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Prepare To Exit

Exiting a business with financial success takes knowledge and planning.

Change is an inevitable aspect of every life cycle. With business, the final evolution can take a variety of forms. You may be ready to retire and pass the business on to a family member. Perhaps your goal is to sell to outside investors and use the proceeds as a retirement nest egg. Or the business may have declined so much that the best exit is a legal dissolution of your company. These tools and resources will help you manage the big decisions ahead for a successful transition.

How to retain key employees during the transition

Alvin Fritschle

By Alvin Fritschle

Alvin Fritschle is the Chairman of the Board of First Bank, a community bank serving Southeastern Illinois and Southwestern Indiana. He has provided financial advice to numerous entrepreneurs for over 40 years as a certified public accountant and the President of First Bank. Over this time, he has demonstrated a strong commitment to assisting his clients with their strategic decisions.

Transition in ownership of a company creates a period of instability for its employees. While they may be happy for your ability to move on to the next chapter in your life, they do not know what the impact of this change will have on their life. Will the new owner keep all of the current employees? Will there be changes in pay and benefits? What will the changes in culture be?

Since they do not know what their future with the company will be as a result of the transition in ownership, they will be much more susceptible to competitors recruiting them to join their teams. In fact, competitors will actively be recruiting them during the transition period. This is especially true of non-owner management and key sales people. The loss of these key employees can negatively impact the value of the company and limit the number of potential buyers.

To keep these key employees and ’rainmakers’, many companies will offer generous financial incentives for them to stay through the transition. While these incentive packages are an important part of retaining key employees, financial incentives by themselves are an ineffective way to retain these key people.

Communication is critical to success

Ultimately, what is most important to all employees is clarity about their future. Are they going to have a job once the transition is completed? What changes will impact them? If these key employees are involved in this process, they are more likely to know what their future holds and are more likely to stick with the business owner or their heirs. For some companies, this process will not only look at ownership succession but also management succession. These key employees who will be needed to train the next generation of management must feel that they will be rewarded for their efforts.

For ownership and management transitions to be successful, timely and frequent communication with these key employees needs to become a management priority.

To promote understanding of everyone’s expectations, we recommend that the business owner have an executive team meeting to discuss expectations early in the exit planning process. For most people, this discussion is uncomfortable because they are not accustomed to dealing with the expectations of others.

Before the executive team meeting, we recommend that the business owner sit down with each of the key employees separately. In these individual meetings the business owner can explain his goals and expectations and the need to consider the expectations of everyone in the company. Each key employee will have the opportunity to explain his or her concerns about a future role in the company and future retirement plans that may also become a part of the discussion. All of these discussions should be open and honest.

During these meetings, the business owner should take detailed notes to compile each key employee’s concerns and expectations.

Defining who is a key employee

Too often, CEOs only look to executive officers and top sales people for incentives to remain through the transition period. Unfortunately, this is not the most efficient or beneficial approach to assigning incentives. Management consultants will tell you that there are two primary factors to consider when determining who will get financial incentives to remain with your company through the transition.

First, have Human Resources meet with the managers to identify those employees whose departure would have the greatest impact upon the company. This list will generally include over 30% of the employees and will likely include sales support staff who have frequent contact with clients and employees with institutional knowledge of the company who are critical to keep the company running on a day-to-day basis such as IT, high level accounts receivable clerks and some administrative personnel.

Once this comprehensive list is completed, HR and the managers can begin to group the employees based on their critical roles and importance during the transition period. This usually cuts the list to under 10% of the total number of employees.

Second, evaluate the probability that identified employees would consider leaving given the opportunity. In all likelihood, some of these key players have no intention of leaving and a smaller incentive will suffice. The key to transition incentive plans is to tailor the plans to the needs and aspiration of these critical employees.

It may be that direct financial incentives are not the most important to the key employee. Relocation expenses, assistance with a spouse’s change in employment and educational benefits to train for a new profession may be more important to the key employee than a cash bonus.

Financial incentive for employee retention

There are numerous types of financial incentives to get employees to remain during a transition period.

Bonuses

The most common type of incentive to keep employees during the transition period is cash bonuses. Generally, these bonuses are paid out upon the transaction closing. If agreed to with the new management, some bonuses may be payable one-third at the closing of the transaction and the remaining two-thirds payable six months to a year after the transaction closes.

Incentive stock options

Another financial incentive that is used to incent key employees to stay over a longer period of time is incentive stock options. This type of incentive allows the key employee to purchase stock in the company in the future at a pre-determined price. The price is generally set at the fair market value of the stock today and allows them to purchase the stock at some point in the future, five years as an example. If the company does well over the five years, they will be able to purchase the stock a discount. If the key employee holds the stock for a minimum of two years, they will get the tax advantage of a capital gains tax rate.

If the company is closely held and the owners wish to maintain tight control of the company, the stock can be non-voting and the employee can be required to sell the stock back to the company when they leave.

Phantom stock

An alternative to the stock incentive plan is the phantom stock incentive plan. In this incentive plan, the employee is given stock appreciation rights to a specific number of shares. While the employee does not own any stock, they will participate in the appreciation of the stock if the company does well. This is the equivalent of an accrued bonus over a period of years.

The disadvantages of this plan are that the income is ordinary income to the key employee, and they are treated as a general unsecured credit should the company have financial difficulties.

Non-qualified pension plan (supplemental executive retirement plan)

Non-family executives are often put in a no-win situation when the family business is being passed from one generation to the next. These key executives may have worked for the company for 30 or more years and making more money with the company than they could elsewhere. They are expected to help train the next generation of family executives, and this can create a very difficult situation for the non-family executive. If they do a great job at mentoring the next generation of leadership, they may find themselves not needed as the new executives gain confidence.

Retirement for these individuals is not that far away and this transition can create a great deal of anxiety for these key executives. An effective way to alleviate these concerns is to give the non-family executive a Supplemental Executive Retirement Plan (SERP). To get the tax-favored treatment of most retirement plans, you must treat all employees the same. The SERP does not get tax-favored treatment and the company can give the benefit to only selected employees.

The most common type of SERP is called a Top-Hat Plan. In this plan the key employee receives enhanced retirement benefits of a salary continuation for a specified number of years. As an example, the non-family executive would receive $25,000 per year for 15 years upon their retirement after training the next generation of family executives.

The disadvantage of this plan is that the employee benefit is considered an accrued bonus and is a general creditor of the company. This type of plan is often funded by a whole life insurance policy on the key employee’s life with the benefit payable to the company.

In summary

A well-executed management succession plan requires the company’s owners, HR, and key executives to be in agreement on what is important in designing the financial incentives for key employees to stay through the transition.

The key to the success of the plan is one-on-one communication to put together incentives that are important to each key employee that align with the company’s goals. Ultimately, what is really important to these key employees may cost less than large bonuses.

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