Cory C. Grant, J.D.
Chairman & Managing Partner, Grant, Hinkle & Jacobs, Inc.
David H. Crean, Ph.D.
Managing Director, Objective Capital Partners
Acquisitions of a business are often driven by the target company’s strong earnings, efficient operations, intellectual property, core capabilities and workforce, and strong synergies with the buyer and their business. Transitioning the ownership of a business is a significant undertaking that requires help from key employees of the target’s team. Much literature has been written by others regarding the retention of key staff affecting the overall success of most M&A deals. Key employees drive customer retention, product and service quality levels, and in some cases business survival.
The reality and risks of losing key employees during the process of a sale poses a real threat that could disrupt the business after the transaction and fail to meet expectations on value. Remember that what gives a business value is the expectation of future earnings, adjusted for risk. As you reduce risk for buyers, business value and probable selling price go up. From a buyer perspective, the cost of acquiring a business is more than just the purchase price. Human capital management can make a transaction successful, or it can destroy value and even break a deal.
Sellers and prospective buyers need to address this important issue prior to a transaction and head-on during the due diligence and negotiation process. It’s easy for sellers and buyers to get wrapped up with issues revolving around purchase price, indemnification and other aspects of the transaction. However, ignoring key employees completely before and during the process is to the detriment of both parties.
How can you ensure staff retention during and after the sale?
A plan is needed to mitigate this risk. Targeting retention measures at the right people using a tailored mix of financial and non-financial incentives is crucial for managing organizational transitions that achieve long-term business success; it’s also likely to save money. One such way to target retention of key employees is using non-qualified plans.
Limitations of qualified plans
Retirement plans are a common way for businesses to attract and retain all types of employees.
Most business owners and employees have participated in a qualified retirement plan, such as a 401(k). Contributions by the employer and/or employee are tax-deductible, but distributions are fully taxable as income.
The Employee Retirement Income Security Act (ERISA) provides a level of asset protection for qualified plans but also requires participation that is open to virtually every full-time employee at the company, and detailed plan reporting.
More importantly, qualified plan limitations and caps often do not allow for the level of financial incentives needed to keep an executive who is accustomed to a certain standard of living from exploring more lucrative opportunities elsewhere.
A discriminating solution
Many business owners do not realize that there is a way to provide the necessary benefits to their key employees for retention purposes, without having to include rank-and-file staff.
A non-qualified retirement plan is a tax-deferred, employer-funded retirement plan that falls outside of ERISA guidelines. Non-qualified plans are designed to meet specialized retirement needs for key executives and other select employees.
Non-qualified plans emerged because of the cap on contributions to qualified plans. High-income earners are unable to contribute the same proportional amounts to their qualified retirement plan as rank-and-file income earners. Non-qualified plans are a way for high-income earners to defer current income tax and enjoy tax-deferred investment growth until they retire. These plans are also exempt from the onerous reporting and discrimination testing that qualified plans are subject to.
Employer contributions to non-qualified plans are not tax-deductible, but employees are permitted to defer taxes until retirement, when they are presumably in a lower tax bracket. Non-qualified plans can still be designed to maximize flexibly and provide tax-efficiency, especially when tax-favored life insurance is used as a funding mechanism.
Non-qualified plan structures
There are several varieties of non-qualified plans, but they are all, in essence, individual legal agreements that promise to pay a benefit to an employee at a date in the future, after certain conditions are met. Conditions may depend upon the nature of the position. For example, to trigger a benefit, a CFO may be required to stay five years beyond a business transition or a salesperson may need to increase sales every year for the next ten years. If the executive leaves or fails to meet required conditions, the employer can retain and/or redirect the benefits. That’s why non-qualified plans can be such an attractive tool to incentivize key people to stay and perform.
Benefit payments are flexible, but agreements are typically structured to provide the participant with a defined stream of retirement income annually for a period of years.
Funding non-qualified plans
Once a benefit is triggered, it will put too much stress on the company to support payments from cash flow alone, so it is critical that the employer begin setting aside assets now to meet future retirement and other benefit obligations.
Although employers can fund non-qualified plans with just about any type of asset, 75% of Fortune 1000 companies utilize Corporate Owned Life Insurance (COLI) to fund their supplemental executive retirement obligations, as well as 43 of the top 50 bank and thrift institutions in the U.S. This is because life insurance is by far the most cost-effective and tax-efficient funding option, and unique in that it provides an economic benefit at just the right time in every situation.
COLI policies are owned by the employer and insure the lives of one or more employees. They can be used for a variety of purposes that may or may not bear any relation to the anticipated actual financial loss to the employer upon the death of the covered employees.
If the participant performs, a retirement benefit is paid from the policy cash value, which grows tax-deferred. The cash value can be accessed tax-free by taking policy loans or withdrawals up to basis. If the participant dies, a death benefit is paid to the company tax-free, and perhaps a portion to the participant’s family (can be tax-free if arranged properly).
The legal fees for drafting non-qualified plan documents and the life insurance premiums associated with funding are minuscule compared to the value created by retaining key people. Suppose that after 25 years of owning and growing your business, you are ready to sell and retire. Your key employee, Emily, has a high-level security clearance required for your company to bid on certain lucrative government contracts. A buyer will not offer you nearly as much for your company if Emily leaves, which will impact your ability to retire comfortably.
Before you start entertaining offers, you enter into a non-qualified arrangement with Emily that requires her to keep her security clearances current and stay on for at least ten years after a sale of the company. In exchange, she will receive a $100,000 benefit each year from ages 60 to 85, as well as a $500,000 pre-retirement death benefit for her family. This is a generous benefit that will make any desire to depart a very difficult decision.
Your company owns and pays the premiums on a permanent policy insuring Emily’s life for “key-person” purposes. The cash value is earmarked as a source of Emily’s future retirement benefit. When she retires, the company (under new ownership) uses tax-fee loans and withdrawals from the cash value to pay the $100,000 promised annual benefit. These plan distributions are taxable to Emily and tax-deductible to the company.
If Emily passes away in the meantime, the company will receive a tax-free death benefit to compensate for lost revenue and find a replacement. Your company agrees to provide $500,000 of the death benefit (a small fraction of the total) to Emily’s family, which can be tax-free if she recognizes a small amount of additional income tax each year.
Should she fail to meet the requirements, Emily does not receive a benefit and the company can do what it wishes with the life insurance policy, including keep it, sell it, borrow against it, cancel it, or use the cash value for a different participant. This structure offers far more flexibility and retention power compared to a one-time “retention bonus,” plus the opportunity for the company to recover all of its costs over time.
Retaining key people can be an effective way to grow the value of your business and increase the chance that a buyer will pay top-dollar. Non-qualified plans can help you accomplish this without your having to include rank-and-file employees and with minimal reporting. Flexibility and tax-efficiency can be maintained by using permanent life insurance as a funding vehicle.
These arrangements are more appropriately viewed as “transaction insurance.” The range of outcomes in sale transactions can be very wide. Motivated employees are an additional attraction for a purchaser and if concerns about the retention of staff are addressed by the seller and buyer, the risk of transaction failure falls dramatically and a premium valuation becomes more likely.
Planning ahead pays off. Arrangements made to realize the value in a business can be quite complicated, particularly when the goal is to secure the greatest value upon its sale. It is important for the owners of a business to take the time to properly implement arrangements well before they intend to sell it. In the long run, dealing effectively with key employees can help owners maximize the company’s value.
The more time you have to prepare and make the recommended changes to the business, including installing non-qualified plans to retain your key people, the higher the price it will fetch. Once you begin to even consider a transition, your first step should be to contact a reputable broker who can analyze your business and advise you on ways to prepare it for sale and increase its value, before it is put on the market. If you wish to learn more, please contact either author of this article at firstname.lastname@example.org or email@example.com.