We’ve recently discussed how next-level management teams are the drivers behind building business value. But how can owners and their advisors attract and keep next-level management teams throughout the owner’s Exit Planning process? The answer lies within incentive plans.
Successful incentive plans motivate members of a management team to measurably increase the value of a company. If incentive plans fail to motivate management to increase value, they aren’t worth the trouble or expense to the owners who create them. Because an owner’s advisors typically do the heavy lifting in creating successful incentive plans, advisors must know how to create them properly. How do Exit Planning Advisors bake success into the incentive plans they help their clients create?
We suggest that incentive plans should reward management only if business value or cash flow increases by a predetermined amount each year. These plans should incorporate four basic elements:
- Performance standards that are tied to increasing the value/cash flow of the business necessary to meet the owner’s exit goals
- Specific standards
- Substantial incentives
- Golden handcuffs that keep employees committed to the incentive plan
Let’s look at each of these elements in more detail.
Next-level managers or key employees should earn incentive bonuses only when they achieve a performance standard that increases the value/cash flow of the business. The rate or amount of the increase must be directly tied to the growth rate needed to achieve an owner’s exit goals by the target departure date. This rate/amount of increase will vary depending on an owner’s goals. To establish that rate, advisors should consider asking the CFO or the company’s CPA to create a cash flow model.
This requirement differs from ordinary bonus structures found in most non-qualified deferred compensation plans or cash bonus plans for one big reason:
The performance standard, when met, measurably increases business value. Since buyers (especially those of service companies) typically use valuation formulas based on a multiple of cash flow or EBITDA, using a performance standard or benchmark based on increasing cash flow is both simple and tied directly to what the business must do—increase its cash flow.
Key employees and managers must know in advance which standards they need to meet to receive the incentive each year. Without knowing the standards prior to pursuing them, it’s next to impossible for employees and managers to meet them. That’s why Exit Planning Advisors and their Advisor Teams put incentive plans in writing. Writing the plan down and presenting it in written form keeps everyone on the same page and working toward the same goals.
To motivate key employees and managers, the potential incentive must be substantial. In the past, owners and advisors typically used 10% of a key employee’s annual compensation (in stock or cash) to motivate that key employee. Today, that minimum is likely closer to 25% (or more) of annual compensation.
Advisors must remind owners that they will pay this substantial amount only if employees attain the performance standard set in the incentive plan. Employees make more money only as cash flow, EBITDA, or other benchmarks are achieved each year.
When creating incentive plans, we often talk about “golden handcuffs.” This phrase means that the incentive plan must motivate key employees to stay with their employers in the short term and, more importantly, after the owner leaves. To handcuff employees in the longer term, advisors can use vesting schedules if the performance award is cash and forfeiture provisions if the award is in stock.
In a prior post, fictional owner Carl Foley learned that he had to close a gap of $4 million in seven years if he wanted to achieve his goals. Using those two parameters ($4 million and seven years), Carl and his advisor, Larry Spelling, created a growth plan that incorporated several strategies to strengthen Carl’s company’s Value Drivers and increase cash flow at the rate necessary to close the gap in seven years. As cash flow increased, the incentive portion of Carl’s plan rewarded management for its successful performance.
No Single Advisor Builds Successful Incentive Plans Alone
When many advisors learn what it takes to create a successful incentive plan in the context of Exit Planning, they think, “Designing incentive plans is too far outside of my expertise and beyond my comfort level,” or “I have no time or desire to learn all this.” And those advisors are typically right: No single advisor can effectively tackle incentive planning alone. But a team of advisors coordinated by a trained and experienced Exit Planning Advisor can.
Working Together With Other Experts
We’ve found that each profession or advisor usually has a favorite tool or technique for motivating and retaining the all-important management team. By working together, they can combine different designs, tools, and experiences and choose best possible tool/design for each client. For example, when Exit Planning Advisors begin planning work with their clients, they draw upon the following people:
- CPAs knowledgeable in using financial metrics and other evaluative tools
- Business consultants with both general and specific knowledge (e.g., compensation specialists, marketing consultants)
- Attorneys with expertise in designing incentive plans for management
- Financial planners and insurance professionals whose funding solutions help owners set their financial goals and calculate investments return rates
Depending on an owner’s objectives and the key employees’ motivations for ownership or cash, Advisor Teams can consider a host of designs and tools, including the following:
- Non-Qualified Deferred Compensation plans with incentive-based benefit formulas
- Stock Appreciation Rights plans
- Phantom Stock plans
- Cash bonuses (current and deferred)
- Stock bonus plans
- Stock option plans
- Stock purchase plans with or without minority discounts
A Job for Outsiders
Growing an entrepreneurial business requires owners to consult people about basic decisions and who can contribute informed ideas. Peter Drucker believed that those people are rarely found inside a company and instead are outsiders who constantly work to make certain that they meet a business’ growth needs. This is where advisors are important.
While advisors aren’t part of the final management team, advisors do help owners find and retain next-level management teams. To find and retain that next-level management, advisors need to work with the right network of professionals, both to sniff out next-level managers and to create incentive plans that keep them with the company after the owner exits.
Creating long-term relationships with advisors from other professions can be challenging without the right tools and strategies. But once advisors start developing long-term relationships with experienced advisors and successful business owners in the Exit Planning context, they often find that they gain more work, more referrals, and a more rewarding advisor experience.
- Incentive plans must build business value to a point that enables owners to achieve their exit goals. If they don’t, they’re a waste.
- Successful incentive plans only provide a benefit (e.g., ownership or cash) to key employees/management if business growth meets predetermined benchmarks.
- Proper incentive plan design requires advisors from multiple professional disciplines.
- Advisors must draw upon the experience of other advisors to recommend the most appropriate incentive plan for each business owner.