Tired of hearing that equity is the only way to attract and keep rockstar employees? What if there was a better way — a way to offer generous compensation that aligns incentives, fuels growth, and lets you stay in the driver’s seat?
In an exclusive interview with Christopher Rhyme of the Business Transition Group, on the Angels, Exits and Acquisitions podcast, we found out Rhyme, an expert in exit planning and executive compensation, explains how NQDC plans can supercharge your business without the risks and complexity of equity. Watch the full interview here.
The Allure (and Illusion) of Equity
Equity can be an alluring offer, especially for employees of early-stage startups or closely held businesses. The promise of striking it rich if the company succeeds is enticing. However, this promise often obscures the realities of equity ownership, particularly for employees who may lack a full understanding of the complexities of entity taxation. Employees may find themselves facing an unexpected tax liability based on imputed income reflected on their K1s, even without receiving a corresponding cash distribution.
Another potential pitfall is the issue of liquidity. In closely held businesses, there’s no readily available market for employees to sell their shares, essentially rendering their stock options worthless in the short term.
The Downside of Traditional Compensation
While equity might seem like the answer, simply offering a higher salary or a profit sharing plan based on revenue only can be a recipe for disaster for the company long term. Employers will struggle to meet payroll during lean times. And if you reward employees based on top line growth only, they’ll prioritize revenue over profitability and create unsustainable business practices. As business consultant Mike Michalowicz says, “Revenue is vanity, profit is sanity”. In the end, profitable and sustainable growth is the real measure of success.
The Solution: Non-Qualified Deferred Compensation
Nonqualified deferred compensation plans are a better alternative to equity grants and traditional compensation. These plans allow you to share profits and potential appreciation upon sale with key employees while you maintain control of your business and avoid the complexities of equity ownership. NQDC plans let you attract, incentivize and retain top talent without diluting ownership or creating conflicts with minority shareholders.
Non-Qualified Deferred Compensation Plans: Demystified
Nonqualified deferred compensation plans are a specific type of deferred compensation plan that falls outside the realm of traditional qualified retirement plans, such as 401(k)s and IRAs. They are not subject to the stringent regulatory requirements of ERISA or IRC Section 409A, which govern qualified plans, allowing for more flexibility in their design. Employers are not bound by contribution limits and have greater latitude in tailoring benefits to individual employees or roles, as NQDC plans allow for discrimination among highly compensated employees.
NQDC Plan Features
Deferred Compensation: A portion of the employee’s compensation is deferred to a later date. This can be tied to achieving specific performance milestones or a liquidity event, like the sale of the company.
Tax Advantages:
Contributions are typically funded with after-tax dollars and are not taxed until they are distributed.
Employees can potentially reduce their current annual taxable income and defer paying taxes until they are potentially in a lower tax bracket, such as during retirement.
Employers can take a tax deduction when the deferred compensation is paid out, potentially lowering their overall tax liability.
Flexibility in Design: Employers have a wide range of options when designing NQDC plans:
They can tailor payment schedules and vesting periods to fit the specific needs of their companies and employees.
They can establish performance-based metrics, such as profitability targets, that must be met before deferred compensation is paid out.
NQDC plans offer flexibility in terms of payment triggers, allowing plan sponsors to define events, such as a change in control, that will trigger the distribution of benefits.
Investment Options:
NQDC plans are not limited to specific investment options.
This allows plan sponsors to create more customized plans that align with the specific financial goals of their employees.
Benefits for Employers:
Retain Top Talent: By offering compensation packages that include NQDC plans, employers can attract and retain top talent without relinquishing ownership control or creating potential conflicts with minority shareholders.
NQDC plans can be particularly effective in incentivizing highly paid employees and key employees critical to the company’s success.
Align Incentives: NQDC plans can be structured to align employee incentives with company goals by tying deferred compensation to specific performance metrics.
Maintain Control: NQDC plans provide a way to share profits and potential appreciation upon sale without relinquishing any ownership control.
Benefits for Employees:
Earn Significant Rewards: NQDC plans can provide employees with the opportunity to earn substantial financial rewards if the company performs well.
By sharing in the company’s profits and potential appreciation upon sale, employees can benefit from the growth and success of the business without the risks associated with equity ownership.
Potential Tax Benefits: NQDC plans offer potential tax benefits, allowing employees to defer paying taxes on their deferred compensation until a later date, potentially when they are in a lower tax bracket.
Clearer Financial Planning: NQDC plans offer predictability which can be helpful for financial planning.
By establishing clear metrics and vesting schedules, employees can better understand their potential future earnings.
Employees can also work with a financial advisor to develop a strategy for managing their deferred compensation and plan for future financial needs.
NQDC Legal Considerations: Substantial Risk of Forfeiture
Another important NQDC plan consideration for both employers and employees is the concept of “substantial risk of forfeiture”. If the company were to go into financial distress, like bankruptcy, plan participants might not receive their deferred compensation. They’d become creditors of the company and have to stand in line with other creditors to try to get their money back. So both parties need to carefully consider the company’s financial health when entering into an NQDC plan agreement. It’s also highly recommended to consult with a financial advisor who is familiar with NQDC plans to ensure compliance with legal and tax regulations.
Real-World Examples: NQDC Plans in Action
NQDC plans can be used to attract and retain key executives by giving them a share of the company’s profits as deferred compensation, so they can focus on profitability and get rewarded for exceeding expectations. In a generational transition, business owners preparing to transition to a family member can use an NQDC plan to offer a competitive compensation package to the interim management team while preserving equity for the next generation. NQDC plans can also facilitate internal buyouts where successor owners have different time horizons by structuring deferred payments for an owner who might not have the time to wait for a long-term payout, so the equity can be transferred to a younger successor owner with a longer time horizon.
Find Top Talent: Using NQDC Plans as a Filter
A-players, who are high achievers and results driven, will rise to the challenge and responsibility of an NQDC plan.
B and C players, who may be less ambitious or risk averse, will hesitate or decline to participate, potentially showing their lack of commitment to the company.
Ownership Transition: NQDC Plans as a Succession Tool
NQDC plans can incentivize and reward key employees who will be critical to the company’s success during and after the ownership transition.
Owners transitioning to a family member can use an NQDC plan to compensate and retain experienced managers to mentor the successor.
In an internal buyout, NQDC plans can offer financial security and incentives to key employees involved in the transition.
Summary
NQDC plans are a powerful and versatile tool for business owners and founders to attract, incentivize and retain key talent without giving up control of their business. When done right, these plans can align incentives, grow enterprise value and facilitate smooth ownership transitions. By working with qualified professionals to design and implement these plans, businesses can create a win-win for themselves and their key employees.
Entrepreneurs looking for more resources and information on business growth, investment strategies and capital raising can also check out:
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Listen to Chris talk about NQDC plans and more on the Angels, Exits, and Acquisitions Podcast.
