BONUS PLAN AS A SUCCESSION PLANNING TOOL
For many private companies succession planning amounts to bringing into the business one of the founder’s children who has the apparent interest in the business or commercial ability to take up a managerial role in the company. The “chosen one” has the dubious benefit of assisting in the development of the business in the hope of receiving shares in the business, a profit share or a part of the sale price in the event of a trade sale.
For founders who have no children, or none who are interested in the business, succession is problematic. In there cases a trade sale process (essentially sale to a competitor, junior partner or other industry participant) is the usual mechanism available to the proprietor to gain some payback for the toil in establishing and working in the business.
One option that could be used by these businesses lacking a successor (BLS’s) is to create a bonus plan which could be structured to allow unrelated up and coming management with some of the benefits of ownership.
Traditionally these types of arrangements have been styled as “shadowed equity” because they seek to mirror or shadow the benefits of equity participation but fall short of an issue of shares or other contractual entitlement to participate in the benefits of ownership.
Some features of a bonus plan arrangement that might be
adopted by BLS’s is as follows:
- Establish a base line. This is the earnings level and related equity value estimate, which has been established by the founder. The level is typically calculated by reference to an agreed maintainable earnings estimate.
The founder would work with their commercial advisers as to what constitutes an appropriate stand-alone equity value in the firm to be used in this bonus plan.
The aim is to develop an earnings base and related equity value that can be seen by participating executives as attributable to the founder and that is a reasonable base line.
- Establish two bonus pools underlying the bonus plan – an earnings bonus pool and a growth bonus pool.
- The earnings bonus pool represents an agreed annual bonus payment (in addition to the participating executives annual salary) paid out in the event that the BLS earnings exceeds the base line (being the founder-attributed earnings).
- A payment from the growth bonus pool is made to participating executives in the event of a change in control of the business or other defined event such as a trade sale (100% sale of the business equity or assets).
Again a percentage payment over and above the agreed base line equity value would be made to participating employees from this bonus pool. The payment for this bonus pool might be seen as being akin to a long service leave entitlement.
The foregoing plan needs to be properly documented in executive service agreements. Transparent processes such as monthly management meetings where monthly and year-to-date financial performance is discussed need to be established so the executives are made aware of how firm performance is tracking and what if any their bonus pool entitlement is.
The key features of this bonus pool are for BLS’s and the key non-associated executives participating in the bonus scheme include:
- no issue of shares or other equity interests and thereby avoiding the creation of minority equity stakes;
- no requirements to fund the acquisition on equity for value in the firm created by the founders and granted to the key staff or executives.
- staff only participate in earnings growth or business value growth achieved over and above agreed base lines;
- tax deductibility of earnings and possibly growth bonus payments;
- bonus eligibility for staff only exists if employment status is maintained.
Obviously both commercial, taxation and legal advice needs to be obtained by clients to ensure that the bonus scheme can meet their specific objectives.
Prepared by:
James Taylor
First City Corporate