Business owners have at their disposal a variety of employee incentive compensation tools to attract and retain talent. In terms of employee incentive plan design, business owners work to strike a balance between “carrots”–rewards to employees–and “sticks”–measures to protect the company’s downside if the employee fails to deliver value.
What should a properly-designed employee incentive plan do? Generally speaking, a well-crafted employee incentive plan will incentivize key employees to drive value and build the company; and in exchange be rewarded with a “piece of the pie” when the company is sold.
Unfortunately, many employee incentive plans are not drafted as strategically as they should be. And, when an employee incentive plan is flawed, one likely and unhappy outcome is that one or more key employees “get paid” but the company and its owners still own the company.
Let’s look at how such a thing could happen. For example, the owners of “Company X” put an incentive plan in place. The plan provides for the “awards of units” to key employees and these units translate into a fictitious right to a specified percentage of the value of Company X. The plan also provides that once a key employee has “vested” to (as in, earned) the units by virtue of the key employee’s years of service with Company X, the key employee can exercise the units.
Importantly, the plan does not limit the exercise of the units to a sale of the company or any other triggering event. In other words, the key employee has the right to convert the units to their cash value even though a sale is not even on the horizon, and then depart from Company X. Worse yet, the plan does not specify that a pay-out in this situation be paid out over time. Company X therefore must pay the key employee all cash right then and there.
This early cash-out and departure is just one example of how an incentive plan that is not drafted with careful thought can result in unintended, adverse financial consequences to the company and its owners.
For that reason, when designing employee incentive plans, business owners need to carefully consider what goals and objectives they want to achieve and make sure the provisions in the plan will advance their cause. Otherwise, the plan might contain unintentional “trap doors” that allow key employees to be enriched prematurely at the expense of the company’s owners.