One question I’m frequently asked by owners considering a high-level hire (President/Integrator/COO) is whether or not equity will be necessary to land an exceptional candidate.
My quick answer is the following: “Except for a few rare circumstances, a real equity package is not a good idea for privately held companies.”
Here's why real equity doesn't work well for either owners or hired executives
Firstly, most private business owners mentally struggle with bestowing a stake in the company to an individual who has not yet created any value in the business. Generally, the owner has worked hard over many years to create whatever value does exist, and giving it away with no guarantee of return seems foolish. Due to this, the discussions and negotiations around the equity package often become difficult with the owner believing the candidate is greedy and entitled, and candidate feeling the owner is cheap and unrealistic.
Secondly, if an equity deal is put together and for some reason the new Integrator/President doesn’t work out, unwinding the equity is always costly and usually ugly. As anyone who has experienced this will tell you, exiting a shareholder is right up there with a root canal.
For the hired Executive, there are also reasons equity is not desirable
Firstly, owners can and do have enormous influence over profitability, company value and share value. For example, an owner can decide to spend frivolously, reducing both profit and the overall “value” of the firm. Secondly, real equity has the potential of going negative, creating not only a loss in stock value but also tax consequences. The kicker in these scenarios is the losses may have very little to do with the Integrator/President’s performance on the job.
Long Term Deferred Compensation Plans
For all these reasons, I am a big proponent of Long Term Deferred Compensation Plans, or Phantom Equity plans for private companies. In my experience, these plans achieve all of the benefits of an equity plan i.e. driving long term growth/performance, without the aforementioned snags of real equity.
Basically, the plans work like this: The hired President/Integrator will be granted cash rewards for the year-over-year value growth created after they join the company. However, this reward will not be paid out yearly, it will be deferred into a fund to be accessed upon a targeted date or event.
For example, if the company is worth $15M today and after a year on the job, the Integrator/President has grown the company value to $16M, he/she will be awarded a designated % of $1M. This % is determined when the plan is designed, but for sake of example let’s say it’s 6%. Therefore, the award after year one is $60,000. This $60K is then set aside in an account with a vesting schedule attached. Again, this can be customized for your situation but typical plans have a 5-7 year vest with no access to cash for at least 3-5 years. This incentivizes the new Integrator/President to drive long term growth and also locks them in with “golden handcuffs.”
Conversely, if the Integrator/President drives zero value growth in a particular year, no contribution is made. In essence this is a fail-safe plan for the owner; if the new President/Integrator makes money for me, I’ll share some. If not, there’s no obligation.
Assuming the Integrator/President does their job well, they walk away at some point (retirement, sale of the company, etc.) with a substantial chunk of cash. They are also spared from the possibility of losing money because of an owner who drives the stock price down. The contribution to their plan can never be less than zero and money earned is always there.
We have found these plans to be incredibly effective and about 80% of the clients we serve utilize some form of phantom equity to attract great candidates and incentivize growth.
KeyStone Search Can Help
If you have questions about LTDC Plans (Phantom Equity Plans) give us a call anytime (612-375-8900). We’re glad to share what we know and connect you with experts who build and administer these plans for companies across the country.
If you'd like a free consultation, email us at email@example.com