its balance sheet as it represents a future obligation to pay. Without advance planning, the company may be strapped for cash in years that require payments. The company may, but is not required to, set aside funds for this future obligation. 

Phantom stock and SARS plans along with other similar types of plans such as non-qualified deferred compensation can be excellent tools to attract and retain key outsider talent in your family business. The plans are flexible and with the help of qualified professionals can be tailored to meet your goals. 

Jeff Nauta, CFA, CFP, CAIA, CDFA, is a principal with Henrickson Nauta Wealth Advisors.

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