The heart of every successful business—particularly any growing business—is its leadership. Often, the clear leader is the owner or entrepreneur who founded the company.
Joe founded Success Co. and, over the years, built a management team to help lead it. Each member of the team is responsible for some significant aspect of the company. One member has already been assigned by Joe to take over the business’ day-to-day operating problems/decisions when Joe retires.
Then it happens: One of the key members of the management team, Sam, gives notice. He’s leaving to go work for a competitor. Ouch!
Sam had not been looking to leave but was recruited by a headhunter. A key guy on a well-working management team—gone. Worse yet, Sam, who knows all of Success Co.’s secrets and strategies, now becomes a competitor trained by the company.
You can’t stop the headhunters from hunting, but there is a strategy you can use to entice the Sams in your organization from jumping ship.
Mimic ownership. Give such valuable employees the same challenges as an owner and, when successful in meeting those challenges, the rewards of ownership. Our experience has taught us that top non-owner executives want four core benefits of ownership: 1) a piece of the action (a share of company profits), 2) to get paid when they are sick or become disabled, 3) to receive adequate retirement pay when it’s time to leave the company and 4) death benefits for
Over the years, we have created hundreds of contracts that attract and keep the kind of key people you want in your organization. The technical name for such a contract is a “non-qualified deferred compensation agreement”; the non-technical name is a “golden handcuff agreement.”
Let’s take a closer look at each of 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 profits grow. For example, perhaps an employee like Sam will get 4 percent of all the company’s before-tax profits beyond the first $200,000 per year. He will also receive 6 percent of profits over the $400,000 threshold. Say the amount Sam earns for year one under such a plan is $21,000. He may get about one-third ($7,000) in cash, and the balance ($14,000) is deferred and invested for his later benefit. This “side fund” of deferred money and the accumulated earnings will be available when Sam becomes disabled, reaches retirement age or dies. It usually is paid out in equal annual installments (say, over 10 years). If the side fund contains $500,000 by the time Sam can collect on it, he will receive 10 payments of $50,000 per year, plus the additional investment earnings for that year.
2. Disability. The employee gets paid when he becomes sick or disabled—whether for a day or for the rest of his life. Typically, this benefit is covered by long-term disability insurance. It is essential that the “disability” be very specifically defined in your agreement, the same as it is defined in the disability insurance contract.
3. Retirement. The side fund described above supplements any regular retirement program such as 401(k) or profit-sharing plan. Typically, the executive is allowed to direct the investment of the side fund, which, until paid out to him, remains an asset of the employer.
What are the tax consequences of such an 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 the company for any reason other than disability, retirement or death, the entire side fund is forfeited and remains the property of the company. Hence, the name “golden handcuffs.”
4. Death benefits. When an owner dies, the family can sell the business, assuming it has not already been transferred to his children. A similar death benefit can be given to the employee and should be insurance-funded.
We have been setting up these non-qualified plans for years. Done right, they work wonders. Often, when an owner does not have family members to pass his business to, the side fund can serve as a down payment by one or more of the business’ key employees to buy the company from the owner.
This article does not attempt to cover every detail and the endless variations for tailoring a perfect agreement for your company and the key people you want to include in it. Always work with an experienced advisor. Years of experience have shown us that the right agreement will make good employees even better. Sadly, however, there is no agreement we have ever seen that will make a bad employee even a little bit better.