The Salary Sage

Conversation with Susan Donker

Three years ago, we introduced a new management compensation program for hospitals that we now call MAP (Management Accountability and Performance). It began in partnership with Memorial Medical Center (MMC) in Modesto, California, a Sutter Health Affiliate. MMC and its visionary CEO (David Benn) and Vice President of Human Resources (Susan Donker) were looking for a better way to motivate and reward their managers. They came to Romanoff Consulting for help. Now that three years have passed, we decided to circle back and ask Susan how things have been going. Here’s what she said.

Q: Why did you decide to develop incentive plans for your organization?

SD: We were frustrated by how managers were being rewarded. In our old system, compensation was not tied to organizational results. By using incentives, we shifted to a program that makes leaders feel more connected and accountable to the organization. They recognize their direct ability to impact the organization’s goals. If they do their job right, they will be rewarded. We eliminated the accepted idea that if you just wait for time to pass and keep breathing, you’ll make more money.

Q: What benefits have these incentive plans brought to your organization?

SD: We have seen a definite improvement in the key measures that are required for all leaders: quality and patient satisfaction. People are paying a whole lot more attention in these areas. These results didn’t change overnight, but over the past three years we’ve seen a significant boost in the two measures that we deem most important to our organization’s success.

Q: What do you appreciate most about the process and logic behind the MAP (Management Accountability and Performance) program?

SD: It drives home the message that salary programs are designed to pay for a person’s worth in the market and incentive plans are designed to pay for their results. An employee’s ability to move through their salary range should be a direct reflection on what kind of a leader they are. Our old program allowed people to move through the range for market adjustments and for performance, even if they failed to meet specific goals.

Q: How has MAP helped you improve your organization’s success?

SD: Having two distinct measurement systems, one focusing on leadership effectiveness and the other on results, allows us to track each critical component separately. We’ve discovered that certain managers who rank very high in leadership don’t produce very good results. We’ve also learned that some of our best results are coming from out least effective leaders. This knowledge enabled us to pinpoint which are managers need to improve and where.

Q: Do you like the plan documents created using the Incentive Plan Builder software?

SD: Yes, the presentation of data is very clear. At the end of the year, we enter the data and verify the results. In addition to generating each manager’s incentive plan, IPB gives us the ability to collect all kinds of data from which we can develop meaningful reports that pinpoint trends.

Q: How do your employees react to these incentive plans?

SD: The majority of employees get it and like the reward system. Good leaders love it. Poor performers tend not to like it because it exposes their weaknesses and withholds dollars they used to get automatically.

Leading Companies Offer New Employee Benefit – Nap Time

 
When you consider the billions of dollars that Americans spend on coffee, caffeinated soda, and energy drinks (Redbull, Monster, Rockstar), one thing comes clear – as a nation we’re either very thirsty or very tired. TV commercials feature droopy-eyed automatons struggling to reach the office vending machine or refrigerator before collapsing from exhaustion. One sip of magic elixir returns color to their face, they puff up like freshly baked bread, and return to work with a bounce in their step, presumably now able to survive the remainder of the day. Yes, we are a tired lot.

Enter the latest weapon in the war on exhaustion – the nap. In an effort to combat the nation-wide epidemic of torpor, companies are turning to a proven solution. Time was when we derided Mexicans for their daily siesta. Perhaps they were on to something all along.

But it’s not all one big joke. Recent studies have attempted to quantify the productivity impact of fatigue and the results are staggering. A study appearing in the January 2007 issue of the Journal of Occupational and Environmental Medicine, official publication of the American College of Occupational and Environmental Medicine (ACOEM), claimed the annual health-related costs of exhaustion exceed $138 billion in lost productivity.

With so much at stake, it might be worth giving the power nap a little more thought. Many companies are doing just that. Below are excerpts from two recent articles about napping in the workplace: Some Companies Encourage Napping at Work to Increase Productivity and Don’t Call After Lunch—I’m Napping.

• MedicalNewsToday.com says that "dozens of small medical studies have shown that napping for about 30 minutes to an hour in the early afternoon increases a person's productivity, alertness and sometimes even their mood.”

• "Still, unsanctioned napping —or to put it more precisely, 'drowsiness' —on the job actually costs U.S. businesses $18 billion a year in lost productivity, according to a recent report in the Minneapolis Star-Tribune."

• “Bloomberg Businessweek reported that companies where employees stay at the office past the typical eight-hour day tend to be more lax about napping at work. Nike, for example, has provided employees with nap-friendly "quiet rooms". These rooms can also be used for meditation. Google has a number of napping pods throughout its Mountain View campus. Airlines, including Continental and British Airways, allow pilots to sleep during long international flights while colleagues take control.”

• “Hearst, Newsweek and Time Warner have all outsourced their employee napping needs to Yelo, a napping spa in midtown Manhattan. The spa offers a "cocoon-like" treatment room where clients can adjust aromatherapy, sound and lighting. A 20-minute nap, which is all you really need to reap the benefits of a midday slumber, costs $15.”

• According to Bloomberg Businessweek, early research has shown that short periods of sleep "improve alertness, memory, motor skills, decision-making and mood".

• Christopher Lindholst, co-founder of MetroNaps, which markets a napping chair called the EnergyPod, said, "Over the last few years, there's been a lot of focus on exercise and nutrition, but adequate sleep is arguably the most important element of productivity."

• “Despite the data, however, The Wall Street Journal pointed out that a 2010 survey by the Society for Human Resource Management found that only 5 percent of employers have on-site napping rooms.”
“While beneficial, napping at work can have some drawbacks. For example, if an employee has been up all night, a midday nap can cause a hangover effect known as "sleep inertia". Napping policies may also pressure employees to stay at the office late into the night.”

Remember Robert Fulghum’s wonderful book All I Ever Really Needed to Know I Learned In Kindergarten? It’s one of the best books about business (and life) ever written. And guess what? It’s right there in black and white – take a nap every afternoon!

I know, it seems a bit comical. Unless, that is, you’re on the plane where the pilot dozes off. While it’s true the vast majority of jobs don’t require that level of alertness, we’ve all experienced moments at work when we just can’t keep our eyes open. I have an overstuffed chair and ottoman in my office for just such moments. You know, all this talk about naps is wearing me out. Hold my calls. I need to shut my eyes for a few minutes.

Salary Freezes Finally Thaw!

After the longest salary slowdown (and reversal) in recent memory, it looks like salaries are once again on the move.

According to results from the 2010-2011 Culpepper Salary Budget & Planning Survey, reported in a recent article on the SHRM website entitled Global Salary Increase Budgets for 2010 and 2011, “Salary budgets for 2011 are projected to continue rising after hitting historic lows in 2009. Projected budgets for 2011, including salary increases, promotional increases and variable incentives, are all higher than 2010. Furthermore, the number of companies reporting salary freezes has declined significantly, and salary reductions have nearly disappeared.”
 
What does this mean for you? Well, like most things, it depends which side of the fence you’re on. What may be great news for employees may be not so great news for businesses who are once again about to see their fixed costs rise. Smart companies learned their lesson during the downturn, and never want to be confronted again with runaway salary costs leading to layoffs and cuts. How can you avoid this? Simple. Rather than starting the long slow progression to higher base salaries, why not shift some of those dollars to variable pay (i.e., incentives)? That way, you can limit your expenditures to only those employees who generate meaningful outcomes that help your business become (or stay) more competitive. But either way, it’s time for you to plan your next move carefully. Read on for more details…

Based on data from 933 organizations in 90 countries, some of the key findings are:

• Salary increases rise. Average global base salary increases across all jobs and locations are projected to jump from 2.59 percent in 2010 to 3.14 percent in 2011.

• Salary freezes continue to thaw. The number of companies freezing salaries is projected to decline sharply from 14 percent in 2010 to 4 percent in 2011.

• Very few companies cutting salaries. Only two-tenths of 1 percent of companies plan to cut salaries in 2011.

• U.S. salary increases. Base salary increases in the United States are projected to rise from 2.38 percent in 2010 to 2.91 percent in 2011.

• Technology, life science and energy sectors lead the way. Base salary increases in technology, life science and energy sectors are projected to outpace other sectors in 2011.

• Salary range structure increases. Average global salary range structure increases across all jobs and locations are projected to rise from 1.41 percent in 2010 to 2.10 percent in 2011.

• Most companies aim to match or lead market pay rates. Nearly 70 percent of companies have a base salary philosophy with an objective to match or lead the market, and they have salaries at or above current market levels.

Be sure to read the full article to view several enlightening graphs and charts on pay trends, base salary increases by region, base salary increases by type of company.

Using "Burden" or "Load" in Commission Calculations

Many companies use a “burden” (or “load”) when calculating sales commissions. The amount of the burden can be critical to both the company and the sales person; the company wishes to cover its costs of doing business, and the sales person desires to earn a reasonable and appropriate commission for their efforts. Currently, there is little data available as to the burden’s size and how it is calculated. I recently conducted a survey designed to shed some light on this issue.

Burden impacts the commission calculation in various ways depending on the nature of the sales job. Below is an example for a billable consultant:

[Consultant Bill Rate minus Consultant Pay Rate = Gross Margin]

[Gross Margin minus Burden = Commissionable Amount]

The burden is considered an off-set for various mandatory and miscellaneous costs incurred by the company in the course of doing business. In California, these costs involve some or all of the following:

CATEGORY	TYPE (1)
FICA -- Federal Social Security & Medicare	M
FUTA -- Federal Unemployment Tax	M
SUTA -- State Unemployment Tax	M
ETT --California Employment Training Tax	M
Workers Compensation	M
401-k	O
Healthcare	O
Corporate E & O Insurance	O
Accounting & Admin Overhead	O
Background Checks	O
City Tax	O
Vendor Charges	O

 

(1) KEY

M – Mandated. These are charges that all California employers are required to pay regardless of whether or not they elect to include them in the burden calculation.

O – Optional. These are charges that many companies incur but some elect not to include in their burden calculation.

Burden Amount

The size of the burden applied by the companies in this survey (Note: this survey was limited to California Companies) to cover mandated expenses ranged from 11.5% to 24.2% depending on whether the employee was a contractor or full-time employees, and whether or not they received healthcare benefits. NOTE: This figure does not include optional charges.

Optional Charges

Optional charges typically fall into the category of recurring and non-recurring. Non-recurring (i.e., one time) charges are normally charged at 100% during the month they occur. Such charges include background checks and one-time vendor fees (i.e., placement fees, hiring bonuses, etc.) Recurring charges (i.e., on-going charges ) such as city taxes are normally charged at 100% of the associated charge whenever they occur (i.e., monthly, quarterly, annual).

SUMMARY

Although this survey included companies of the same size and in the same industry, it was striking how little (if any) consistency existed in the way burdens are calculated (or applied). Some companies charge a considerable burden and some charge none at all. Some reflect every possible charge incurred by the company that could be allocated to the commission calculation; some reflect only a few major charges. Since there is greater consistency in the size of the commission paid to sales people within a particular industry than to the way it is calculated, I suspect that the commission percentage is being adjusted to reflect each company’s method for calculating the burden. In any event, I normally advocate applying some sort of a burden to commission calculations; if only to remind the sales person that the company incurs considerable cost associated with their activities. It is surprising how often sales people forget this and think that they are the entire business and without them nothing would happen. Many companies go so far as to withhold all commission payouts until the sales person has covered their fully-loaded carrying cost (base salary plus benefits plus burden). Depending on the size of the salary, this can either be a very effective cost control measure or it can represent a severe hardship on the sales person. Care must be taken to strike the proper balance.

Tangible Equity vs. Synthetic Equity In Privately Held Companies

It's commonplace for newly hired executives to expect (or request) equity when joining a company. This is true regardless of whether the company is privately held or publicly traded. At one time, such equity was reserved for unique circumstances such as turn-around situations or when attempting to attract a uniquely talented individual who could add special value to the business (e.g., an inventor with a special patent or an executive from a key competitor with unusually valuable contacts or relationships). In such instances, it was easy to see why the new executive should join as a "partner." Over the years, these practices have become commonplace and in all but the smallest businesses it is customary for executive compensation plans to include some form of equity.

In general, I am opposed to granting equity to new executives because I see no need for the owners to give away hard-earned value to someone whose future contribution is uncertain. Remember, on their first day every new employee is considered a star (or they wouldn't have been hired), yet three years later half of them are gone. Others would argue that granting equity to executives ensures that they will have the best interest of owners in mind (since equity makes them an owner themselves). The advisability (or lack thereof) of granting any form of equity to employees is a worthy topic for a future posting, but for now I am going to assume that you have already decided to grant equity and are considering what type of equity to grant.

WHAT'S THE DIFFERENCE?

In general you have two types of equity to consider -- Tangible Equity and Synthetic Equity. Within each are specfic sub-categories.

Tangible Equity (also referred to as Incentive Stock Options ISO or Stock Grants) is actual legal ownership of some portion of the business.

Synthetic Equity (also referred to as Phantom Equity or Stock Appreciation Rights SARs) simulates the cash value of tangible equity but entitles the holder to none of the rights of legal ownership.

When considering which ownership vehicle is right for you, it is helpful to view them separately from the viewpoint of the employee and the employer.

LET'S SIMPLIFY MATTERS

Any Internet search involving tangible equity will reveal a labyrinth of arcane tax treatments and legal considerations. At the end of the day, they are all designed to ensure that the employee and the employer pay their fair share of taxes. This generates an elaborate dance with each party trying to outsmart the others. If half as much energy and intelligence went into trying to increase the value of the business as goes into trying to minimize taxes, so much money would be made that paying taxes would not be inconsequential.

Which brings us to the key issue. With Synthetic Equity all payouts will be taxed as ordinary income (this is not always true, but let's take it as a given since it is true in the vast majority of cases). From the point of view of the employee, this can be viewed as a non-starter. From the point of view of the company, Synthetic Equity payments must be paid out of cash flow and/or retained earnings. Neither of which seem particularly desirable. Let's look at an example.

Consider an executive who has been granted SARs (stock appreciate rights) worth 5% of the business' increase in value over three years. Let's assume the company was valued by an independent appraiser at $20 million on day one. Fast forward ahead three years, and let's say that appraisal values the company at $28 million. The three-year increase in value amounted to $8 million of which the executive holding SARs worth 5% would be due $400,000 (5% of $8 million = $400k). That $400k would be taxable as ordinary income. So the good news is the executive would get around $250k of that after taxes. The bad news from the point of view of the employee is that Uncle Same would get the other $150k. The bad news from the point of view of the company is that they will have to cought up $400k in cash at that point (unless they have negotiated payout terms which is often the case).

Now if this same executive is granted 5% tangible equity in the business, in the scenario described above, there are only three points in time when the executive will ever see any money:

1. When the company is sold.
2. When the executive leaves
3. When the majority owners choose to buy him out.

Unlike Synthetic Equity where the executive usually has access to cash within a specified timeframe, with Tangible Equity the executive cannot count on ever seeing any cash. This is usually considered as desirable from the vantage point of the company since they don't have to come up with any real dollars unless they choose to do so.

Most companies and executives seem to be enamored with the idea of tangible equity. Executive like the idea of "owning something" and companies like the idea of not having to pay anything until it suits them. I look at it differently. I am a huge fan of synthetic equity. From the point of view of the executive, it means real cash in a reasonable timeframe. From the point of view of the employer is it is much simpler to set up, easier to administer, and less costly in the long run considering the legal and accounting fees associated with tangible equity.

THE PERFECT PAY PLAN

In addition to your well designed base salary and annual incentive plans, consider adding SARs to your executive pay plans. They are an excellent tool for simulating ownership and improving focus on increasing the value of the business.

MEASURE OF THE MONTH -- Appointments

DEFINITION

Scheduling, preparing for, attending, and following-up on sales calls.

CALCULATION

This measure involves some or all of the following elements:

1. Identifying the lead.
2. Scheduling the appointment.
3. Preparing for the appointment.
4. Conducting the appointment
5. Following up after the appointment
6. Closing the business

WHEN TO USE THIS MEASURE

Certain types of sales processes lend themselves very well to this measure. These are processes where it has been determined in advance that the sale is a "numbers game;" that is, where a certain number of phone calls generates a certain number of appointments, which leads to a certain number of meetings, which results in a certain number of proposals, which ultimately produces a certain volume of sales. In these situations, it is essential that sales people "make their numbers."

That said, many people, including me, shy away from measures like these, favoring instead measure that focus on the desired outcome (i.e., the sale itself) rather than the steps along the way. In addition, experienced sales people don't appreciate being "micro-managed" and may perceive such measures as demeaning. It is important to recognize that not every sales person approaches the sales process the same way.

That said, there are certain situation where measuring and paying for key sales milestones works well:

1. When you have an inexperienced sales force
2. When you are certain that following a certain process will maximize sales
3. When you have a large and/or geographically diverse sales force making consistency important.

HOW TO USE THIS MEASURE

When you use this measure, remember to:

1. Specify in detail what constitutes a "qualified lead" and only give credit for these leads.
2. Couple process measures (like appointments) with results measures (like closed business) on the incentive plan.
3. Weight the results measure (the sale) higher than the appointment since that is what you are really after.

WHO IS MEASURE BEST SUITED FOR?

This measure is best suited to new or inexperienced sales and/or marketing people as a way to motivate them to follow a particular sales process and to reward them when they successfully achieve certain milestones.

CAN THIS MEASURE BE GAMED?

If you pay for appointments, you will get appointments. But you may not get the type of appointments you really want. We have all heard stories of sales people padding their calendars with friends, neighbors and relatives just to show activity, even though it is not likely to produce business. When using this measure, be certain to define in detail what constitutes a "qualified lead" and only give credit for those leads.

It is also important to make sure that sales people document their appointments and that the sales manager follows up to make sure that not only did the neeting happen, but they happened the way the sales person said they did. You don't want to give credit for an appointment that lasted 5 minutes because the prospect had to leave or one that didn't happen at all because the prospect called to cancel.

I may sound cynical, but these are the kind of issues that come up when you decide to measure the process rather than the outcome. If you use these types of measures, you should be fully aware of the behavior they can create.

EXIT STRATEGIES

In the final of three entries in the recent series on ESOPs, I discussed the merits of one particular type of ESOP, Employee Stock Ownerships plans. This type of ESOP is designed for business owners to sell all or part of their business to their employees. This can be a very effective exit strategy for owners who wish to detach themselves from the business.

This got me thinking about exit strategies in general, so I decided to include additional information. 

What Is An Exit Strategy?

Business owners have dreams. Successfully growing the company is one of them. Building and running a successful business has it’s own rewards; but the real payoff comes when the company has material value in the market place. That’s where an exit strategy comes in. An exit strategy is more than a last minute way to detach oneself from a changing business -- It is a comprehensive plan designed to ensure that the business grows and develops in ways that will help owners achieve their personal, professional, and financial goals.

When Should I Create One?

Most people think an exit strategy is the last thing they do before leaving the company. In truth, by that time, it’s way to late. The savvy CEO develops an exit strategy long before that ‑ perhaps as early as the initial business planning process!

Where to Begin?

A good place to start is with an Owner’ Profile. This involves extensive goal-setting around both the lifestyle the owner hopes to lead, and the type of business s/he wishes to build (and sell) in order to achieve it. Such a profile encourages owners to reflect deeply on their values, beliefs, motivations, and goals regarding current and future wealth. The goal is to examine and identify the elements of the lifestyle owners wish to lead, and the people, organizations, and causes they hold in highest esteem. This will lead to early decisions about how owners spend their time and money, how much money will be required to accomplish their goals, and how they will distribute their wealth to heirs and benefactors. It is true that business plans and exit strategies must change due to economic and technological circumstances, but it is easier to edit than it is to create.

What Comes Next?

Armed with a clear and compelling understanding of where the owner hopes the business will take them, they are equipped to take the steps necessary to make it happen. When it comes to that, I think in terms of the following steps:

1. Market Analysis ‑ This involves studying industry trends, evaluating the economic outlook, and reviewing recent M & A activity.

2. Company Valuation‑ This entails establishing the company’s true value using key variables such as EBITDA. It might also involve paying a professional for an independent valuation.

3. Acquisition Strategy ‑ Key elements of this plan include determining when the company is ready to sell, deciding how and when to contact prospective buyers, and developing the preferred transaction structure.

4. Acquisition Team ‑ This includes gathering all the specialized support necessary to do the deal including accounting, finance, legal, tax, financial planning, and brokerage.

5. Marketing the Company ‑ This involves more than just selling the bottom line: It involves packaging the company in a way that evokes excitement and enthusiasm from prospective buyers.

6. Pre-Qualifying Buyers ‑ Preparing the company for sale is half the battle; the other half is finding the right buyer.

7. Preparing Employees ‑ Preparing employees for change is one of the most frequently mishandled aspects of the sales process. Done right, employees are energized to face the challenges ahead. Mishandled, the company stands to lose its key talent.

8. Negotiating the Sale ‑ When you get to this point, you’re almost there. But this is no place for amateurs. Get good help!

9. Due Diligence ‑ More promising deals fail at this time than at any other. Again, plan well and get good help.

10. Motivating Employees ‑ In most situations, maximizing value depends on keeping employees focused and motivated before, during, and after the sale.

11. After the Sale ‑ Even after the deal is done, there’s still work to do. This is the time for earn-outs, transition strategies, and integrating diverse cultures.

In the end, my message is simple. Don’t wait until the end to develop an exit strategy. Create one early and update it as you go along. This way, you will increase the likelihood that the business will help you fulfill your lifelong dreams.

The Right Leverage Can Move Mountains

In the last entry I addressed how much stretch to build into goals. In this one I take a look at another key element of incentive design, how large should the incentive earning opportunity actually be? Incentive opportunity is also referred to as leverage (because it is normally calculated as a percentage of base salary or salary range midpoint), or dollars at risk (because incentive dollars are not guaranteed. Whichever term you use to refer to it, the table below gives you a rough idea of what would be considered typical leverage for a variety of positions:

(1) Sales positions at this level may have a Target greater than that shown depending on the nature of the sale. Some sales and sales management positions may even have targets as great as 100% of base salary. Click here for more information on setting sales targets.

Check out Incentive Plan Builder for more information on payout targets.

Goal Setting & Probability of Achievement

When designing incentive plans, the question often arises "how hard should it be to reach target?" There are many theories about this, but in general I follow this approach:

I like to set Threshold (i.e., the minimum level of performance below which there is not payout) so that there is 1 in 5 (20%) chance they WON’T be met. This is important. Thresholds should never be set so low that they are virtually guaranteed. When that happens, the company very well might be making payments and getting nothing of value for them. On the other hand, if Thresholds are too difficult to achieve, too many people will fail to reach them and the incentive plan will be perceived as unrealistic resulting in many participants not even trying.

I like to set Targets (i.e., the desired or expected level of performance) so that incentive plan participants have a slightly better than 50/50 chance of hitting them. Am I a “softy?” Maybe, but I prefer to look at it this way – Success breeds success. And I would much rather have people hitting targets more often than not for the confidence that provides. Yes, you may say, but aren’t you giving away money? No, because I always make sure that the company’s return on performance is greater than that of the employee. That way, I can always be sure that the Company is better off having the results than not having them. Yes, you might add, but what if the company would have had the results anyway? To this I would answer, you might get away with that for a while, but eventually employees are going to feel used and undervalued and either leave, or worse yet, their body will keep coming to work but they’ll leave their brain at home.

As for Outstanding, that should be a real stretch. I like 10% because that suggests that one year in 10 someone could reach or exceed them. Said another way, if 10 people are given the same goal one might reach the Outstanding level of achievement. Going beyond Outstanding can be a very good thing for both the employee and the company (provided the goals are set right). This is the stuff myths are made of. When someone goes beyond outstanding, the word gets out and, if you play your cards right, everyone will be imagining it might happen to them. And good things happen when people dream!

In summary, when goals are calibrated correctly, in any given year (or on any given measure), you would have 80% of employees "in the money" by being above Threshold (20% would be below Threshold and earn no payout), 50% to 60% at or above Target, and 10% at or above Outstanding.

Establishing the right probabilities of achievement when setting goals is something of an art form and it can take a few years to get it right. If you keep the probabilities mentioned above in mind and check actual results against them each year, you can fine tune your performance predictions until you reach the right overall levels of achievement.

Check out Incentive Plan Builder for more information on goal setting.

 

 

 

 

 

The ESOP I Love and the ESOP I Hate (Part 3)

And now, for something completely different. . .

The last two blog entries have dealt exclusively with one type of ESOP, the Employee Stock Option Plan. If you have read those entries, you know that I am not a big fan of such plans. In this third and last installment of the three-part series on ESOPs, we are going to look at an entirely different type of ESOP, the Employee Stock Ownership Plan. What a difference a word can make. This type of ESOP, while not appropriate for every company, can be an enormous benefit when all the right pieces fall into place.

A TRUE WIN/WIN

The term win/win is thrown around rather blithely, but in the case of an ESOP it is really quite accurate. An ESOP simultaneously does all of the following:

1. It provides an exit strategy to owners of privately held businesses by using company profits to fund the sale of the business to the employees.
2. It enables employees to acquire ownership in their company without having to invest their own money.
3. It creates a beneficial relationship between the company and federal and state governments by allowing the Company to use pretax profits to fund the buy-out of the owners.
4. It provides significant tax and retirement benefits to the employees after they become owners.
5. It provides continuing tax advantages for the company after the original owners have sold the business to the employees.

That is the essence of an ESOP. Of course, the devil is in the details and ESOPs are usually highly complex to set up and administer. But beyond the near term financial benefits already mentioned, there are a host of other benefits:

1. Because ESOPs are wholly or partially employee-owned, they tend to have a very unique corporate culture that is built around openness, fairness, and egalitarianism.
2. ESOP companies tend to enjoy unusually high productivity that stems from high levels of employee involvement.
3. ESOP companies tend to place high importance on employee education, participatory decision-making, and open communication.

In general, this makes them a lot of fun to work for.

THERE ARE SOME DISADVANTAGES

As I mentioned earlier, ESOPs are not for everyone, and it is important to consider the downside before taking the plunge. Here are a few things to keep in mind:

1. Availability of Financing -- Fortunate are those companies that are able to finance the sale of the company to employees through cash-flow and associated tax benefits. But most often some form of financing is required. If the transaction is financed with a bank loan, the company must have the ability to qualify for this loan. Otherwise the seller may have to give a personal guarantee and/or self-finance the sale.
2. Disclosure -- ESOPs are required by law to produce a considerable amount of paperwork for the government and the employees.
3. Valuation -- ESOPs must secure an independent valuation each year to establish the value of the stock.
4. Liquidity -- In order to fund transactions as employees leave and/or retire, an appropriate amount of cash must be kept on hand to repurchase their stock. This is not normally a problem for the first few years, but it must be carefully managed after that.
5. Fiduciary Liability -- The plan committee members who administer the plan are deemed to be fiduciaries and can be held liable if they knowingly participate in improper transactions.
6. Stock Performance -- If the value of the business does not increase over time, the employees may feel that they would rather have a cash incentive rather than the deferred benefit provided by an ESOP. In the extreme case, if the company goes out of business, employees stand to lose everything in their ESOP account.

THE BOTTOM LINE

Clearly, the brief and simple description of both types of ESOPs reveals the complex nature of these types of pay plans. To sum it up, I would steer clear of Employee Stock Option Plans in favor of annual cash incentives (provided the cash incentives are self funding and the company can afford them). I encourage owners of privately held businesses who seek an exit strategy to look into Employee Stock Ownership Plans as they provide intriguing possibilities

MORE INFORMATION

Check these links for more information on Employee Stock Ownership Plans:

Menke & Associates -- Consulting firm specializing in setting up and administering ESOPs

National Center for Employee Ownership -- National association made up primarily of ESOP organizations

Great Game of Business -- Organization dedicated to disseminating the principles of employee ownership