Incentive options to ‘lock in’ key personnel to grow profit

In our experience, the success of many SMEs rests in the skills, knowledge, experience, and commitment of key personnel. While no person is indispensable, often the departure of an employee in a key management, production or customer-facing role can cause significant challenges, a drop in turnover, and even loss of profit. This is exacerbated if the departing staff member sets up in opposition to their former employer.

Alternatively, ensuring the long-term commitment of key people can be part of a business growth strategy; retaining skills and experience, and incentivising people to contribute to growth by rewarding them for those efforts.

Locking in and incentivising key people may also be part of an owner’s exit strategy; the start of succession planning discussions to take the business into the future.

When asked by business owners for strategies to retain key personnel and safeguard business prosperity, we consider a variety of options to identify the ‘best fit’ for that particular business and importantly, the key personnel in question.

In this article, we explore a number of those options to provide ‘food for thought’ for business owners facing this situation. It’s important to note that there is no ‘one size fits all’ answer. Here are some of the possible options you might consider.

Profit sharing schemes
Profit sharing can be a great way to improve and maintain employee morale, loyalty, and retention; motivating employees to participate in earning and protecting company profits because as part of the scheme, they have a vested interest in doing so.

This opportunity can help focus a business culture on ‘how do we get things done and maximise profits at the same time’. And the vested parties are highly likely to hold other employees accountable to contribute towards profitability.

It is also more straightforward than employee buy in options as it provides the immediacy of a cash in hand payment (taxable), rather than the more abstract ‘on paper’ share options.

The success of a profit sharing scheme lies in the details. The parties agree on the percentage of profit to be shared, and the timing of that measurement. However, it is critical that financial systems are in place to predict and measure true profitability in a simple and easy-to-understand format so that everyone can determine the amounts to be shared.

Deferred bonus schemes
This variation of profit sharing provides pay out in the medium to longer term – again at pre-agreed timing/s. This locks in your key personnel for a pre-determined period, rather than on a shorter annual or bi-annual basis. It could be that a portion of agreed profit share is paid out with the balance deferred into a fund for future access, either as a cash payment or for share purchase.

This option may well suit the situation where a business is being prepared for sale, for instance, locking in a CEO to provide a sustained effort to improve the business performance and profitability over a five-year period, rather than leaving in a shorter period.

Superannuation schemes
Offering a lump sum pay out on retirement of accrued profit sharing is another long-term option. Key personnel need to stay and perform for a certain amount of time before all or portions of the money shared becomes theirs. This approach can be complex due to the legal and tax considerations. Also, KiwiSaver tends to usurp the need for such a scheme. It can, however, be a starting point for a share buy in option.

In both these variations, the benefit to the business is that cash is retained and available to facilitate growth strategies.

Employee buy in options
This approach is more complex than a profit share arrangement and requires work to establish the value of the business and its shares. This work also determines the fairness of shareholder salaries and other benefits and establishes a dividend policy including mechanisms to determine what happens when a shareholder leaves the business i.e. what constitutes a good or bad leaver, and consequently how the leaver’s shares will be treated. Likewise, the mechanism to prevent a ‘hold out’ by a minority shareholder should the majority wish to take a specific course of action i.e. sell the business.

Identifying the tax implications of the considered options for the company and current owner/s is part of the process. (Employees taking up shares will have their own legal and accounting advisors.).

Share options to employees
Share options give employees an option, but not an obligation, to buy shares in the company at some time in the future, at a price agreed now.

When the options are exercised, employees receive the benefit of any increase in value of the shares in the company, but without having to outlay any upfront cash, or taking the risk that the value of the shares might diminish.

When share options are exercised by employees, the difference between the original share option price and market price at the time the options are exercised, is usually taxable income to the employee.

Employee share purchase scheme
This option provides an immediate, upfront cash payment to existing shareholders in return for an agreed number of shares. The employees are usually entitled to dividends, and benefit from any increase in share value over time as the business grows.

New shareholders may borrow interest-free from the company with a tax exemption from FBT (on the interest-free loan), with the annual dividend payment offset against the loan. It is usual that the shareholding cannot be increased until full repayment of the loan is made.

Generally, a dividend is paid to existing shareholders immediately prior to the share allocation to new shareholders. There may also be different classes of shares introduced, with corresponding rights.

Best solution for your business
If maintaining your business’ competitive advantage relies on retention of key personnel, then offering an incentive to stay and perform could be beneficial. There are numerous options available and we can help you work through the pros and cons of these to determine the best fit for your business.

Written by Moore Stephens Markhams Directors, Sam Bassett and Belinda Young.