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University of Massachusetts Amherst

Family Business Center

Synthetic Equity: How to Compensate the Non-Family Executive Who Wants an Equity Share of the Enterprise

By Robert M. Fields

The last few decades have seen a significant growth in the number of relatively large (revenues of at least $25 million) family-owned, non-public companies. As these companies increase in size, or the founders head for retirement, they often have to bring in non-family executives to hold high-level positions. Increasingly, these executives, being intimately involved in the financial success of the companies by which they are employed, desire to participate in the increase in the value they helped create. Thus, they often turn to the family-member owners and request equity interests in the companies.

Most often, this puts the family owners in quite a quandary. For a number of reasons, they are usually loath to granting equity interests to non-family members. These reasons include:

  • For purely emotional reasons a desire to keep ownership of the company exclusive to themselves and to their progeny.
  • A desire not to spread ownership beyond family members because the interests of the non-family executives often clash with those of the family.
  • A desire not to have to deal with the legal rights of minority stockholders.
  • A desire not to make confidential financial information, such as the amounts earned by the family members, available to the non-family members (as may be required in the case of LLCs and similar business entities).
  • Lastly, a desire not to be put into the position of having to redeem company stock at the time of the termination of employment of the non-family executive or, in the alternative, have to deal with non-family owners who no longer work for the company.

Nevertheless, the owners of the company are often quite aware of the value the non-family executives bring to the table and, accordingly, want to satisfy their requests. Caught between two competing interests, they are often at a loss as to what to do.

This is where constructing “synthetic equity” interests go a long way to assuaging the demands of the non-family executives while keeping real ownership of the company solely within the family groups. This “synthetic equity” is essentially what it sounds like. It is a mix of short and long-term cash incentive plans that have the look and feel of basic equity interests. First, there is the short-term (annual) incentive component that is intended to replace dividends and other similar distributions. However, in stark contrast to actual dividends, these incentive payments are made only upon the attainment of specified financial targets and goals. At the beginning of each year, the company and the non-family executive will agree to a set of goals and targets to be met during the year. For example, they may identify three goals, such as gross revenue, net profits and market penetration and assign targets such as $X gross revenue, $Y net profits and Z% additional market penetration for the year. If, at the end of the year, these goals and targets are just met, the executive will receive his target bonus, usually defined as a percentage of salary. If the targets are exceeded, the bonus will increase, up to a maximum percentage. If the targets are not met the bonus will be reduced until a specific floor is reached (such as 80% of target), below which no bonus will be paid. For many of my clients, I have included a “negative bonus” structure if actual performance is significantly below target. Not only will no current bonus be paid at year end, as a result of a negative bonus, the following year’s bonus, if any, will be reduced by a specified amount.

The beauty of this type of incentive program is in its flexibility. Each year different goals, targets and bonus levels can be chosen which meet the current business interests of the family owners and which take into account current financial realities. The non-family executive can be handsomely compensated under such a program; however, if the goals and targets are carefully structured, the family owners will always come out ahead of the game even after the year-end bonus is paid to the executive.

The other component of “synthetic equity” is a long-term phantom stock plan pursuant to which a payment of a specific amount is made to the non-family executive upon (i) a “liquidation event” (i.e., a stock or asset sale of the company), (ii) if the owners desire, upon the death of the executive (where the amount of the payment can be recovered from a key man life insurance policy held by the company on the life of the executive) or (iii) in certain cases, upon the termination of employment of the non-family executive on or after a certain date or event (such as retirement). In rare circumstances, family owners have elected to allow payments to be made upon a termination of employment at any time.

The amount of the payment is usually a small percentage of the amount realized upon a liquidation event, but only if the sales price is equal to or greater than a predetermined base amount. If the sales price is greater than the base amount, the percentage of such amount paid to the executive can be increased; provided, however, that any increase will be regulated so that the owners will always come out ahead even after the payment to the executive. For example, the increase in the sales price of the company often twice the increase in the amount of the payment to the executive. If the sales price is below the target amount, no payment (or an extremely reduced percentage) will be paid to the non-family executive.

If the owners desire, payments under the phantom stock plan can re restricted only to those executives who are employed upon the liquidation event or who remained employed to a specific date or event, such as retirement on or after age 65. A “redemption” of phantom shares made upon termination of employment at retirement or upon death will be based upon either a fair valuation of the company or a formula (often a multiple of EBITDA or book value). In the event of a payment triggered upon an event other than the liquidation of the owners’ interests in the company, I usually draft the phantom stock program to provide that the payment will be stretched out over a number of years, with each annual payment is limited to the lesser of (i) available cash profits or (ii) a specific dollar amount; thus, guaranteeing that the payment will not put the company into a cash-strapped position.

Payments on the phantom stock can be conditioned upon the executive completing a minimum number of years of employment with the company and are often withheld upon a termination of employment for cause or, as mentioned above, a termination of employment before a certain date (such as normal retirement date under the company’s pension plan), or before a liquidation event. These restrictions place “golden handcuffs” on the executive as they give him or her an incentive to remain employed for the long haul.

In summary, synthetic equity can be designed to pay the executive for superior financial performance. The executive can be highly compensated, but only upon events that result in a superior return to the family owners. This gives the family owners the best of all worlds, retention of actual ownership within the family ranks and payment to the executive only upon a net-positive return to the company. At the same time it goes a long way to satisfying the non-family executive’s desire to participate in the profits and growth in value of the company. As a result, all parties are happy and a significant thorn of contention is removed from the employer-executive relationship. These programs are quite flexible and can be individually designed to meet the specifics of any situation.

Robert M. Fields provides executive compensation expertise to both executives and corporate management on employment and severance agreements, and advises in the installation of executive incentive programs. Contact: rmf@fieldsconsult.com.

© 2005 Robert M. Fields. Reprinted with permission.

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