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Bar News - December 14, 2012

Business Law & Business Litigation: Retention Bonus Plans: An Alternative to the Equity Incentive Plan


One of the many struggles of an entrepreneurial venture, which often has limited financial resources, is finding unique ways to attract, motivate, and retain talented employees without the ability to pay top-dollar salaries.

Often, the first approach explored is establishing an equity incentive plan through which employees will be granted stock options or other equity-based compensation. Granting stock options provides employees with the opportunity to buy a fixed number of company shares in the future, but at todayís price. The theory is that stock options provide employees a stake in the success of the company that, through their hard work and loyalty, will return a financial windfall when the stock option is exercised and the stock sold. However, stock options do not always result in a financial reward to employees. Implementing an equity incentive plan isnít the only approach and isnít always the best approach to entice, motivate and retain top talent.

For many reasons, including the capital structure of the company, the amount and terms of any venture capital money invested in the company, the level of the companyís debt, and how the company performs after it grants options, the value of the stock may appreciate little or not at all (or worse, decrease) between the time the option is granted and the sale of the company. In such a situation, the stock option does not provide the financial windfall that underlies its intended purpose.

Another alternative is a non-equity retention bonus plan, which may be a more suitable device for a company to motivate and retain its most valued employees. With a retention plan, participating employees are eligible, upon a sale of the company or other specified event, to receive a bonus from a "bonus pool" created from setting aside a portion of the proceeds from the sale of the company. The size of the bonus pool is governed by the terms of the retention plan, and it is frequently determined based on a certain percentage of the net proceeds from the sale. The amount of the bonus pool paid to each participant is also governed by the terms of the retention plan, and may vary from participant to participant. In addition, one of the major advantages of a retention plan is that a grant doesnít involve the issuance of any equity (i.e., ownership rights) to the participant.

Generally, with a retention plan, a company has substantial flexibility to create a plan that fits the companyís needs. The company may customize various provisions of the plan to best meet its needs, including: eligibility to participate, vesting restrictions, conditions and limitations on when a sale or other event triggers a bonus, how the amount of the bonus pool is determined, the form in which the bonuses are paid (e.g., cash, securities, a combination of cash and securities, etc.), allocation of any excess in the bonus pool, if and when participation rights are lost (e.g., upon termination of employment), and when bonus amounts are paid.

For example, a participantís bonus could be a fixed percentage of the bonus pool, or it could be based on a formula set forth in the retention plan (e.g., pro-rata based on the participantís wages over a fixed period compared to the aggregate of all participantsí wages over the same period). As another example, any excess funds left in the bonus pool after paying all bonus grants could be distributed pro-rata amongst the participants, or could revert back to the company for use outside the retention plan.

Depending on how the company drafts its retention plan, the company, through its board of directors (for a corporation) or managers (for an LLC), also has substantial discretion in, among other things, determining which employees participate in the plan, how much of the bonus pool will be allocated to each participant, and whether a particular participant is subject to vesting. A retention plan may also provide the board with substantial authority to reduce a participantís allocation of the bonus pool, or even terminate a participantís participation in the plan altogether. In other words, retention plans provide a level of flexibility that exceeds what may be accomplished with equity incentive plans.

A retention plan may also have other advantages that are not necessarily available with an equity incentive plan, including: no obligation to "buy in" on the part of the participant, no holding periods for preferential tax treatment (but also no preferential tax treatment Ė i.e., capital gains treatment), the bonuses are paid out before any liquidation preferences to preferred stockholding (which means there isnít the same possibility of the bonus grant becoming worthless as there is with an option grant), and with respect to LLCs, retention plans tend to be easier to implement than an equity incentive plan.

In addition, grants under a retention plan do not include any equity or other ownership rights, and therefore there are no securities compliance, ownership, voting or other dilution issues arising as a result of a grant under a retention plan.

However, there are also some potential negatives to retention plans, that, under certain circumstances, may be avoided with an equity incentive plan, including: the bonuses, when paid out, are always taxed as ordinary income and never receive capital gains treatment, option grants (and other equity grants under an equity incentive plan) are generally more familiar to employees, and employees are less likely to understand what they are getting under a retention plan (e.g., retention plan grants may not have the same perceived value to employees as would option grants.).

In short, a retention plan can be a valuable tool for entrepreneurs looking for creative and unique ways to attract, motivate, and retain talented employees, consultants and advisors.

Scott Aronson and Matthew Benson are corporate attorneys at Cook, Little, Rosenblatt & Manson, PLLC in Manchester.

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