Employee Ownership Opportunities

EMPLOYEE OWNERSHIP OPPORTUNITIES

One of the key elements in creating a team of employees dedicated to achieving agency objectives is to provide meaningful incentives that will reward individuals for their support of the group effort. When commissions, bonuses, and awards are used in conjunction with a participatory management style and an overall atmosphere of mutual respect, such performance-based rewards will help maintain the necessary level of enthusiasm. But sooner or later most agency owners will be faced with the question of whether to give employees the opportunity to obtain equity, the 'ultimate' incentive.

Twenty years ago, the term 'equity' was almost always associated with actual ownership in the agency through the transfer of stock or partnership shares. Today there are other options available that can give deserving employees a piece of the action without compromising agency perpetuation plans or the principals' voting rights. Although an employee's contribution to the achievement of agency goals should definitely be one of the criteria used in selecting future owners in the dependent agency system, the decision to share agency ownership should not be based solely upon the desire to reward performance. When the best producers lack the other qualities that you want in fellow owners, you should offer other types of incentives.

In evaluating the many options now available, it is important to remember that implementing any type of equity sharing program is more permanent than simply giving a raise or bonus. Before entering into any arrangement that ties individual performance to the value of a book of business or to the value of the agency as a whole, it is essential that all of the owners come to grips with their own personal desires and also that they jointly decide what they want for the future of the agency. Consider each of these alternatives within the context of the goals of the existing ownership group, and accept or reject them based upon their compatibility with the bigger picture:INDIVIDUAL STOCK OWNERSHIP-Agencies that plan to perpetuate internally will be looking for employees who possess an entrepreneurial spirit, a desire to participate in the management of the agency in the future, and a willingness to contribute to the buy-outs of retiring owners. Most employees will say that they would like to be owners, but when push comes to shove only a small fraction of them are truly willing to make the financial and personal sacrifices that are associated with a major ownership role. Promising ownership when you hire someone is like playing Russian roulette with five loaded chambers. No matter how qualified a candidate seems to be, you cannot know at this point whether he or she will work out as an employee, much less as an agency principal.

The initial employment contract and/or compensation plan can certainly indicate an intent to consider the person for ownership but, if so, it should clearly spell out the criteria that must be met (on both sides) for that to occur. And it should present a specific timetable for when the decision is to be made. Simply saying to someone 'if you do a good job we will make you an owner' is not sufficient. How do you define 'good job'? When will this happen? How much ownership are you talking about? Will the stock be given to them or must they buy it? At what price?

Because it generally takes an employee several years to get acclimated to the agency environment and start to produce at an optimum level, most agencies will consider someone for ownership only after they have been employed for at least two years. At that time successful candidates will either be allowed to purchase stock immediately in the future (with or without a discount); be granted a stock option for purchase (usually at a discount or with a frozen value); or, in the case of a family situation, may be gifted stock. Depending on the perpetuation goals and personal wishes of the principals, the ownership can be in the form of voting stock, non-voting stock, or junior stock.

In situations where a discount is being given or where the amount of stock being offered is flexible, it is most appropriate to base the decision on some measurable aspect of the individual's performance as a producer or employee. This could include: prospects obtained; effective hit ratio; commissions written; department/unit growth or profit; education milestones achieved, etc. Take special care not to offer too much of a discount off of the value that the current owners are using for their Buy-Sell formula. There is a finite amount of money available for perpetuation, and if the new owners do not put enough into the ownership pie (directly or by way of increased production with lower compensation percentages), there will not be enough capital available to buy out the existing owners when they retire.PHANTOM STOCK/PERFORMANCE UNITS-When agencies are owned by third parties such as financial institutions, real estate firms, or the largest client, sharing ownership with the employees including the Agency President may not be an option. In other situations agency owners may not yet have decided whether they want to implement an internal perpetuation plan or whether their children will be coming into the agency. In these cases it is still possible to give key employees a form of equity by awarding them profit sharing units that are frequently called phantom or shadow stock.

The most common way to create such a profit sharing program is to set up the same number of units as there are shares of common stock in the corporation and to value these units in the same way that agency stock is valued. As the value of the agency increases, the value of the phantom stock also goes up although the employee does not have any of the other rights or benefits of stock ownership. When the employee retires or leaves the agency, he or she will be paid for the value of the phantom interest, usually over the same period of time and under the same terms that apply to the owners of the real stock. A provision can also be placed in the contract that the phantom stock can at some time in the future be converted into actual stock at the mutual agreement of all parties either by setting it up as a stock appreciation right in the beginning or simply by treating it as a conversion privilege later on.

There are a number of variation on the phantom stock theme, all of which can be used to reward past performance by tying the individual's eventual pay-out to the future success of the agency as a whole or to the results of a specific department. Performance units can be granted that are based upon commissions, revenues, profit or some combination of measurable results. These units would either be valued at a fixed dollar amount with the number of units varying based upon performance criteria, or they could be set at a fixed number with the value increasing as results improve. This approach can be very useful in larger agencies where department managers may have a lot of control over their own area but where it may not be appropriate to award shares that are based upon the value of the total agency. Some examples of this are life, group, or personal lines departments in commercial property-casualty agencies. Again, performance units can either be converted to agency ownership in the future or they can simply be a means of paying deferred compensation.

There are times when executive employees or key producers will develop a real or perceived fear that the agency will be sold out from under them before they can become owners and that they will receive nothing in return for their past loyalty and service. One way to allay these concerns is to provide a deferred compensation program based on phantom stock or performance units and to further sweeten the deal with a 'golden parachute' provision that tacks on an additional percentage (10% - 25%) of value to the units if the agency is sold to an outside party. On the other hand, the owners may be concerned that the employee will take the phantom stock and then quit at the end of a very good year when the value is high. This eventuality can be controlled by using 'golden handcuffs' such as: vesting provisions that discount the value until a number of years have past; or, having two values, one that kicks in at retirement/death/disability and another if the employee leaves before age 65.VESTING IN BOOK OF BUSINESS-An increasingly more popular form of providing equity is to allow producers to vest in the value of their own book of business rather than in the value of the agency as a whole. In these programs the agency agrees to pay the producer deferred compensation when he or she leaves the agency. The compensation is generally based upon a percentage of the commissions produced by the person, such percentage increasing the longer the producer stays with the agency (hence the use of the term 'vesting'). Agency owners thinking about setting up programs for new or existing producers must make some important decisions about what they are trying to accomplish. These decisions should then be documented in the written employment contract so that there is no confusion later on:

• Definition of Commissions to Be Included-Will this include: all commissions even agency business given to the producer to handle; life and group business in addition to property-casualty; only the book that the producer brought to the agency initially; or only new business produced after the first year?
• Length of Vesting Period-Generally somewhere from five to 10 years.
• Percent of Additional Vesting Each Year-Generally from 10% to 20%.
• Maximum Amount of Vesting-Generally 50% but some go to 100%.
• Value of Deferred Compensation-Generally from three-quarters times commissions up to two times commissions with the amount depending to a great extent upon the vesting percentage and number of years.
• Higher Value Opportunities-Agency may (or may not) pay more if the producer leaves at normal retirement, dies or is disabled versus termination.
• Timing and Method of Payout-Price can be fixed based upon last 12 months' commissions and paid out over a number of years with or without interest or it can be based upon the retention of the business over a two or three year period after the producer leaves [note: we prefer the latter].
• Option for Conversion of Vested Value into Agency Stock-Can be guaranteed, contingent upon reaching production goals, at agency owners' option in the future, not included as an alternative at all.

All producer vesting contracts should clearly state that this is simply a right to receive deferred compensation and that the ownership of the expirations remains with the agency. Further, it should be clear that the deferred compensation is being paid as consideration for the producer's agreement not to solicit that business for a period of at least three years after leaving the agency. If he or she does write any of the accounts either the entire compensation is forfeited or at least the portion that was based on the accounts in question.

It is also important for agency management to recognize the impact that these plans have on the total producer compensation program and available agency cash flow. If you are agreeing to pay producers on the back end, you cannot afford to pay as much on the front end. In other words, the percentage of commissions paid to the producers for selling and servicing the business should be lower in an agency that has a vesting program. How much lower will depend upon the vesting period, percentage, and valuation method.EMPLOYEE STOCK OWNERSHIP PLANS-An ESOP is an employee benefit plan in the form of a trust fund that invests primarily in agency stock. It is in effect a deferred compensation plan in which employees participate in the ownership of the agency according to their salary level and length of service. By setting up an ESOP agency owners can provide an opportunity for employees to share in the growth of the agency, without having to take a reduction in take home pay as they would if they were going to buy stock directly. If the annual salary levels are based upon individual performance the employee's contribution to the ESOP will also be based upon performance. The ESOP can therefore provide an incentive program that rewards both individual and group results.

ESOPs were popular in the '80s more as an internal perpetuation mechanism than as an employee incentive program. Although changes in the tax laws have restricted some of the benefits inherent in the use of such a plan for perpetuation financing they can still be an attractive ownership transfer option for agencies meeting certain stringent criteria. First, the principals of the agency must be philosophically in favor of employee ownership. Second, the agency has to have a large enough profit potential (20%) and high enough eligible payroll costs (at least $400,000) to fund the ESOP and the relatively high administrative costs. Third, agencies in which revenues and profits have not been growing at a healthy rate may risk having the stock price decline after the implementation of the ESOP and should postpone the adoption of the plan until there is more stability. Fourth, there must be at least one person in the agency who is capable of running the place after the current owners leave or start to slow down. ESOPs may help with the financial aspects of perpetuation transfers but they cannot provide on-going management direction for the organization.

For agencies meeting the above criteria, the following is a list of the major advantages of adopting an ESOP:

Agency principals that are considering implementing an ESOP should investigate all of the pros and cons and get a feasibility study done by a reputable financial consultant who is experienced in insurance agency situations. This research process should include talking with the remaining agency principals in firms that instituted ESOPs several years ago.

[Note: Asking the principal who sold out and got top dollar for the shares about the advantages of an ESOP will not provide you with the complete story.]

The bottom line is that ESOPs can be very expensive and will therefore not be a good idea for most insurance agencies. It costs a minimum of $25,000 and usually more the first year and at least $5,000 or more in subsequent years to get the documents in order and the necessary valuations done. In a leveraged ESOP the agency must make a predetermined contribution every year in order to meet the loan payments, something that can be difficult during tough times in the market or economic cycle. If the agency has a large number of older employees who have been around for a long time and who are making pretty good salaries, the buy out obligations could be significant at a not too distant time in the future. And the remaining agency principals have to be careful how they spend money since the obligation to the employees and the stock value will have to take precedence over personal goals in making management decisions on how to spend the agency's money. Remember, ESOPs come under all federal ERISA guidelines and restrictions and the fiduciary responsibility can be an overwhelming burden.

By utilizing the equity programs we have outlined here (or some variation thereof) agencies of almost any size and orientation can still obtain a number of the benefits of employee group ownership without many of the negative side effects associated with an ESOP. For example, the phantom stock or performance unit programs can be expanded to include all employees rather than just a select few. With a little creativity the increase in unit value can be translated into increased 401(k) matching amounts thereby giving employees protection under a qualified plan that they would not have with regular deferred compensation plans. Another option would be to give all employees who meet certain criteria the opportunity to purchase career shares at book value (very low in most agencies) which will then be convertible to agency stock at fair market value upon both the agency and the individual reaching certain performance and/or longevity goals.