Keeping qualified employees - particularly top performers - is a problem faced daily in the TMT- industry, especially when companies merge and/or restructure to seize strategic opportunities. Losing key employees may create a risk for business continuity and lead to the loss of knowledge/intellectual capital and of client relationships.
In the worst case the business will not survive if key employees leave instead of adapting to the new owners and management. Therefore, a retention plan is ''key'' to identify, retain and reward these employees. The purpose of such plan is to connect the dots between performance and results, providing a means to create and sustain long-term engagement. The main questions are: which possibilities of retention are provided and which ones are the most suitable under what circumstances and conditions?
Retention: Short-term incentive compensation
In one way or the other, financial remuneration is required to retain key employees. It is however important to design it appropriately and use it in a targeted way. In case of an acquisition, a retention bonus can be agreed. The amount of money that is earmarked for employee retention is generally considered part of 'the costs of the deal'. Timing of the retention offer and date(s) of payment are important. For example, 30% of the retention bonus might be paid to key employees even before the deal is closed, with the remaining 70% to be paid out a year later - dependent on the results of the acquired company. Companies do forget however that once the bonus is paid, employees may be more inclined to consider other employment opportunities. The payment of retention bonuses is in fact a short-term solution to retain key employees, but a retention bonus alone will not create long-term engagement. Key employees in such situation in general expect to receive a compensation package consisting of salary, bonus and long-term incentive compensation.
Retention: Long-term incentive compensation
Long-term incentives are better suited for creating long-term engagement. Also, it offers a good window for start- and scale-ups that compete with larger, well-capitalized companies to attract and retain top staff. For those companies it is a challenge to compete with mature companies in the area of incentive compensation due to lack of liquidity, difficulty in valuing equity, and concerns about loss of control. Equity based compensation can equally provide a means for middle staged and larger, well-capitalized companies to attract and retain the talent that will drive company innovation and growth without loss of control.
There are many types of compensation plans and differing tax, legal and accounting issues that should be considered when reviewing each. A full discussion of the issues is beyond the scope of this article, but three common plan types are summarized below:
Restricted Stock Units (RSU's)
A RSU-plan transfers RSU's to employees subject to certain restrictions. The RSU's are transferred to the employee at no cost, with the exception of wage tax obligations, but are subject to forfeiture if the employee fails to fulfil the terms of the plan. A common restriction requires employees to remain with their employer for a particular length of time, often three or five years. RSU's can be advantageous for companies in early stages of development whose stocks have little value, but are expected to go up. The benefit of the company is that they can reward key employees with equity ownership for their past effort or in anticipation of future services, without paying a financial remuneration at hand. In general, if the RSU's are transferred the RSU's come with voting rights and other benefits for the employee immediately, because the employee actually owns the RSU's as from the moment the RSU's are granted. However, under Dutch law it is possible to receive RSU's without giving the employee voting rights. The plan can be structured so that the employee receives RSU's with all the benefits, but without voting rights. It should be noted that if the RSU's are granted - and the employee owns the RSU's as from that moment -, the employee might consider to leave the company. To downsize that risk it is preferable to adopt a ''clawback'' in the deed of transfer of the RSU's, so that if the employee leaves within a particular length of time he must transfer the RSU's back to the employer.
Example: 100 shares of restricted stocks are granted to a key employee. A share of the companies’ common stock is worth €10 on date of grant. Therefore, the employee has received stocks worth €1,000 on the date of grant. If the stock value increases in five years to €20 per share, then the employee has received €2,000 in value. If the stock decreases to a value of €5 per share, the employee has received value of €500.
Stock Option Plan
Stock options can provide employees additional compensation through the opportunity to share in the appreciation of the companies’ stock value. The stock options are issued with a grant date. The grant date is the date at which the employee is given the stock options. The grant date is also the date at which the stock options are valued. The grant price is the price at which an employee can buy the (underlying) shares. A certain period of time must pass before the employee can buy the shares. At the date of grant and during the vesting period, the employee is not required to invest any capital and thus has no significant downside risk if the company stock declines in value before the option is exercised. There is great upside potential for increases in value so this type of plan is a useful tool to motivate key employees through the vesting period. A stock option is useful for companies in the middle stage of development, which may or may not stay private. Stock options provide the right to the increase in value of a designated number of shares. When a stock option is exercised, the company usually pays the employee cash equal to the stock's appreciation, but the employee could also decide to buy the shares.
Example: the employee receives a stock option to 100 shares. A share of the companies’ common stock is worth €10 on the grant date. Therefore, the employee has received stock options worth €1,000 on the grant date. If the stock value increases to €20 per share at the moment the option can be exercised, then the employee can decide to buy the shares for €1,000 (grant price) and receive an amount of €2,000 (market value). The employee can also request for the difference in value between the grant price (€10) and the exercise price (€20 per share). If the stock decreases to a value of €5 per share, the employee will most likely not buy the shares for €1,000 (grant price) if he will receive an amount of €500 (market value).
Phantom Stock Plan
A phantom stock plan is an employee benefit plan that gives key employees many of the benefits of stock ownership without actually giving them any company stock. This is sometimes referred to as shadow stock, because it is a contractual right that mirrors real equity. Phantom stocks are purely a bonus issued at regular intervals based on the performance of the related company share price.
Example: A key employee is entitled to receive every 2 years a bonus equal to an agreed percentage ofthe increase in the equity value of the company. Another option can be to pay the employee an amount equal to the value of a fixed number of shares set at the time the promise is made to the employee.
The challenge to retain key employees in order to remain competitive has prompted many companies to adopt additional financial remuneration methods. In summary, companies can choose to offer a real equity (actual shares or stock options in the company) or phantom equity (a contractual right which mirrors real equity). In doing so, companies should also take their sizes (start-up, middle staged or larger, well-capitalized company), their financial viability and the tax and accounting consequences into account.