American businessman Lee Iacocca once said,

Start with good people, lay out the rules, communicate with your employees, motivate them and reward them. If you do all those things effectively, you can’t miss.

Chances are the success of your business relies at least in part on the talents and performance of your employees. And while each employee is important, there may be a few that are key to attaining your business objectives.

Just as each business has a value proposition it offers to prospective customers, the total compensation package you offer key employees is part of your value proposition to them. In addition to competitive wages, there are many different forms of compensation and benefits an employer may offer to motivate and incentivize the talent they need to succeed (see the Key Compensation Strategies table at the bottom).

A strategic approach in designing your compensation plans could greatly increase their potential effectiveness to incentivize your most important employees and align them with your objectives. The following are six key considerations that can help allow you to structure the compensation plans with the most impact.

Define Your Goals

Different forms of compensation arrangements are better suited for accomplishing different goals. Before committing financial resources, it is important to determine exactly what your goals are. For example, is your business a start-up that needs to quickly attract top talent, or is it an established business concerned with retaining employees who would be difficult to replace?

Align Compensation with Desired Business Results

You may have both short-term and long-term goals, and they may evolve over time. Such goals may include maximizing revenue over the next three years before the sale of the company; protecting and incentivizing employees after a sale; rewarding company loyalty in line with goals of long-term growth of the business and expansion into different markets; or acquiring new talent with unique skill sets to get you over a specific hurdle in order to take your company public.

One advantage of the compensation arrangements discussed below is their flexibility. By varying the amounts contributed, vesting schedules, timing of distributions, performance goals, and other rights and obligations, arrangements may be designed to accomplish your specific business goals.

Tailor the Plan to the Individual Employee

Providing only one form of additional compensation to key employees may be the simple way to go, but individuals are motivated by different goals. Providing key employees with an employer-paid supplemental retirement plan may sound like a plan everyone would appreciate. But the reality is the 55-year-old executive will appreciate it significantly more than the 35-year-old executive. The executive making $350,000 a year might appreciate the ability to defer taxation on income, while the key employee making $90,000 with two children in college would have very little use for such a benefit. The 35-year-old may want additional life insurance benefits while the 55-year-old may prefer long-term care insurance. If the compensation doesn’t motivate or incentivize a particular employee, you risk wasting financial resources.

Decide Who is "Key"

In every business there are employees who are hard to replace and those who are not. An employee’s compensation level does not always indicate if they are a key employee. A number of compensation arrangements discussed below actually require the plans to benefit only a select group of highly compensated employees or management. The rules generally do not require including all highly paid employees and do not require they all receive the same benefit. There is considerable flexibility. In addition, there are many ways to reward other employees who may not be highly compensated yet are key to your business operations.

Review and Modify

Events may occur that cause the compensation package you offer key employees to lose its motivational influence.

For example, taxation plays an important role in the appeal of many of the compensation arrangements.

Unfortunately, tax laws tend to be a moving target. The Tax Cuts and Jobs Act of 2017 included substantial changes that affect businesses and individuals.[1] It is important to reevaluate the compensation arrangements offered to key employees after such a change in the tax laws to determine if they continue to provide the motivation intended.

Communicate

If you commit to using business financial resources to recruit and retain key employees, by all means let them know about it, and not just when they are hired. As with any financial outlay, you should expect a return on your investment. In this case your return should be more effective, better performing, harder working, and loyal employees. To maximize your return, it is important your key employees fully understand what these additional forms of compensation are, how they work, and what benefits they receive from them.

Non-Compete Agreements

Many business owners look to non- compete agreements as their primary means of retaining key employees. While a well-designed non-compete may be useful, it can be limited. If your goal is to retain key employees that will help grow your business, it helps to give them a reason to stay. Offer a carrot to go with the stick.

According to a recent report, 14.5% of the U.S. working age population intend to start a business in the next three years.[2] Based on these figures, if you have 10 valuable employees, chances are at least one of them is contemplating leaving and starting their own business. While this article will focus on compensation arrangements as a tool for retaining top talent, employment contracts with non-compete terms may play a role as well. The terms of such agreements vary, but generally they limit the employee’s ability to provide similar services to other employers during the term of their employment and for a period of time after their employment terminates. The enforceability of the agreement will largely be dictated by state law. In general, the agreements need to be reasonable and may not overly limit the ability of the employee to earn a living. Only a few states prohibit non-compete agreements or severely limit their applicability.[3] Having key employees sign a non-compete agreement may be a sound business decision to protect intellectual property and trade secrets, but as a retention tool it is limited.

Cash Bonus Plans

A simple and flexible form of incentive compensation is to pay the key employee annual cash bonuses. There are very few limitations on the amount, timing, performance measures, or number of employees included in the plan.

As long as the bonus is a reasonable amount, the employer may deduct the payment when made.[4] The employee will recognize the bonus as taxable income in the year received.[5]

There are, however, a number of disadvantages of providing annual cash bonuses. First, they are immediately taxed to the employee at ordinary income tax rates when paid. Second, because bonuses are discretionary and the employee has no assurance of future bonuses, they have minimal impact as a recruiting or long-term retention tool. In fact, employees may come to expect the bonuses causing them to lose their motivational impact. And finally, paying substantial unrestricted cash bonuses may actually backfire. A skilled, experienced employee with intentions of going out on their own may simply use the bonus money to terminate their employment and establish themselves as a competitor.

Restricted Bonus Plans

If you like the idea of annual bonuses for their simplicity, low administrative burdens and costs, and immediate tax deduction, an alternative would be to implement a restricted bonus arrangement. This typically involves the combination of three separate elements: an employment contract, bonus arrangement, and a restrictive endorsement. The employee receives bonuses that are paid into an investment such as a mutual fund portfolio or cash value life insurance policy owned by the employee. The employment contract requires them to pay back the bonuses should they violate the terms of the agreement, for example, if they terminate employment or provide services to another employer. The restrictive endorsement limits their ability to gain access to the investment assets or insurance policy values. When designed properly the bonus is deductible by the employer when paid and provides sufficient restrictions to motivate the employee to continue their employment.

Nonqualified Deferred Compensation Plans (NQDC)

Qualified retirement plans such as 401(k) plans provide employees an opportunity to defer taxation on their income until retirement.[6] However, qualified plans limit the amount of income an employee may defer and prohibit the employer from discriminating in favor of highly compensated employees. Nonqualified plans are designed to provide similar tax deferral benefits to key employees without the limitations on the deferral amount and without the participation requirements of qualified plans. In order to avoid many of the burdensome requirements of the Employee Retirement Incomes Security Act (ERISA), nonqualified plans are actually required to limit participation to a select group of highly compensated employees or management.[7]

Employees who elect to participate may defer their salaries and annual bonuses. But the real potential as a retention tool for employers is in their ability to contribute additional amounts to an employee’s plan. The employer may base additional contributions on the performance of the company, aligning the goals of the employee with those of the business. The plan, known as a Supplemental Executive Retirement Plan (SERP), may include a vesting schedule that limits the employee’s rights to the additional employer contributions for a period of time, providing incentive for the employee to stay with the company. The amount of the contribution, the length of the vesting schedule, the formula for determining the contribution, and how plan contributions are invested are all at the discretion of the employer with very few limitations.

One concern for employee’s participating in a NQDC plan is that any assets or funds the employer sets aside to meet their future obligations remain available to the general creditors of the company and the participants have no legal rights to these funds. In addition, new restrictions were implemented in 2006 that limit the flexibility of NQDC plan design and distribution options.[8] A disadvantage for the employer is that contributions made to NQDC plans are not deductible until payments are made to the employee.

Equity Compensation Plans

Compensation may come in the form of ownership in the business, either through a direct grant of stock, restricted stock, or through stock options. This may be the most direct way to align additional compensation with the success of the business. However, business owners should consult with their legal advisors to fully understand the implications of bringing on additional shareholders or partners. A minority shareholder or partner may have rights beyond the right to distributions of profits. For example, in Pennsylvania minority shareholders have the right to bring suit against officers and directors for wrongful acts against the corporation, the right to inspect corporate books and records, and the right to not be oppressed by majority shareholders.[9]

Synthetic Equity Plans

An alternative to compensating key employees through direct ownership is synthetic equity plans. There are a number of different variations, but in general synthetic equity plans attempt to mirror the financial rewards employees receive with direct stock ownership without providing the employee all the associated legal rights of ownership. Two common forms of synthetic equity plans are phantom stock and stock appreciation right plans (SARs).

Both phantom stock plans and SARs are designed to provide key employees with additional compensation based upon the success of the company.

They are contractual agreements between a key employee and an employer whereby the employer promises to pay the employee additional compensation at some point in the future based on the value and growth of the employer’s stock. In order to receive this additional compensation the employee is typically required to continue employment for a period of time. The employee may receive a payout of their vested account balance upon termination of employment, a change in ownership control, death, or permanent disability, depending on the terms of the agreement.

The main difference between the two plans is how the reward is measured. While a phantom stock plan provides additional compensation based on the value of the employer’s stock including appreciation, a SAR provides additional compensation based solely on the appreciation of the employer’s stock. Both provide incentive compensation based on how well the business does, both have tax deferral advantages for the employee, and both provide incentive for the employee to retain their employment.

Stay Bonus 

Retaining key employees is important while you are starting and growing a business. But it may have additional value when you are considering transitioning out of business ownership. Whether you are selling to a third-party buyer or gifting the business to the next generation, there is value in having key employees remain with the company after the transition. A stay bonus plan is designed to provide incentive for a select group of key employees to continue their service to the company for a period of time after a change of control occurs. Those who continue their employment receive a cash bonus as long as they continue their employment for the designated time, typically no longer than two or three years.

Perquisites

Perquisites, commonly known as perks, are minor benefits that add to a key employee’s quality of life and overall employment experience. They generally are not financial rewards or retirement supplements, but are rather items that make the key employee’s life easier during their employment so they can focus more intently on their duties. Perks are a form of compensation, and the equivalent dollar value of the perk will be imputed to the employee as an addition to cash compensation.

Some popular perks include income tax preparation, financial counseling, estate planning, club memberships, automobiles, personal use of corporate aircraft, home security systems, and concierge medical services. As with other benefits, employers should align any perk with corporate goals and to attracting and retaining key employees.

There can be significant costs associated with certain offerings.

There are many reasons why an employee may choose to dedicate their time, talents, and energy to your business. It could be the corporate culture, the challenges the job presents, the potential for advancement, or simply the people they’ll work with.

Employers who develop a compensation strategy that balances the employee’s need for financial rewards with the business’ need for high-performing, motivated, loyal employees should have a leg up on their competitors.

Key Compensation Strategies

Strategy Factors*
  Timing of Cash Flow Timing of Company Deduction Control Over Assets Once Granted Benefit Tied to Success of Business
Cash Bonus Annual When paid Employee If bonus based on business performance measures
Restricted Bonus Annual When paid Employee — but restricted If bonus based on business performance measures
Nonqualified Deferred Compensation Deferred, based on a specified number of years or upon triggering event (i.e., retirement, death disability) Delayed until compensation is paid Employer No
SERP Deferred based on a specified number of years or upon triggering event (i.e., retirement, death, disability) Delayed until compensation is paid Employer If additional employer contributions are based on business performance measures
Grants of stock None When stock is transferred Employee Yes
Restricted Stock None Delayed until employee recognizes taxable income — when vested. Employee — but restricted Yes
Stock Options None Delayed until option is exercised. Deduction equal to spread between stock's fair market value and the exercise price. Employer Yes
Phantom Stock Deferred, based on a specified number of years or upon triggering event (i.e., retirement, death, disability) Delayed until compensation is paid Employer Yes
Stock Appreciation Rights Deferred, based on a specified number of years or upon triggering event (i.e., retirement, death, disability) Delayed until compensation is paid Employer Yes
Stay Bonus After change in control When paid  Employer No

*There are a number of different factors that go into selecting a compensation plan. Here we review four common factors.