Oct 29, 2014

In the High-Stakes Search for Talent, Can Small to Mid-Size Firms Even the Odds with Fortune 1000 Companies?

Does company size matter when business competes for employee talent?

Yes, if you represent a small, mid-sized business (SMB) because the same opportunities to lure talent that exist for major corporations do not exist for SMBs.

Yes, if you are a talented employee or executive who believes the best opportunity for advancement and the best benefit packages are available in major corporations.

What’s more, the smaller the company, the greater the influence for a key employee to make a difference in business outcomes.

How then can SMBs compensate for disadvantages in size?

The steel-fused backbone of the economy, SMBs keep the nation’s economy upright. I’ve run SMBs for decades so pardon me if I take pride in these facts from the Small Business Administration (SBA):

  • 22.9 million small businesses occupy virtually all neighborhoods across America.
  • Small businesses make up more than 99.7% of all employers.
  • Small businesses create 75% of the net new jobs in our economy.

SQUARING OFF WITH THE BIG BOYS

Private companies, including closely held and family-owned businesses, often find it difficult to attract and retain key management personnel. That’s because publicly held companies lure talent with huge signing bonuses, company stock and creative perks to magnetize total compensation packages.

While equity in a private company may not be marketable in a traditional sense―not tradable on a stock exchange—private companies can provide long-term equity incentives as liquid investments for employees.

Unfortunately, many business owners shy away from using their equity. They don’t want to give up control or account to minority shareholders. But you can create long-term, equity-type incentives for employees without ceding control to them.

Most publicly held companies offer four compensation elements: salary, annual bonus, long-term incentives and equity compensation such as stock options or restricted stock awards. [See Chart I] Many times the long-term incentive is the equity in the company.

But private companies find it difficult to recruit top-level management talent because they typically do not offer equity compensation, the fourth key element in a competitive compensation package.

In lieu of equity, many private companies use nonqualified deferred compensation (NQDCs) plans to fill this void. However, they structure the plan with incentives built around the long-term goals of the company. [Right side of Chart I]. These plans usually provide for employer contribution, based on select indicators set by the company: revenue growth, after-tax profits, and cash flow.

For example, a company can tie its key employee to itself with a vesting plan; the company funds the plan with life insurance or other assets to minimize its cost over time. This approach works far better than phantom stock plans that possess an adverse accounting treatment.

For more information on structuring this approach, download my recent white paper:How Executive Benefits Enhance Executive Compensation Programs—Cost-Effective Benefit Programs Provide Win-Win Outcomes for Executives and Shareholders.

Because most private companies and professional firms use much different corporate tax structures than the Fortune 1000 companies as discussed above, many nonqualified plan strategies just don’t make good economic sense.

PAY FOR PERFORMANCE—DEFERRED COMPENSATION

As a method to reward performance, deferred compensation aligns the interest of key employees with those of shareholders. These plans are the most benign of all compensation methodologies. In a deferred compensation arrangement, select people are offered the option of deferring “their own compensation.” They don’t receive their “own money” until some future date, often at or near retirement.

In some plan designs, the employer will also set aside a percentage of cash bonuses in the plan. The monies deferred go into the company’s coffers and are subject to the claims of creditors should the company fail. Because they do not receive the money deferred, executives and key employees are not taxed on these amounts until they withdrawn. [Download deferred comp booklet]

CHALLENGE FOR CLOSELY HELD BUSINESS

Deferred compensation is similar to a 401(k) plan, except that no guarantee exists that, when the money becomes due, it will still be there. What sounds riskier than that? These plans are not formally funded or protected by ERISA like a company’s 401(k). They’re informally funded, which means the assets are subject to the claims of the company’s creditors.

In addition to employee risk, the company does not receive a current tax deduction for any money deferred or any contribution it may make on behalf of the key employee. This restriction is where the problem lies for the closely held business that has a tax pass-through structure.

TAX LEVERAGE OF DEFERRED COMPENSATION

Before we discuss an alternative for the pass-through tax structure, let’s examine why Fortune 1000 companies use deferred compensation and why they are so popular among highly compensated executives and employees.

Tax leverage is the most important attribute of NQDC plans, most of which are funded with corporate- owned life insurance (COLI), an asset that provides many tax benefits. Fortune 1000 companies generate leverage with the combination of non-taxable insurance proceeds, non-taxable accumulation of the policy’s cash values and, when benefits payout, tax deductibility. This leverage enables the employer to provide substantial benefits to key employees with little or no cost.

Using life insurance as a vehicle to obtain leverage may be a little confusing so let’s address how the leverage works. When cash value life insurance is used by the employer to “informally fund” deferred compensation arrangements, three income tax questions are raised:

  • Does the employer’s tax deduction pay the premiums? No.
  • Are the benefit payments, when paid by the employer to the employee, tax deductible? Yes.
  • Are the life insurance death proceeds paid the employer income tax-free? Yes.

You can see how the leverage emerges. The employee defers tax money and the employer uses the policy to create tax leverage. Fortune 1000 companies take advantage of this concept because they are not as concerned with tax deductions today. That means premiums and amounts deferred are not tax deductible, and the major corporations hold plenty of cash to fund these arrangements, while they wait several years to get the life insurance benefits tax-free.

The closely held business or professional firm cannot wait out the 20, 30 or 40 years required to make all of this leverage work.

Chart II below shows how the leverage builds on a 45-year old employee deferring $100,000 for seven years, and then taking a distribution on retirement benefits beginning at age 65 for 15 years.

We then assumed in this illustration that he or she would die at age 82. (At this point, the tax-free life insurance benefits return to the company.) Notice how the company ties up a sizeable amount of cash for 37 years―assuming he dies at age 82—before it recaptures its cost. For most pass-through entities we’ve work with, this outcome does not work.

So why do Fortune 1000 companies fund their executive benefits with COLI, especially since cash flow isn’t as important to them as earnings per share? Their profit and loss statements shine when using COLI.

Major companies also insure much larger groups than small organizations; it is likely they won’t have to wait 37 years to recapture a portion of their costs. Finally, major companies operate under much higher corporate tax rates, which is why COLI serves as a far better taxable asset than say, mutual funds.

DEFERRED COMPENSATION IN SMBS

To learn the alternative that works for both the key employee and his employer—one that could be tax deductible to the firm today, and grow tax-deferred to the employee without the risk of general creditor status, please click here for detailed position paper on competition for talent between the minnows and whales.

In the position paper, we look at two executive situations, one where the executive works for a large organization and one where he or she is employed by a private firm. My goal is to uncover a differentiating benefit the private company can offer to compete against the large, publicly traded company. What’s more, I discuss the critical phases of retirement planning: Contribution, Accumulation, Distribution, and the financial imperatives of moving through each. I trust you will find the information useful.