More Skin in the Game: Why Your ESOP Needs an MIP

December 9 2022 | 3 Min Read Time

Will Stewart

E: wstewart@pcecompanies.com

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All for-profit companies share a common goal: financial success. That can mean something different to employees, however, compared with owners. For companies owned by an Employee Stock Ownership Plan (ESOP), employees become owners and benefit directly from growth in the share price—but for highly compensated employee-owners, that may not be incentive enough. The best solution may be a management incentive plan (MIP), which provides additional motivation for upper-level management to continue to push your company forward.

When ESOPs provide too little incentive for upper management

Alignment of interests is a key element of any company’s success, and when you need different entities to work toward a common goal, ESOPs are an excellent broad-based option. Providing shareholder benefits to employees in your company is great for top-to-bottom alignment, giving everyone skin in the game as the value of your company increases. Yet the ESOP incentive can have less impact for your highly compensated ESOP participants, who may enjoy a smaller benefit (as a percentage of their higher compensation) than their colleagues—and may even be offered ownership opportunities with your competitors.

A management incentive plan is a great solution to this challenge. Designed to complement your ESOP, an MIP can ensure that your upper-level managers’ benefits align with all of your employee-owners’ interests as well as those of any other shareholders. After considering several alternatives—from traditional stock option plans for publicly traded companies to profit sharing or bonus plans in smaller, private companies—you can choose which MIP is the correct fit for your company.

Choosing the right MIP for your ESOP

Although a MIP can adopt one of many structures, we find that equity-based incentives work well in an ESOP. An ESOP requirement is to value your business annually to arrive at a share price that can be used to compensate those who help it grow. Moreover, granting actual stock or the right to purchase stock (such as an option) can be challenging from a tax perspective, for both the recipient and the company.

If your business is like many ESOP-owned companies, you’ll find that an S corporation is the most advantageous tax structure. A 100% S corp ESOP is exempt from federal income tax—an arrangement that can be vital to your company’s success. Allowing your employees, who are taxable shareholders, to own shares directly can jeopardize this tax-advantaged status. For these reasons and more, we recommend implementing stock appreciation rights (SARs) for a MIP in an employee-owned company.

Why SARs are the preferred option

SARs don’t just add to our bevy of financial-industry acronyms. Stock appreciation rights work well with ESOP-owned companies because they are easy to understand, cannot be exercised into actual stock, and align the interests of SARs recipients with those of the other shareholders.

SARs are a favorite of ESOP trustees, who need to be involved in the adoption and implementation of the SAR plan. SARs function much like a bonus plan or phantom stock plan: they are paid out in cash, taxed as ordinary income to the recipient, and deductible for the company. While much of the SARs pool typically is based on performance metrics, often a portion is reserved for the purpose of retaining or attracting employees for key positions. Referred to as “retention SARs,” this smaller pool consists of awards that can be bestowed or vested based on time criteria rather than a performance basis, to make sure you can hire—and retain—valuable leadership for your company.

Designing your SAR plan with an eye to the future

Despite being tax-deductible, SARs represent a company expense, and this arrangement can be viewed as diverting value from ESOP participants generally to a smaller group in upper management. This is one reason why your trustee is a vital participant in the design of your SAR plan: to be sure the majority of SARs are accretive to value and result in better positioning for all ESOP participants. Making some of the SARs contingent on meeting certain performance criteria or achieving growth goals can ensure that the management team benefits only when all employee-owners benefit.

Finding the right mix of SARs for your ESOP-owned company can be difficult. One of the best things your company can do to ensure a robust future is to grant SARs to key members of management over time. Reserving the majority of your plan for upcoming years will give you time to measure the impact of the early SAR grants and then refine your strategy as you move forward under employee ownership. This approach also reserves some of the pool as a recruiting tool, to entice future hires who may prove crucial to your financial success.

However you decide to implement and award them, SARs can enhance your company’s performance and provide greater returns for all shareholders regardless of your ownership structure. And their underlying characteristics make them a particularly good fit for ESOPs.