FAMILY OWNED BUSINESSES: How to Compensate the Non-Family Executive

How to Compensate the Non-Family Executive Who Wants an Equity Share in the Enterprise

The last few decades have seen a significant growth in the number of mid-market family-owned or other non-public companies. As these companies increase in size, or the founders head for retirement, they often have to bring in non-family executives to hold high-level positions. Increasingly, these executives, being intimately involved in the financial success of the companies by which they are employed, desire to participate in the increase in value they helped create. Thus, they often turn to the family-member owners and request equity interests in the companies.

Most often, this puts the family owners in quite a quandary. For a number of reasons, they are usually loath to granting equity interests to non-family members. These reasons include:

For purely emotional reasons a desire to keep ownership of the company exclusive to themselves and to their progeny.

A desire not to spread ownership beyond family members because the interests of the non-family executives often clash with those of the family.

A desire not to have to deal with the legal rights of minority stockholders (and, accordingly, not to have to establish complicated stockholders’ agreements).

A desire not to have to spend significant money to obtain a valuation of company stock for grant / redemption purposes.

A desire not to make confidential financial information, such as the amounts earned by the family members, available to the non-family members (as may be required in the case of LLCs and similar business entities).

Lastly, a desire not to be put into the position of having to redeem company stock when sufficient cash may not be available (such as the time of the termination of employment of the non-family executive) or, in the alternative, have to deal with non-family owners who no longer work for the company.

Nevertheless, the owners of the company are often quite aware of the value the non-family executives bring to the table and, accordingly, want to satisfy their requests. Caught between two competing interests, they are often at a loss as to what to do.

This is where sophisticated planning and design can be of great assistance to the family owners by constructing “Enhanced Phantom Stock” interests that go a long way to assuaging the desires of the non-family executives while keeping real ownership of the company solely within the family groups. This “Enhance Phantom Stock” is a mix of short and long-term cash incentive plans that have the look and feel of basic equity interests.

First, there is the short-term (annual to tri-annual) incentive component that is intended to replace dividends and other similar distributions. However, in stark contrast to actual dividends, these incentive payments are subject to vesting and also are made only upon the attainment of specified financial targets and goals. At the beginning of each bonus period, the company and the non-family executive will agree to a set of goals and targets to be met during the period. For example, they may identify three goals, such as gross revenue, net profits and market penetration and assign targets such as $X gross revenue, $Y net profits and Z% additional market penetration for the year. If, at the end of the year, these goals and targets are just met, the executive will receive his target bonus, usually defined as a percentage of salary. If the targets are exceeded, the bonus will increase, up to a maximum percentage. If the targets are not met the bonus will be reduced until a specific floor is reached (such as 70% of target), below which no bonus will be paid. For many of my clients, I have included a “negative bonus” structure if actual performance is significantly below target. Not only will no current bonus be paid at year end, as a result of a negative bonus, the bonus for the following period, if any, will be reduced by a specified amount.

The beauty of this type of incentive program is in its flexibility. At the beginning of each bonus period, different goals, targets and bonus levels can be chosen which meet the current business interests of the family owners and which take into account current financial realities. The non-family executive can be handsomely compensated under such a program; however, if the goals and targets are carefully structured, the family owners will always come out ahead of the game even after the bonus is paid to the executive.

The other component of “Enhanced Phantom Stock” is the general type of Phantom Stock described in Section 8 of the Topic on “Incentive Plans – Equity, Phantom Stock, LTIPs and Profits Interests.”

In summary, Enhanced Phantom Stock can be designed to pay the executive for superior financial performance. The executive can be highly compensated, but only upon events that result in a superior return to the family owners. This gives owners the best of all worlds, retention of actual ownership within the family ranks and payment to the executive only upon a net-positive return to the company. At the same time, it goes a long way to satisfying the non-family executive’s desire to participate in the profits and growth in value of the company. As a result, all parties are comfortable and a significant thorn of contention is removed from the employer-executive relationship.

Other Important Design Considerations:

· Phantom Stock / Phantom Units should be expressed as a target number of “notional shares/units” and not as a percentage of the proceeds from a sale of the company or its assets or as a straight dollar amount. Expressing the benefit as a number of notional shares/units will subject the participants to the same dilution as will the owners in the event of a new investment in the company.

· A Phantom Stock / Phantom Unit program can be designed so that it only pays out upon a change in control of the company. It can also be drafted to require that the participants must be actively employed by the company on the date of the change in control and only if they have been employed by the company for a certain period of time.

· A generous employer can provide for a formula-based payment upon certain terminations of employment (such as due to death, disability or termination without cause) prior to the change in control and the payments can be structured to be made over time and in such a manner so that they will not cause the company to incur a “cash crunch.” These individuals will not participate in the program upon a subsequent change in control.

· The plan can be drafted so that the target number of notional shares/units can be adjusted up or down based upon the sales price derived from the owners/company from the change in control.