Building a Deferred Compensation Plan to Drive Business Objectives

By Tom Ovendale, Principle, and Bob Gruber, Founder, The Rainier Group. Deferred compensation can be a valuable tool in helping CEOs accomplish their employee retention and incentive objectives. Retirement plans, pension plans, and stock-option plans can all aid in making employment opportunities attractive for recruiting. Unfortunately, many deferred compensation plans fail to deliver the desired results both for the company and for their participants. The success or failure of a deferred compensation plan is usually determined at the beginning. This includes the proper assessment of plan objectives and the plan’s design to meet those objectives. Properly defining the core issues often drives whether that plan will be a success or a failure.

Definition of Plan Objectives

There are many reasons to put a deferred compensation plan in place. They usually boil down to one or several of the following:

• Provide incentive for key employees to grow the company
• Retain key employees
• Attract outside talent with a compelling benefit plan
• Have key employees act and make decisions like owners
• Groom select individuals to become future owners
• Reward employees for past service
• Provide a retirement benefit
• Reward key employees for the eventual sale of the company and retain them through that sale
• Timing of the objective (short, mid, or long-term)

While it’s tempting to develop a plan to address all these objectives, it’s usually best to focus on a small subset. Trying to develop a plan that is all things to all people is a common path to plan failure.

Meeting Objectives Through Plan Design

Once a set of objectives is defined, it’s time to decide what type of plan might best fit. This choice will be heavily dependent on meeting objectives.

• Deferred Bonus Plans
• Phantom Stock
• Stock Appreciation Rights
• Profits Interest (LLC)
• Profit Participation
• Stock Options (Non-qualified)

Example 1:

Company A has several employees with critical skills in a very competitive employment environment. The company wishes to dissuade these key employees from leaving for other offers. A secondary objective is to incentivize company growth. These objectives suggest certain characteristics that the plan should have:

• Significant unvested benefit from day one from which the employee must walk away if they go elsewhere
• A plan tied to the value of the company

A mid-term Phantom Stock plan might best fit the circumstances. Participants would have an immediate unvested benefit, which they would forfeit at their departure. There is also incentive for them to grow the company since their eventual benefit and the company’s value tie together.

Example 2:

Company B is interested in providing incentive for key employees to grow the company. A secondary objective is to tie them to the company long term.

• The plan should reward growth before other objectives
• Immediate benefit is less important
• Employees should vest in the benefit slowly to enhance retention

These factors suggest a long-term Stock Appreciation Rights plan might be appropriate. Participants would start with no accrued benefit. But, they would receive a percentage of the increase in company value from the point of grant. The participants would vest into full ownership of the benefit over the term of the SAR grants, providing a retention incentive.

Plan Design Considerations

Once the type of plan is selected, there are many details to be considered. The objectives will inform each detail:

• When do benefits get paid (maturity date)
• Over what period of time are benefits paid
• Vesting period and speed of vesting
• What happens if the participant voluntarily terminates
• What happens if the company terminates the participant (for cause, not for cause)
• What happens if the participant dies or becomes disabled
• What happens if an employee retires
• How are participants treated at the sale of the company
• How is the value of the company determined and can it be changed
• Amending and freezing the plan

Companies, owners, and participants can receive meaningful benefits from properly designed deferred compensation plans, but there is significant complexity. CEO’s must rely on consultants and attorneys who travel this road with frequency. For legal guidance, contact the Equinox attorney team at 425-250-0205 or contact@equinoxbusinesslaw.com.

Legal Disclaimer: This article contains general information. Do not view this article as legal advice. Talk with counsel familiar with your unique business needs before taking or refraining from any action.