Considerations for Equity Based Compensation to Management
By: C. Lee Lovett
In today’s market environment that sees high inflationary pressure paired with a competitive labor market, dealers have been evaluating the ways to attract and retain talent without necessarily increasing pay-plans and draining cash reserves. Often times equity participation can be a win-win scenario for all parties involved so long as such participation is properly structured to meet the needs of not only the company but management as well.
Given the variety of forms that an equity participation can take, owners can often find themselves in a ‘paralysis-by-analysis’ state when assessing whether an equity participation is right for their company. It’s important to segregate the analysis and evaluate each set of factors not only for what best serves the company and the management, but also taking into account the current ownership and potential succession planning.
Vesting and Performance Targets
When determining what will qualify a manager for eligibility in an equity participation program, employers will frequently establish either time-based or performance-based targets (or a combination of both). Time-based targets are an effective means in retaining employees, as they tend to vest over a prescribed period of time provided that the manager remains employed with the company.
Performance-based targets are the most prevalent in the industry and often times take the form of a target tied to profitability. While profitability may be the most popular metric used, dealers can also be well served by incentivizing metrics which they in turn are judged on by their respective manufacturers. Targets tied to such metrics that account for customer satisfaction and sales performance, can help shift managers thinking from a purely short-term profit focused mindset to one that is more holistic and aligned with the mindset that owners often must undertake in evaluating their company’s performance.
Buy-in and Participation
Once a company determines the vesting structure, they must then make a determination as to what is a fair valuation for the purchase or award. This analysis often goes hand-in-hand with determining the redemption rights.
The three most common methods utilized are i) multiple of earnings ii) “book value” and iii) Grant of the equity.
The ‘multiple of earnings’ is the method most in line with the true valuation of the dealership, as this is the method that an owner would likely get on the open market for the entire group. The main advantage to this method is the current ownership obtains compensation for the stock that is most aligned with the current market at the time of the buy-in. This comes with the obvious downside of a buy-out that can be increasingly costly for the company if a redemption occurs in market such as the current one.
Book value in this context is not necessarily a particular number on the balance sheet but rather an agreed upon and repeatable method to determine the fair value based on audited/manufacturer balance sheet items with agreed upon holdbacks and addbacks. Consistency and repeatability are the keys for this method, as often a company will use the same valuation to determine a redemption value in the future. This method is popular for the reason that it is more affordable from both buy-in prospective for a manager and also is often more affordable to a company at the time of a buy-out.
A grant or award of the equity is the method that is most advantageous to the manager as the equity is issued upon the vesting with no additional consideration changing hands (i.e., sweat equity). In these scenarios the vesting targets are often set higher and the redemption rights are often more restrictive than they otherwise would be under the other buy-in methods.
The participant’s source of funds and access to capital will play a role in determining the potential buy-in valuation method. Frequently the company itself or the current ownership will end up financing the buy-in and holding a promissory note. When drafting the terms of such agreements, dealers should keep in mind that when the ownership change paperwork is submitted, manufacturers often request supporting documentation related to the source of funds.
Additionally, conversations should be had and clear guidelines established related to how the company views the participant’s future participation in relation to items such as distributions, capital calls, participation in future dealerships, transfer restrictions, estate planning and future equity issuances.
In addition to vesting and active participation guidelines, it is also necessary to evaluate the factors related to a potential redemption event. While this part of the process may feel like talking about divorce while you’re standing at the altar, it is a necessary and beneficial exercise. Owners should establish at outset the company’s position on items such as:
- The Four D’s (Disability, Divorce, Death and Departure);
- Rights related to ‘for cause’ and ‘without cause’ termination;
- Payout options of the redemption amount (e.g. lump sum vs. periodic);
- Non-compete and Non-solicitation Restrictions; and
- Participation rights related to a potential sale of the company.
While the conversation may be difficult at the time, establishing these conditions in the beginning and having a fully formed equity participation structure that accounts for all life-cycles of the partnership will significantly reduce the risk of conflict throughout the process. When structured correctly, equity participation for management can allow for a greater retention of top-level talent while at the same time rewarding that talent for the overall appreciation of a company’s value.
As the tax code provides the primary source for regulation related to executive compensation, including equity-based compensation, it is advised that dealers not only consult their legal counsel but also consult with and involve their tax advisors early and often throughout the process.