Publications

Minimizing Key Employee Defections

How to Hold on to the Young and the Restless

The Problem

The most valuable asset of any employer is its key, young employees. Many companies have become much more aggressive in their efforts to recruit key employees from competing firms. Young, competent managers and professionals are frequent, and willing, targets.

The direct and indirect costs of losing such an employee can be devastating: you lose the benefit of the time invested in training the employee; the employee may take clients and other employees when he or she leaves you; the employee may take a wealth of tangible and intangible information to your competition; and you must then invest the time and money necessary to find and train a replacement employee.

The solution is, obviously, much more complicated than giving valuable, young employees what they want; there is only so much of what they want to go around. This is a very difficult and sensitive area and, as much as anything else, determines the ability of a company to survive in a competitive market.

Why Do Young Employees Leave?

Young, ambitious employees leave their employers even when there is no compensation issue or other obvious source of discontent. Why do such employees consider, and often seek, competitive offers?

• The "I'm just a cog in a wheel" lament. The employee does not feel connected to the firm and has no emotional stake in its success. The firm is nothing more than a place at which the employee logs time and makes money. There will be little separation anxiety in seeing if the grass is greener elsewhere;
• The "I'm not getting any younger" fear. The employee perceives no clear or predictable path to future advancement, the assumption of responsibility and/or accession to ownership status. He or she is afraid of being left behind, and of not advancing at a proper rate along a desired career path;

• The "its not what you know, its who you know" complaint. The employee believes that advancement decisions will depend less on merit than on politics, family ties, personal relationships, etc. The employee wants to "get somewhere" and is fearful that hard work and good results may not be enough;
• The "I've got to find out if I can do this myself" challenge. The employee is impatient about trying his or her own wings at decision-making and management, is willing to have some aspect of compensation tied to performance, and will leave for such an opportunity.

Why Do Young Employees Stay?

It is not easy to convince ambitious, talented, young employees that the devil they know is better than the devil they don't know. Studies indicate that three, key factors, which must be provided in tandem, make the difference, and must form the cornerstone of a firm's efforts to retain valuable, young, key employees:

Participation in management

Ownership (or the functional equivalent)

An attainable future that is worth waiting for

Providing Participation in Management

Allowing young employees input into certain decisions and/or involvement in the management of certain business functions gives them an emotional stake in the firm and a feeling that they have some control over their destiny. The challenge, however, is to avoid creating the expectation (and subsequent disappointment) that they are entitled to run the business. A program of this nature has the added benefit of helping you to identify who among your younger employees has the potential to move into a position of management responsibility. Some business functions in which you might consider involving younger employees include:

• Recruitment (for instance, review resumes, conduct initial interviews to select those to bring back for second interviews)
• Responsibility for a particular area of expertise in the firm (for instance, select an area of expertise that requires someone to be informed and up to date, and select an employee to be the firm resource in that area)
• Training (for instance, assign areas of responsibility for training and answering questions for both professional and staff personnel)
• Forms and procedures development
• Computer software and hardware analysis and upgrades (for instance, review new software packages, install upgrades and train others)
• Library (for instance, organization and updating responsibility)
• Information gathering functions (for instance, investigation respecting potential jobs, vendors, customers, RFP's)
• Client development (for instance, developing proposals and presentations, initial client meetings, internet research, etc.)

Some firms also create "employee advisory councils" (i.e., employee groups that are encouraged and sponsored by the firm and meet regularly to provide ideas and help to firm management)

Providing Ownership (or the Functional Equivalent)

Studies have shown that participation in management, by itself, is not enough to improve commitment or performance. Similarly, some sort of ownership or other participatory interest in the firm's success, by itself, is also not enough. But the two, together, have a synergistic effect. The sort of ownership or other interest to be provided raises difficult and important issues.

First Decision: Stock or Money?

A crucial, initial decision is whether you will provide actual ownership (i.e., stock in the corporation), or some other participatory interest (which usually takes the form of money).

The downside of employee stock ownership

• Access to information: Minority shareholders have the right to probe into financial records you would otherwise consider confidential.
• Minority stockholder rights: Minority shareholders have a variety of other rights, like questioning compensation decisions.
• Value: You may create a backlash when employees realize that owning one-tenth of one per cent of the firm does not really provide anything of value to them.
• The complications of buy-sell and related shareholder agreements: You must foresee and resolve complicated issues, like making certain you can re-purchase the stock when the employee leaves or dies, who has voting rights, dovetailing all arrangements with estate plans of existing owners, etc.
• Licensing issues: Some service firms, such as architectural firms, in particular, must monitor ownership in order to comply with licensing requirements

The upside of stock ownership

• Perception: In the culture of some firms, only an ownership interest will be perceived as having value, and will bind young employees to the firm.
• Money in the pockets of current owners: Selling stock is a way for current owners to cash out.
• Cost: The most obvious advantage is that it is cheaper to provide company stock than it is to write a check to the employee.

Second Decision: Qualified or Non-Qualified?

No matter whether you opt to provide ownership, or some other monetary benefit, you need to decide whether to offer a qualified plan or a non-qualified plan (or a combination). The advantages of a qualified plan are tax driven -- stated generally, employer contributions are tax deductible, employees will generally not be taxed until the contributions are distributed to them, income earned on the assets in the plan is tax deferred, and employees can make pre-tax contributions to the plan. The disadvantages of a qualified plan stem from the hypertechnical, cumbersome and expensive requirements in the Internal Revenue Code, ERISA and other statutes that must be satisfied, including the requirement that the plan be made available to a broad range of employees and not focus on selected or highly-compensated individuals. Non-qualified plans, on the other hand, can be structured as the employer sees fit, without regard to such requirements, but they do not offer tax advantages.

A Menu of Some Alternatives

Set forth below is a list of some qualified and non-qualified methods that can be used to give employees some indicia of ownership.

Keep in mind that a firm may reward particular employees who deserve special treatment with a non-qualified benefit, stacked on top of a qualified benefit plan. For instance, all employees may be entitled to a 401(k) but, in addition, certain employees may be selected to receive phantom stock benefits or bonuses. This is particularly useful if you seek some kind of restrictive covenant (see the last section, below) from the employee in question -- the extra benefit is a fair exchange for the covenant.

Also keep in mind that to make stock (or stock equivalents) meaningful to an employee, the stock has to be worth something when the employee "cashes out". This may require some meaningful valuation method, and an agreement to convert the stock into money. This is normally required in qualified plans (like ESOPs).

Employee stock ownership plans (ESOPs)

• In an ESOP, the employer makes defined contributions of company stock into a trust which holds it for the employees. Each employee's entitlement is based upon relative compensation. If highly technical and complex rules are met, the company can deduct its contributions to the ESOP, and the company can deduct dividends paid on ESOP-held stock.
• ESOPs are often used to satisfy some broader need of the employer. For instance, an ESOP is often used as means for owners of a closely-held company to cash out. Owners who sell to an ESOP can avoid paying capital gains taxes on the sale proceeds by reinvesting in securities of U.S. companies. In addition, the employer can borrow money to buy the stock from itself, and can deduct the payments it makes to repay the loan. This is a unique benefit, normally not available in other qualified plans.
• Disadvantages: (1) Cost and complexity of administration. All ESOP transactions must be based on a current appraisal by an independent valuation expert. Very complicated and highly regulated; governed by ERISA; (2) Disadvantage: virtually all full time employees must be included. This is not a method for rewarding key employees.

Incentive stock option plans (ISOs)

• An ISO is a way to get stock to an employee with favorable tax consequences. The corporation allows selected employees to purchase stock at a price that cannot be less than fair market value.
• May require independent appraisal of the company to qualify.

Nonqualified stock options

• Does not meet ISO technical requirements and, as a result, can be more creatively structured. Employee does not have taxable income when the option is granted, but when the employee exercises the option the difference between the exercise price and the fair market value is taxable compensation, for which the employer is entitled to a compensation deduction.

Profit sharing and incentive plans

• Employees can be give stock, SARs, phantom stock, or cash, as a bonus. The criteria can be anything the firm desires -- firm revenues or profitability, division or project revenues or profitability, etc.
• Useful for younger employees who want a "piece of the pie" but do not yet qualify for stock ownership -- firm can make a payment that simulates stock ownership, on a discretionary, flexible basis, without any commitment from year to year.

401(k) plans

• Extremely valuable employment benefit that allows employees to make pre-tax contributions of their pay into an investment fund.
• Must be broad-based to qualify. To encourage participation, employers often match a portion of what employees contribute. The match can be made in company stock.

Phantom stock

• Employees are given "units", each of which represents the value of a share of company stock. The units are credited to an employee account. Upon termination or by a specified date, the employee is paid (usually in installments) an amount equal to the current fair market value of the units, along with dividends, as if it were stock. There are various alternative plans. The corporation receives a deduction when the money is paid, and the payment is taxable to the employee when received.
• Requires careful planning in respect to funding the eventual payouts. Use selectively.

Stock appreciation rights (SARs)

• Similar to phantom stock. Each SAR entitles the employee to receive cash in an amount equal to any appreciation in the value of the stock since the date of the grant. Some plans allow the employee to purchase additional SARs. The payments are taxable to the employee and deductible to the corporation.
• Requires careful planning in respect to funding the eventual payouts. Use selectively.

Providing A Future That is Worth Waiting For

Young, ambitious employees generally want to know three things about their future:

• What do I have to do in order to advance in the firm?
• How long will it take me?
• What will get once I get there?

If the answer to any of these questions seems unreasonable, an impetus to search for another position is inevitable. The alternatives available for accession arrangements is beyond the scope of this presentation, but the following general guidelines have to be kept in mind:

• Give them the answers to the questions before they ask
• De-mystify the process by which they will be considered and the factors that will be most important in the decision
• Make sure that the process sounds "fair"
• Let them know when they might expect to start to be considered
• Let them know what it will cost them
• Let them know what percentage of ownership they might expect
• Let them know how their role in the firm will change once they attain ownership
• Make sure there is a significant gap between the highest paid non-owner, and the lowest paid owner - make ownership something worth striving for

Golden Handcuffs and Safety Nets

"Golden handcuffs" make it painful for an employee to leave and make it more difficult for a competitor to recruit the employee. (Usually, these measures can only be used in respect to non-qualified benefits.) For example:

• Deferred compensation. For instance, a substantial portion of a bonus, or entitlement to phantom stock or SARs, can be deferred, and can be made payable only at stated times in the future, provided the employee is still employed by you.
• Forfeitures and penalties. For instance, various benefits, like phantom stock and SARs, are held in accounts and are paid out only when the employee terminates employment or retires. Some or all of these benefits can be forfeit if an employee leaves to compete with you, or the value of the employee's account can be reduced unless the employee remains employed for a minimum number of years.

"Safety nets" cover you in the event an employee decides to leave. They will normally take the form of some kind of restrictive covenant in an employment agreement, and can be of varying severity. Often, to retain a valuable employee, an employer will offer an employment contract with stated benefits and a "just cause" termination provision, in exchange for which the employer will seek a post-termination restriction on the employee's activities. These covenants are enforceable (with various exceptions) in Pennsylvania if they meet certain requirements, such as the requirement that they be reasonably related to a bona fide interest of the employer, that they not be overly oppressive, and that they are supported by adequate consideration. Some of the typical choices, in descending order of oppressiveness to the employee, include:

• Covenant not to compete. This covenant will preclude the employee from competing with the employer, usually in a stated geographic area, for a stated time.
• Nonsolicitation of clients. The employee will be permitted to compete with the employer, but will be precluded from soliciting or doing business with any of the employer's clients with whom the employee had contact while employed by the employer, for a stated period of time.
• Nonsolicitation of employees. The employee will be permitted to compete and solicit clients, but will not be permitted to solicit or hire the employer's employees for a stated period of time.
• Nondisclosure and confidentiality covenants. The employee will be permitted to compete and solicit clients and employees, but must keep confidential the employer's confidential information (business plan, finances, prospects, etc.)

©2009 Powell, Trachtman, Logan, Carrle & Lombardo, P.C. The foregoing is intended for general information purposes only and does not constitute legal advice. All business and legal decisions should be made in conjunction with competent legal advice as applied to specific situations. Portions of this article may be quoted for non-commercial purposes with proper attribution.