Articles Tagged ‘Compensation Plans’

Characteristics of Bonus Incentive Plans

Friday, July 6th, 2012

Presented by T. Ray Phillips

Too often, owners only discover that the compensation plans they’ve put in place for key employees are sadly inadequate when those key employees leave their companies for greener pastures. The departure of one or more of these key employees not only complicates your daily business life, but it can slam shut the door on your exit plans. Without experienced management in place, you may find it very difficult (if not impossible) to leave your business in style.

Key employees are aptly named not only because they are key to the efficient and profitable operation of your business; they are also key to your departure. No one will want or be able to run your business without you, unless key management remains after your departure.

How then does an owner manage to keep key employees on board? Rather than tie them to the mast, many owners install Employee Incentive Plans that motivate them to stay. In doing so, owners also work to achieve the goal of ensuring their successful exits.

We have identified four characteristics common to successful bonus plans. They:

Are specific, not arbitrary, and are in writing;
Are tied to performance standards;
Make substantial bonuses; and
Handcuff the key employee to the business.
Let’s look at each briefly.

Clear Communication.

The most basic characteristic of a successful plan is that it is communicated clearly by the employer and understood thoroughly by the employee. Therefore, successful plans are in writing and are based on determinable standards. To be successful, employees know that the plan exists and how it works. Plans are explained to employees in face-to-face meetings, often with the owner’s advisors present to answer any questions.

Performance Standards.

The second characteristic is that the Incentive Plan’s bonus is tied to performance standards. Owners often work closely with their advisors to determine which performance standards should be used—perhaps net revenues or taxable income above a certain threshold—for which employees.

The standards of performance that the owner chooses must be ones that the employee’s activities can influence and that, when attained, increase the value of the company.

Let’s look at how one owner accomplished exactly that.

Duke Manning was struggling to keep his renowned, yet temperamental, chef in line. Henri always wanted more money even though the profits of the restaurant, specifically the kitchen, were uneven. Since Chef Henri controlled both the food costs and the labor costs, Duke and his advisors designed an incentive plan to encourage Henri to keep both items in line, but not too low.

Duke’s incentive plan worked as follows: If quarterly food costs were no greater than 26% and no lower than 22% (a range we once believed necessary to keep food quality high) Henri would receive incentive compensation equal to 1% of the restaurant revenues. Similarly, if quarterly labor costs stayed between 25% and 21%, Henri would receive another 1% or a possible total of 2% of the gross revenues. Duke determined that if the kitchen could not stay within these ranges, profitability or the reputation and quality of the restaurant would suffer. If the restaurant prospered, revenues could be in excess of $3 million and Henri could earn as much as $60,000.

The result? Henri was motivated to increase revenues, because his bonus would increase while keeping costs and quality in line.

Substantial.

Third, the size of the bonus must be substantial enough to motivate employees to reach their performance standards. As a rule of thumb, a plan should create a potential bonus of at least 30 percent of a key employee’s compensation. Anything less may not be sufficiently attractive to motivate employees to modify their behavior to make the company more valuable.

Handcuffs.

Finally, a successful plan handcuffs the key employees to the business. The goal here is to keep the employee with the company the day after, and even years after, the bonus is awarded. Owners typically use several techniques to create “golden handcuffs” for their employees.

Recall Henri’s incentive. Because Duke wanted to keep Henri for the long term, Duke paid half of Henri’s bonus to Henri as he earned it and deferred (and subjected it to a vesting schedule) the other half. Of course, if Henri left the restaurant before he was vested he would forfeit half of his bonuses.

DISCLAIMER: The information contained in this article is general in
nature and is not legal advice. For information regarding your particular situation, contact an attorney or tax advisor. This newsletter is believed to provide accurate and authoritative information related to the subject matter. The accuracy of the information is not guaranteed and is provided with the understanding that none of the providers of this newsletter, including Business Enterprise Institute, Inc., is rendering legal, accounting or tax advice. In specific cases, clients should consult their legal, accounting or tax advisors.
The example provided is hypothetical and for illustrative purposes only.
It includes fictitious names and does not represent any particular person or entity.

To contact T. Ray Phillips Re: subject matter in this article, call
(317) 208-6312 OR e-mail trphillips@finsvcs.com

Please do not leave trade instructions over e-mail, as they cannot be processed.
Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS under circular 230, we inform you that any U.S. Federal tax advice contained in this communication, unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing, or recommending to another party any matters addressed herein.

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