WHY IT IS IMPORTANT TO MOTIVATE MANAGEMENT EMPLOYEES
Attracting and retaining key employees is necessary to the success of any corporation. This factor is even more important in an ESOP company, since the number of beneficial owners in an ESOP company is much greater than in a non-ESOP company.
The most effective way to motivate management employees is to give them a piece of the action. Management employees are accustomed to getting a substantial piece of the action whenever a management buyout is involved. Accordingly, it is sometimes important that management receive a piece of the action in the case of ESOP buyouts.
Under IRS regulations, the “covered compensation” of a key employee is limited to $205,000. In addition, the “covered compensation” of the key management group in most companies is less than 5% of the total covered compensation of all employees. Since the key management group receives a limited portion of the equity participation under the ESOP, it is sometimes important to provide for additional equity participation for management outside of the terms of the ESOP.
WHAT TYPE OF PLAN SHOULD BE USED?
Direct Purchase Plans
Under a direct purchase plan, the management employees are allowed to purchase as much stock as possible directly from current shareholders, utilizing their own accumulated savings or funds that have been loaned to them by the company. The disadvantage of this approach is that the key management group is seldom able to purchase a significant equity interest under these conditions and it requires purchasing the stock using after-tax dollars.
Qualified Stock Options
Under a qualified stock option plan, key management employees are given an option to purchase stock at the current fair market value. The advantage of this approach is that the employee does not have to purchase the stock unless and until the value of the stock appreciates over the current fair market value. The disadvantage of this approach is that the employee must still come up with a substantial sum of money when he or she exercises the option.
Nonqualified Stock Options
Under a nonqualified stock option, the employee may be given an option to purchase stock of the company at a substantial discount from the current fair market value. The discount can be as little or as large as the company desires. However, unless the stock options are restricted under the terms of §83 of the Internal Revenue Code, the employee will be immediately taxed upon the difference between the exercise price and the current fair market value. Another disadvantage of this approach is that if the option price is meaningful, then the employee may still have difficulty coming up with the necessary funds when he or she desires to exercise the options.
Phantom Stock Plans
Under a “phantom” stock plan, the key employee is issued a given quantity of “phantom” shares from time to time. Later, when the employee dies, retires or terminates, the employee will be given a bonus equal to the then-fair market value of the accumulated phantom shares. The disadvantage of this approach is that the employee does not have the feeling of tangible ownership. His stock ownership is not “funded.” He does not enjoy the usual benefits of ownership, such as voting rights and other such rights that are enjoyed by shareholders of record.
Management Stock Bonus Plans
Under a Management Stock Bonus Plan (“MSB Plan”), management employees are issued stock from year to year, in the discretion of the company’s Board of Directors, based upon the attainment of performance goals established by the Board. Under an MSB Plan, the employee does not have to “purchase” the stock. Rather, the stock is issued in consideration for the attainment of performance goals. In order to prevent the employee from being taxed currently on the value of the stock that is granted to him or her, it is necessary that this stock be issued subject to the restrictions of §83 of the Internal Revenue Code. If the stock is properly restricted, there will be no current taxation to the employee. Rather, the taxation to the employee will be deferred until a future date when the restrictions are removed. Because of its flexibility, we believe that the MSB Plan is the best way to motivate the key management employees to increase the total valuation of the company through increases in the company’s earnings.
The number of shares issued each year under the MSB Plan will, of course, gradually dilute the number of shares held by the ESOP. However, we believe that the dilution is warranted to the extent in that it creates an incentive for management to increase the total value of the company over and above the amount, if any, that results in the mere pay down of loan principal, and over and above the amount of increase that is attributable to the current inflation rate.
What are the advantages of a Management Stock Bonus Plan?
From the standpoint of the company, the advantage of an MSB Plan is that it enables the company to condition the issuance of the shares upon the attainment of performance goals. From the standpoint of the key employees, the advantage of an MSB Plan is that the MSB Plan enables key employees to acquire significant ownership without the expenditure of personal funds. In addition, the taxation of the plan benefit is deferred until a future date w hen the restrictions are removed.
What are the disadvantages of a Management Stock Bonus Plan?
One disadvantage of an MSB Plan to the company is that the company does not receive any immediate tax deduction for the shares that are issued under the MSB Plan. On the other hand, the company will receive a tax deduction at a future date when the restrictions are removed and the plan benefit becomes taxable to the employee. A disadvantage to the employee is that the employee will be taxed on the fair market value of the shares at the time that the restrictions are removed. Thus, all of the appreciation, which occurs prior to the date that the restrictions are removed, will be taxed as ordinary income rather than as capital gains.
There can also be additional disadvantages from the company’s point view. From an accounting and tax standpoint, the company must report the fair market value of the shares as “compensation expenses” even though the restrictions have not been removed. This compensation expense will normally be charged to earnings over the relevant period of employment. As long as the company remains privately held, this treatment will not pose a problem. If, however, the company intends to go public, then the ongoing “compensation expense” will have an adverse effect on reported earnings per share. Accordingly, if the company contemplates that it will go public in the future, then we would recommend that the company utilize a qualified or non-qualified stock option plan rather than an MSB Plan.
How many shares should be granted under the management stock bonus plan?
The company must be careful that the number of shares issued under the MSB Plan from year to year does not result in excessive dilution to the ESOP or to the other shareholders of the company.
The following are the steps that the company’s Board of Directors should follow in determining the appropriate number of shares to be issued under the MSB Plan in any given year.
1. The first step is to determine the overall targeted ownership percentage that is to be issued under the terms of the Plan.
The objective of the MSB Plan is to enable the key management group to obtain the same degree of ownership under an ESOP buyout that they would obtain under a management buyout. In the case of 100% management buyouts of mid-market companies (companies having a market value of $20,000,000 or more), it is not uncommon that the (earned) management ownership is as high as 15 %. In the case of smaller companies (companies having a market value of less than $20,000,000), the management ownership percentage may be as high as 20%.
In general, the ownership percentage that is targeted for the management group should be roughly proportional to the ownership percentage that is held by the ESOP. Thus, for example, if the ESOP acquires only 30% ownership, the total ownership that is targeted for the management group should be limited to 4.5% (in the case of a 15% total management target).
2. As a second step, the company’s Board of Directors should determine the time frame during which the stock will be issued to the key management group. As a rule, the shares that are purchased by the ESOP will be allocated over a period of five to ten years. Accordingly, it is also reasonable to issue shares under the MSB Plan over a period of five to ten years.
3. The next step is for the Board of Directors to make a determination at the end of each fiscal year as to the total number of bonus shares that are to be issued for that given year. The following steps should be taken by the Board of Directors in this regard:
A. The Board should obtain a copy of the ESOP appraisal reports as of the prior year end and as of the most recent fiscal year end.
B. Based upon the appraisal reports, the Board should determine the total increase in the value of the company that has occurred during the current fiscal year. Thus, if the company had 100,000 shares outstanding as of the last fiscal year end, and the shares were valued at $100 per share, the total valuation of the company as of the last year end would be $10,000,000. If these same shares are now valued at $110 per share, the total valuation of the company would now be $11,000,000, and the valuation increase would be $1,000,000.
C. As a next step, the Board should request the ESOP appraiser to determine how much, if any, of this valuation increase was attributable to the pay down of loan principal. Under most valuation approaches, the valuation is determined by using a multiple of earnings or a multiple of earnings capacity. Accordingly, the pay down of principal will have little or no impact upon the valuation. If, however, the appraiser uses a discounted cash flow method of valuation, or a method of valuation in which the company’s outstanding indebtedness is subtracted from the debt-free enterprise value, then a portion of the valuation increase will be attributable to the pay down of loan principal. In this event, the valuation increase which results from the pay down of loan principal should be subtracted from the amount that is eligible for the Management Stock Bonus. Thus, for example, if $100,000 of the valuation increase is attributable to the pay down of loan principal, then the amount eligible for the Management Stock Bonus would be $900,000 rather than $1,000,000.
D. As a next step, the Board of Directors should determine the then-current inflation rate. This determination should be made on a year-by-year basis since the inflation rate will vary from year to year. Again, the purpose of this calculation is to determine the amount of the valuation increase that is eligible for the Management Stock Bonus.
Thus, if the Board of Directors determines that the inflation rate in a given year is 3%, then the valuation increase that is attributable to inflation would be $300,000, (3% of total fair market value) and this amount would be excluded from the amount eligible for the Management Stock Bonus. Thus, in the example given above, if the total valuation of the company increased by $1,000,000 in a given year, and if $300,000 of this amount is attributable to the inflation rate, and if $100,000 of this increase is attributable to the pay down of loan principal, the net amount of valuation increase that would be eligible for the Management Stock Bonus would be $600,000.
E. As a next step, the amount of the annual increase that is eligible for the Management Stock Bonus should be multiplied by the percentage rate that is to be bonused to the management group. This percentage rate can be any percentage rate selected by the Board, provided, however, that the percentage rate should never exceed 25%. Thus, for example, if the Board selects a bonus rate of 25%, the net effect is to give management a dollar amount of stock equal to 25% of the increase in the valuation that results over and above the current inflation rate and over and above the amount that results from the pay down of loan principal. In this instance, 25% of $600,000 would result in the Board awarding $150,000 worth of stock under the terms of the MSB Plan. Assuming a total valuation of $11,000,000, this would represent 1.4% ownership. Assuming that this calculation produced similar results in each of the following years, the management group would own 14% of the company after a period of ten years.
Of course, in some years the management group may receive no shares whatsoever, while in other years they may receive greater amounts. We would recommend, however, that an overall limit should be placed on amount of stock granted in any given year, i.e., no more than 5% of the outstanding stock of the company should be issued under the MSB Plan in any given year.
4. Once the total dollar value of the bonus is determined in any given year, this amount should be divided by the per share price in order to determine the total number of shares to be issued as of that date.
5. Once the total number of bonus shares has been determined as of a given fiscal year end, then the Board of Directors should allocate these shares among the respective key management employees. This can be handled in two different ways. Under the first approach, the Board of Directors would allocate the number of shares among the key employees on a totally discretionary basis. In the alternative, the Board of Directors could make an initial determination as to the percentage of the bonus shares that each key employee would be given each year. If this approach is taken, however, the Board must be careful to reserve the discretion to change the percentages over time, as new key employees are hired and as former key employees retire or terminate.
In any event, once the determination has been made as to the number of shares to be issued to each participant, then each recipient should be notified as to the number of shares that have been granted to him for that year.
The above-described procedures are designed to assure complete equality of treatment of ESOP participants relative to the key management group. Thus, the above-described procedures tie the amount of the annual management stock bonus to an exact percentage of the actual increase in the valuation over and above the inflation rate. For some companies, this procedure may be too exacting and difficult to follow. In such cases, the company may want to utilize the following alternative procedure. The alternative procedure is simpler and easier to administer. However, the alternative procedure does not assure that the dilution rate will be uniform from year to year.
Under the alternative procedure, the steps would be as follows:
1. The Board should determine the total number of shares to be issued over the term of the Plan, as described above.
2. Each year the management group should submit a budget, which is acceptable to management and to the Board.
3. At the end of the year, the Board should determine if the company has met its budget with respect to the projected pretax income and/or the projected cash flow. If the projections have been met, then the Board should award a total number of bonus shares ranging from 1% up to a maximum of 5% of the total shares outstanding, with the exact amount depending upon whether the company has substantially met the performance targets or has exceeded the performance targets. Please note, however, that the value of the shares granted for any given year should not exceed 25% of the total increase in the company valuation for that year. As mentioned above, under this approach, the management bonus shares will not be directly correlated with the actual valuation increase, since the shares will be based upon the attainment of the budget, rather than upon the attainment of a specific valuation increase. Nevertheless, attainment of the budget will normally result in a corresponding increase in the total valuation of the company. In the final analysis, the proper design and implementation of a management incentive program is an art, not a science. Accordingly, the Board of Directors should exercise its discretion and good judgment whenever necessary in order to assure a fair and equitable result for all parties concerned. By the same token, the Board of Directors must be mindful of its fiduciary obligations to the ESOP. In discharging its fiduciary obligations, the Board should be advised to base the award of all stock bonuses upon the attainment of performance objectives. In addition, the Board should be careful to avoid overly diluting the ownership interest of the ESOP in any given year.