Growing Your Business

Strategies to Incentivize and Retain Key Employees and Managers

Strategies to Incentivize and Retain Key Employees and Managers

Small business owners want to feel confident about their ability to keep their key employees and managers happy, but the traditional way to incentivize work may leave some owners feeling uneasy. Many companies still find that offering monetary rewards is easier than trying to meet the intrinsic values held by their employees, but this method may not always create the increased engagement levels they want to see in their employees.

Fortunately, several creative incentive compensation strategies exist to help align employee and manager performance and engagement with an owner’s long-term growth objectives for the business, including phantom stock, stock appreciation rights, and non-qualified deferred compensation. These strategies help to drive a key employee’s extrinsic motivation to perform at higher levels in his or her job function.

Intrinsic vs Extrinsic Motivation

To truly understand what motivates employees, owners need to know what makes their people tick. Different rewards are appropriate for different tasks and purposes. It takes work to understand which rewards and motivators are best. Extrinsic motivation includes a drive that is produced based directly on a reward or punishment system.

  • Studying hard to get a good grade
  • Driving under the speed limit to avoid a ticket
  • Doing chores to earn an allowance
  • Showing up on time to practice so you don’t have to run extra laps
  • Reworking an essay to win a contest scholarship

These are all examples of behavior that is driven by a desire to achieve a reward or avoid a punishment. Intrinsic motivation involves a personal drive in which a person engages in behavior for their own sake.

  • Participating in an extracurricular activity (sports, drama club, etc.) because you personally enjoy the activity.
  • Enjoying personally chosen hobbies, such as gardening, crafting, building and renovating.
  • Playing a game because it is fun or entertaining.
  • Spending time with friends or family to grow and develop an enjoyable relationship.
  • Volunteering simply to help other people or important causes that are important to you.

These represent clear examples of how a person’s behavior is motivated by an internal drive to participate.

Intrinsic motivation is found within, while external motivation is created from the outside of the individual. Studies have shown that excessive external rewards can reduce intrinsic motivation by over justifying the activity. Children that were rewarded for playing with a toy they already enjoyed, for example, were likely to become less interested in that toy after an unnecessary extrinsic reward was introduced. On the other hand, extrinsic rewards can be helpful to motivate behavior or participation in something that the individual has no initial interest in doing. Extrinsic rewards can also be used to help individuals find motivation to acquire new skills or knowledge, which in turn can create intrinsic motivation for individuals to pursue new activities with their newly learned skills.

On the other hand, research has also shown that intrinsic motivators can be used to help employees reach greater engagement levels at work. Ivey Business Journal reported four intrinsic rewards for employees:

  • Meaningfulness: Over and over, surveys have shown how much employees value their own purpose in the workplace. Employees want to feel they are accomplishing something valuable and that their work will matter in the larger scheme of things. This makes their path a path worthy of their time and energy.
  • Choice: Autonomy is important to many employees as well. As people age into adults, gaining personal responsibility and space is important – this does not change in the workplace! Companies can encourage their employees to take ownership and increase engagement by affording them room and respect in their duties.
  • Competence: Many employees that leave a job express a lack of training as a major part of the problem. Employees do not like to feel as though they are incompetent or will fall short of expectations. Better training, clear expectations and a defined path of upward mobility are the kind of intrinsic motivators that can make top-notch employees feel satisfaction, pride and confidence in their abilities.
  • Progress: Not only do employees need to know they matter in the big picture – they need to see where the big picture is headed. Giving employees a real sense of direction will help them get on board. Employees are able to see how the company vision is on track and they can rest confident in the choices they have made moving forward.

Common Incentive Compensation Strategies That Help Drive Extrinsic Motivation

Keeping highly important, key employees or managers on staff and satisfied is extremely important to a business’ success.

While designing a compensation strategy that compliments a company’s corporate culture and is mindful of an employee’s intrinsic motivation can be valuable, determining the right incentive compensation strategy to drive a key employee or manager’s extrinsic motivation to perform at high levels in his or her job function can be beneficial to both the employee and the company.

There are many incentive compensation strategies available to help align an employee’s performance with an owner’s long-term growth objectives for the business. Let’s explore three that are more commonly and successfully used.

Phantom Stock

Companies that offer stock are able to promise their employees that they will receive either the equivalent of the value of stock shares, or the equivalent of an increase in the value of shares from one period of time to another. This is known as phantom stock, and it provides a company a way to keep an employee in place for a specific period of time.

To understand this using a specific example, when a new employee has been hired they can be offered the opportunity to earn a phantom stock bonus that is equal to the amount that the company’s stock value goes up over a period of time–say, a five-year period for this example. Another variable would be to establish a specific number of company shares at the time of the employee’s hire as a benchmark, then to pay the value of those shares when the identified period of time (i.e., five years in this example) has gone by. There are many different ways that this type of offer can be made, but all achieve the same thing – they keep employees loyal and in place for a minimum amount of time by offering a bonus.

From a tax perspective, the phantom stock is taxed when the bonus is distributed, in the same way that cash would be taxed. As long as these bonuses don’t cover an expansive number of employees, phantom stock is not tax qualified in the way that a 401(k) benefit would need to be, which means that an employer can be selective or strategic in deciding which key employees or managers to include in the plan. If a phantom stock offer does extend to a broad group of employees, then the employer may end up needing to comply with additional rules (i.e., 409A, ERISA).

Stock Appreciation Rights (SARs)

When a company offers an employee stock appreciation rights, they are promising payment of the value of an increase in (or appreciation of) a specific number of company shares over a defined period of time.

The bonus can be paid in two different ways: either in cash or in actual shares of stock. If an employee has been paid in shares, then once they are fully vested they can be cashed out at will. In some cases, companies offer what is known as tandem stock appreciation rights, which provides either ISO or NSO stock options to their employee at the same time that they provide stock appreciation rights. In doing so they provide the employee with the ability to purchase options more easily, as well as the funds that may be needed to pay taxes that are due when their stocks are exercised.

If you are giving consideration to offering your valued employees stock appreciation rights, be aware that there are many design options, so there are a lot of decisions that need to be made. These decisions include establishing rules about vesting, determine what amount will be offered and who will be eligible to receive the bonuses, addressing concerns about liquidity, and whether ownership of stock will bestow the right to participate in corporate governance where applicable. You’ll also need to determine whether you are going to impose restrictions on employees’ ability to sell shares and the rights to interim distributions of earnings.

Nonqualified Deferred Compensation

It is possible to offer employees the ability to defer payment of some of their income to a future date when they are no longer in the company’s employ. These plans are called non-qualified deferred compensation, and they provide for payments to be made to the employee upon their retirement, death, disability, or separation from the company. 

These plans need to be carefully structured to ensure that no income taxes are assessed until the time that the employees actually receive the payment. One of the more common non-qualified deferred compensation arrangements for key employees or managers is called a “Supplemental Executive Retirement Plan,” since it is designed to provide supplemental retirement benefits, outside of an employer’s 401(k) or qualified retirement plan. 

Tax Issues

When an employee is provided with either SARs or phantom stocks, the tax implications kick in when they receive the bonus, which can be deferred due to vesting or other restrictions. The award’s value is considered ordinary income to the employee. For the employer, the bonus is deductible when paid. In cases when the bonus is provided via shares, taxes are based on the date that the shares are exercised, regardless of whether they are sold immediately or not. For those employees who decide to retain their shares, the shares may be eligible for capital gains tax treatment if the shares gain in value. 

When providing nonqualified deferred compensation to employees or managers, companies must be mindful of four different essential principals: the economic benefit doctrine, IRC 83, IRC 409A, and the constructive receipt doctrine. Properly structured plans will ensure that the deferred income will not be taxed until the compensation is disbursed.

If you are considering offering any of these types of plans to key employees or managers, it is important that you have a complete understanding of all of the legal, tax, and financial ramifications and regulations. Seek counsel from an experienced professional who can ensure that you are structuring the plans appropriately.

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Richard Watson III

Richard Watson III

Richard Watson III is a tax attorney based in Santa Ana, CA. Watson Tax Law Group, APC is a specialized tax law firm, representing high net worth individuals, families and businesses in virtually every industry, focusing on business and real estate transactions and Internal Revenue Service (IRS) and Franchise Tax Board (FTB) audit, collection, appeal, and tax controversy representation. Richard is an Enrolled Agent, a Certified Financial Planner, a Chartered Life Underwriter,a chartered Financial Consultant and has a Master of Law in taxation. His firm services all of Orange County and Los Angeles.

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