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 problems: "How do I keep my top people?" and "How do I attract new quality people?"
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 that 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 could not raise the 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 reconfirmed the original answers. The top (non-owner) people 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 its time to leave the company; (4) and a death benefit for their family. Over the years we have created hundreds of contracts (the technical name is a nonqualified deferred compensation agreement; the non-technical name is a golden handcuff agreement) that attract and keep the kind of people you want in your organization.
Here's a closer look at each of the four benefits:
A piece of the action. Typically, this is a percentage of the yearly profits in excess of specific dollar amounts. Often, the percentage grows as the business and profits grow. For example, Sam Eager will get 3% of all before-tax profits in excess of $200,000 and up to $300,000; 5% from $300,000 to $400,000; and 7% from $400,000 to $500,000. Profits in excess of $500,000 will be entitled to 10%. Say the amount earned by Sam for year one (or any subsequent year) is $24,000. Usually, Sam will get about one-third ($8,000) in cash and the balance ($16,000) is deferred. The deferred portion is invested for Sam's benefit. When does Sam get the deferred portion and the accumulated earnings on this portion (usually called the side fund)? When he becomes disabled, dies, or reaches retirement age (usually set around 58 for younger key employees, 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.
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" is defined "word for word" in your agreement the same as the word is defined in the disability insurance contract.
Retirement. The side fund supplements any regular retirement program (such as a 401(k) or profit-sharing plan). Typically, the employee is allowed to direct the investment of the side fund, which remains an asset of the employer.
Following 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 "golden handcuffs."
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.