Non-Qualified Deferred Comp: The Basics

by | May 14, 2019 | Business Exit Planning, YouTube

Key Takeaways

While losing any of your key people in the life of your business is difficult and can be very detrimental to your business, it’s particularly damaging in the later stages when you’re planning your business exit.

A non-qualified deferred comp plan can be very helpful in keeping those key employees… but how does it work?

In this week’s video, we’re talking about:

  • What a non-qualified deferred comp plan is and how you can use it to reward and retain your key people.
  • The 4 key components of a non-qualified deferred compensation plan.
  • The first step in setting up a non-qualified deferred comp plan and how to identify your key employees.

Click here to watch the full video or read the full video transcript, below.

Transcript

Your key people, they know that they’re key, they know that they have negotiating power and sometimes they’re not too happy when they find out that the business is going to be sold or transferred. We want to do what we can to make sure that we’re:

  1.  Communicating with them in an appropriate way about what’s going on.
  2. We’re retaining and rewarding them and preventing them from going out and hanging their shingle and competing with us – potentially costing us the deal that we’re planning in our exit or a third-party sale that we’re planning.

Any buyer wants to see that the key management team is going to remain intact after the transition. If the business revolves around you or if you have key people that you are not doing anything to retain, that can be potentially very dangerous for a successful exit. That’s what I want to focus on today.

NON-QUALIFIED DEFERRED COMP: The Basics

Today, I want to talk about a very important concept in exit planning which is deferred compensation plans. These can be an excellent tool for planning your exit and making sure that you retain and reward your key people.

In the early days of True North, within the first couple weeks of launching our firm, we lost one of our key people and it was a devastating blow. I had some real reservations about how we were going to move forward from there. Luckily, we were able to bring somebody else on very quickly who was able to pick up the pieces of losing that key person.

WHAT IS A NON-QUALIFIED DEFERRED COMP PLAN?

Let’s talk about what a non-qualified deferred comp or deferred compensation plan is. The name is a little bit self-evident there. Non-qualified means that the plan is not subject to the strict rules of ERISA, which govern plans like 401k’s. There’s a qualified retirement plan, which is like a 401k or a profit-sharing plan and then there’s non-qualified, which is like the non-qualified deferred comp that I’m talking about today. The primary difference between the two is that the laws of ERISA do not govern the non-qualified deferred comp plans, which makes them very flexible.

There’s a lot of options when it comes to designing the plan, who you include in the plan. We’ve got the non-qualified piece of it, but then we also have the deferred compensation. What does that mean? What that means is that when you pay your employee, you can put part of their pay into this deferred compensation plan. It means that they’re still getting the money, but it’s been deferred to a later date. It’s very popular!

These plans are used all the time in large companies and particularly for executives and key people. You can use the plan to incentivize them. Let’s say they get a base salary of x and then they get a bonus of x and if they hit certain parameters, maybe they also get money put into their deferred compensation plan of $x as well. Because they’re so flexible, you can design them in a myriad of ways and have certain criteria like, money is only going to be going into the deferred compensation plan if you hit x target.

The key is, that this is all in writing. You can’t just change your opinion from day to day about what constitutes a qualification of someone getting employer money going into the plan on their behalf. But, they are flexible.

NON-QUALIFIED DEFERRED COMP: Reward & Retain Your Key People

How does a non-qualified deferred compensation plan play into retaining and rewarding your key people? If it’s designed well, a non-qualified deferred comp is often the simplest and most effective way to reward and retain your key people.

I’m recording this video in early May 2019 and the unemployment numbers just came out from last month. The unemployment rate in the United States is 3.6%. That is the lowest it’s been since December of 1969! Many of you watching, don’t even remember a time like this. That’s the same year that we went to the moon – more than half a lifetime ago!

Unemployment rate is very low. What that means is that if you are out looking for a job, if you are a key person, you have a lot of negotiating power. It is one of the best times to be looking for a job in the last 50 years because there are so many unfilled jobs right now and there’s a lot of opportunity for skilled and knowledgeable people to find work.

We must retain these people. It’s not like retaining them in a recession where they’re less likely to make a move and there’s less opportunities for jobs. There are abundant opportunities for jobs right now and it is critical that we retain those people.

KEY COMPONENT #1: Create A Vesting Schedule

I want to talk about four key components of a non-qualified deferred comp plan and how that relates back to exit planning. One of the common things that I see in talking with business owners is, that they don’t do enough to put handcuffs on their employees. I don’t mean handcuffs in a negative way, but there are certainly things that you can do that places handcuffs on your employees.

One of the unique features about the non-qualified deferred comp plan, when it comes to retaining people, is that you can use a vesting schedule. Let’s say, every year you contribute to the deferred compensation plan and you put in x dollars, the money contributed in that year, vests over a period of several years. To get that money that was put in, say in 2019, they need to stay on board until 2025.

You can also write into the plan document referencing when there’s a change of control – everything vests immediately. Or, you can set it up so that when there’s a new ownership, there’s a distributive event. It incentivizes them to stay on because when there is a new ownership change, they’re going to be able to get paid out of the plan and they don’t have to retire in order to get their money out of the plan.

You can have vesting schedules for every single year. I can have a vesting schedule for this year, contribute to the plan next year – where there would be a new six-year vesting schedule for that. If the contributions are significant, these can add up over time to several hundred thousand dollars that an employee would forfeit or could potentially forfeit a significant portion if they were to leave.

KEY COMPONENT #2: Put It In Writing

The other key component of a non-qualified deferred comp plan is, this needs to be in writing. This is very important! It should go without saying, but when it’s in writing, it establishes what all the criteria and the plan design is, what the vesting schedule is, what the criteria is for receiving a contribution, etc. It’s important and a good, well designed, non-qualified deferred comp plan should be in writing.

KEY COMPONENT #3: Determine Your Criteria

One of the more popular ways that employers will use the non-qualified deferred comp plan is, to incentivize employees with a certain set of criteria. You might only reward a contribution for an employee in a non-qualified deferred comp plan for a given year, if certain metrics or certain benchmarks are hit. These are usually tied to growth.

If you need the business value to be worth more through higher revenues, higher profitability, the business is not quite where it needs to be yet – we can use the non-qualified deferred comp plan to align the employee’s interest with that of you as the owner. In an ideal world, we would do that and you can be creative with this.

You’ll want to talk to your advisor or your attorney. Whoever is helping you set up and design this non-qualified deferred comp plan, have discussions with them about what the criteria is to receive a contribution. You can set up a certain set of criteria. People don’t get a contribution just because they’re breathing, and they show up for work. You can set it up so that they only receive money in the plan for a given year if certain benchmarks are hit.

KEY COMPONENT #4: Clearly Communicate The Forfeiture Agreement

One thing that I mentioned earlier, that is very important to discuss when it comes to forfeiture, is you can actually mandate that an employee sign a non-compete or confidentiality agreement.

If you have all these stipulations in their employment agreement that prevents them from taking your customers, your vendors, your employees and setting up shop down the street and they violate that, every dollar of their non-qualified deferred comp plan can be gone. They could forfeit it all if they violate the provisions in their employment agreement. It’s very important that you stipulate that and you communicate that with your employees so they don’t get ideas.

That is one of the things that can go South when you have a key person that leaves. They can take your employees, your customers maybe a year prior to when you exit and totally destroy your business, destroy the valuation and destroy your chances of leaving successfully. Now you’re staring down at maybe 10 more years of working to recover what happened. We want to avoid that at all costs. Incentivizing an employee to stay and not leave and compete with you through a non-qualified deferred comp plan is a not only a very powerful tool to be able to reward your employees, but also incentivize them to have their interests aligned with yours.

NON-QUALIFIED DEFERRED COMP: Get Started

How do we take action on this? Well, the first step in setting up a non-qualified deferred comp plan, is to really sit down and evaluate who your key people are. Who in your organization, if they left tomorrow, are the people who have the key relationships with your customers or your clients? Who are the people that are so deep in the operational side of your business or in the sales and marketing.  Who are the people that if they left tomorrow, that you would be devastated and it would be very damaging for your business. It would be very distracting because not only would you have to replace them, but you’d have to replace everything that they have up in their mind that’s critical to the operations or the growth of your business.

We really want to identify the key people. In a non-qualified deferred comp plan, you don’t have to include everybody. You might have a hundred people that work for you and you may have only one key person. That’s fine. You can set up a non-qualified deferred comp plan for that one person. It doesn’t matter the size of your organization.

It can attract new people in the future too. If you’re bringing on somebody for a critical position like a key management role and you want to incentivize them to work for your company versus another company, you know you can talk about the non-qualified deferred comp plan and how that’s part of the deal too. It’s a way to also not only just keep the people we have but attract new people that we’re going to need down the road.

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ABOUT THE AUTHOR

ASHLEY M. MICCICHE, QPFC®, CRPC®, CEXP®

Ashley helps business owners exit their business and retire with financial security. As a Certified Exit Planner she specializes in helping business owners navigate the maze of decisions that need to happen from full-time running their business to retirement.

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