When considering a deferred compensation strategy for your ownership transition, keep these pros and cons in mind.
There are really four components to a successful internal ownership transition: the financial arrangements, the succession of leadership, the corporate governance or organizational structure, and the cultural continuity of the firm. Transition plans and the impact they have on the entire operational structure of the firm are oftentimes not fully understood. The initial focus is immediately on the financial implications. What is the value, how is the transaction structured, and how can I minimize taxes? Most transitions begin here.
What is not understood early enough in the planning is how the transition will happen with the next group of owners and what the implications are for the rest of the staff at the firm. And quite frankly this is not the top priority of the exiting shareholder in many cases. They are looking for a way to get out of their equity and management position and eventually retire.
Though there are many different ways to execute a transition and the transactions associated with a changing of the guard, there are really three distinct paths for an internal transition. In a complete oversimplification of the options, here they are: you can buy and sell ownership as true transfers of equity, you can use a deferred compensation structure, or you can use an ESOP. Here, I would like to focus on a few of the positives and negatives of using a deferred compensation strategy.
For one, deferred compensation structures minimize the risks and barriers associated with ownership (good and bad!). People are given the opportunity to purchase equity for a fraction of its real value and are then rolled into a compensation plan that involves a pre-tax, pre-bonus contribution to a trust that holds these pre-tax, pre-bonus earnings of the firm. This trust or account can then be used to pay exiting shareholders the difference between the “value” of the equity they sold at a depressed value and get closer to the market value of the firm. In this instance, exiting shareholders are not taxed at preferred capital gains rates, but are taxed at ordinary income rates (see a tax professional to better understand your own unique situation).
The real benefit here is in the assurance that the exiting shareholder will get paid. This is potentially less risky than a traditional transfer of equity with transaction financing through the firm. Mostly because the transaction values and obligations to buyers are smaller. In a deferred compensation program, the incoming shareholder is also “contributing” to their ownership with pre-tax dollars. Incoming shareholders also do not recognize their contributions to the trust as income. This is where plans can get squirrely, but in some cases the funds are going directly through the trust to the exiting shareholders. All in all, new shareholders have less risk and often less urgency or motivation to find ways to “pay” for their equity.
A few of the issues here are that for one, the true value of the enterprise is heavily discounted (50 percent to 80 percent in some instances). With this, there is no incentive for management to grow the firm. Management is incentivized to focus strictly on profitability (not a terribly bad thing!), and may not understand the need to grow their staff professionally and grow their firm from a revenue perspective. And this is where issues arise. It can create stagnation at the upper tier of the firm.
Zweig Group is often called upon to diagnose owner alignment issues, compensation strategy, and transition for firms that have inherited a deferred compensation program. The issues are pretty consistent in that there is no value placed on the investment in the firm, there becomes a stark discrepancy between performers and non-performers, and the overall incentive structure comes into question. It can lead to entitlement issues and the firm functions more like an egalitarian society instead of a true partnership. These are just a couple of thoughts on transition strategy. Does any of this sound familiar or appealing? I am happy to discuss transition strategy and how your firm can get over the hump!
Will Swearingen is director of ownership transition advisory services at Zweig Group. He can be reached at firstname.lastname@example.org.