Overview
Top talent can build enterprise value, but only if they stay. Incentive and retention plans aren’t only perks, they’re strategic tools that align key employees with long-term growth, protect business continuity, and increase valuation multiples. Well-designed plans fund themselves instead of draining cash. Here’s how smart business owners design incentive structures that reward results, retain leaders, and strengthen company value.
Why Incentive and Retention Plans Matter
Most business owners know that people are their greatest asset, but few truly honor how fragile that asset can be – especially the key employees who drive revenue, manage client relationships, and/or hold the operational glue together.
A business without a strong incentive and retention plan is like a championship team without long-term contracts – your star players eventually leave for better opportunities. When they do, enterprise value plummets. Buyers and investors will immediately discount valuation if they see an overreliance on employees who could walk out the door.
When those key players stay – when they’re locked in, motivated, and aligned with ownership’s vision – everything compounds. Growth accelerates, culture strengthens, and consistency turns into profitability. Stability doesn’t just protect value, it multiplies it.
Incentive and retention plans aren’t just about keeping employees “happy.” They’re about creating performance-driven structures that reward excellence, ensure continuity, and fund themselves through growth. The best plans strike a balance between motivating top performers in the short term and protecting and growing enterprise value for the long term.
Different objectives call for different features of a company's incentive plan:
- Drive performance → Clear metrics align teams with ownership’s goals.
- Preserve flexibility → Custom design that doesn't dilute equity, with proper contingencies in place.
- Protect enterprise value → Buyers pay more when key talent is secured in an identifiable way.
- Reduce risk → Long-term commitment strengthens continuity.
- Fund sustainably → The best plans are self-funding – payouts occur only when goals are met, or value is created.
Types of Incentive & Retention Plans
- Performance Bonus Plans (Self-Funded)
Sample Case Study:
Take a medical practice that wanted to drive accountability among its partners. The owners designed a bonus plan tied directly to revenue minus expenses (net collections). The plan was entirely self-funding, meaning if targets weren’t hit, no bonus pool was created for the partners. Over five years, the practice grew 35%, as physicians became more business-minded and aligned with the financial health of the group. They were focused on their objectives and what mattered most to achieve greater growth.
Lesson:
The best bonus plans fund themselves by assigning key metrics that will improve revenue and cash flow, thereby rewarding success without draining cash flow.
Benefits:
Partners and employees win when the company wins.
Risks:
Overcomplicated metrics cause confusion; simplicity drives motivation.
Key Point:
Self-funding plans ensure rewards only come from success, not at the company’s expense. When designed correctly, a no risk, win-win scenario.
- Phantom Stock Plans
Sample Case Study:
Imagine a family-owned distribution company that wants to reward top managers but isn’t ready to give up equity from the family. The owners design a phantom stock plan – granting “units” that mirror the company’s growth in value. As the company expands, the phantom stock values rise, creating a tangible incentive for key employees. When the business sells, participants receive cash bonuses tied to that appreciation – while the family’s ownership remains fully intact.
Lesson:
Phantom stock can create a sense of shared ownership without giving up actual equity.
Benefits:
Aligns employees with decisions that improve company growth without giving up equity; rewards non-family employees to compensate for family preference of pure equity ownership.
Risks:
Requires formal valuations and liquidity planning.
Tax Note:
Payouts are taxed as ordinary income to employees and are deductible to the company.
- Stock Appreciation Rights (SARs)
Sample Case Study:
A professional services firm wanted to reward long-term growth without committing to a full equity plan. They implemented Stock Appreciation Rights – granting value only on the increase from the grant date. Over several years, these SARs became a powerful motivator for the leadership team, since payouts depended solely on improving company performance from the starting point.
Note: This is different than phantom stock because SARs only pay out on the increase in company value after the grant date, while phantom stock is more likely to reflect the full share value – including both the original worth and any growth over time.
Lesson:
SARs can offer the upside of equity participation without ownership complexity and without rewarding newer employees for unrelated prior value growth.
Benefits:
Strong performance incentive, less expensive than phantom stock.
Risks:
Requires valuation and accrual funding – taxed as compensation.
Funding Example:
Firms often allocate a small portion of free cash flow annually into a reserve – effectively a sinking fund – that matches projected SAR liabilities and ensures liquidity at payout.
- Non-Qualified Deferred Compensation (NQDC)
Sample Case Study:
Consider a mid-sized engineering firm that wanted to keep its senior leadership team engaged through a major growth phase. By deferring a portion of annual bonuses for the CFO and COO – tied to long-term company goals – the firm encouraged alignment and retention without giving up equity. When the company eventually sold to private equity, both leaders received significant deferred payouts. But the bigger story was the owners: continuity among key executives had doubled EBITDA and increased the company’s valuation multiple from 4.5x to 6.5x.
Lesson:
Properly structured deferral plans can turn short-term bonuses into long-term value drivers.
Benefits:
Creates “golden handcuffs,” offers tax deferrals for highly compensated employees far beyond qualified plan limits, and flexible designs.
Risks:
Must comply with IRC §409A (penalties for noncompliance).
Funding Example:
Corporate-owned life insurance (COLI) is commonly used to build tax-deferred cash value and fund future payouts. Other firms use sinking funds or segregated investment accounts.
- Supplemental Executive Retirement Plans (SERPs)
Sample Case Study:
A manufacturing company looking to retain long-tenured executives designed a Supplemental Executive Retirement Plan. The employer committed to fund a defined benefit at retirement – effectively bridging the gap between existing savings and desired retirement income. Using company-owned life insurance as an informal funding vehicle, the company built tax-deferred cash value over time to support the future obligation.
Lesson:
SERPs can retain leadership and strengthen loyalty during critical growth years.
Benefits:
Fills retirement gaps for employees to improve long-term security and helps to lock in long-term continuity for the company.
Risks:
Requires a long-term funding commitment.
Funding Example:
Many SERPs use COLI for tax-advantaged growth, more predictability through insurance guarantees, and liquidity at payout.
Key Design Elements of a Strong Plan
Objectives:
Determine whether the primary goal is retention, improving company valuation multiple, incentivizing employees to own company performance, succession, protecting a pre- and post-exit period, rewarding prior contributions, or a blend.
Performance Criteria:
Focus on 2–3 clear metrics (e.g., EBITDA, revenue growth, client retention), especially those with a clear tie to company outcomes that will allow for proper funding and payout.
Funding Strategy:
Use sinking funds, structured reserves, or COLI to ensure liquidity.
Vesting Schedules:
Build “golden handcuffs” that reward long-term commitment and prove to potential buyers that key employees have reasons to stay.
Communication:
Employees must understand the plan for it to motivate them.
Self-Funding Principle:
Structure plans to pay for themselves through improved performance, increased enterprise value, or deferred timing of payouts until a liquidity event. Non-financial metrics can have a place but should be considered carefully to ensure that any bonuses earned are paid for by associated real company results.
Tax Considerations
Employee Taxation:
Most, but not all, forms of payouts are ordinary income when received.
Employer Deduction:
Companies typically receive a deduction at payout.
409A Compliance:
Avoid constructive receipt and meet timing rules.
Funding Mechanisms:
Informal funding is common, but life insurance provides tax efficiency and certainty.
Why Buyers Care About Incentive & Retention Plans
When it’s time to sell, buyers don’t stop at analyzing your financials; they evaluate your people and processes as well. If your rainmakers and key managers can leave after closing, perceived risk skyrockets.
Strong incentive and retention plans:
→ Demonstrate management stability and continuity.
→ Reduce owner dependency (your exit doesn’t trigger chaos).
→ Increase valuation multiples.
→ Provide clarity and predictability around future compensation liabilities.
→ Signal that the business is professionally managed, consistent, and scalable.
Example:
Two manufacturing firms, each with $5M EBITDA, went to market…
Company A
No incentive or retention plans → Valuation multiple 4.5x = $22.5M.
Company B
Phantom stock and NQDC for key managers → 6x = $30M.
That’s a $7.5M value gap, created purely through stronger human capital planning.
The Bottom Line
Don't think of incentive and retention plans as employee perks. Understand that they’re part of company performance infrastructure.
Salaries keep people employed. Incentive and retention plans keep them engaged, loyal, and invested in your company’s success.
When your best people stay, they help to build and capitalize on momentum. They become the force multipliers who attract more talent, preserve culture, and drive enterprise value higher every year. They have a different sense of skin in the game.
When designed correctly, these plans are self-funding – they pay for themselves through improved performance, higher valuation, and long-term profitability.
Without them, you might be risking both painful turnover and enterprise value. With them, you’re protecting your future, maximizing valuation, and securing your business legacy.
This is the importance of "People Planning" in business, and these strategies are too often overlooked. In an environment where talent drives value growth, failing to plan can be a pernicious liability. The best businesses don’t leave it to chance – they design for performance, retention, and long-term success.
2025-8478532.1 Exp 10/27