Many agencies ultimately are faced with having to deal with the expectation of key employees being shareholders. Rather than responding to those expectations by ducking the issue with vague statements such as, "The agency principals are considering the possibility of additional shareholders," it is our experience that it is in the interest of the agency principals to have a plan in place which addresses these expectations.
The fact of the matter is that many key staff members as well as important producers want to feel that they are true "partners" in the agency. Psychologically, even a relatively small level of equity ownership can have a very positive effect on a key individual's perception that he/she is "part of the team."
There are, of course, a number of traditional, equity-based compensation programs including stock options, restricted stock, phantom stock and stock appreciation rights. Although these programs generally are perceived as being exclusively within the domain of public companies, the fact is that the only additional issue which must be dealt with as a private company is the valuation issue. While the value of a publicly traded company can be readily ascertained in the financial press, the value of a private company must be assessed periodically by a qualified valuation expert such as Harbor Capital. Many readers may be familiar with ESOP agencies which must be valued on an annual basis. These valuations are performed with the utilization of accepted valuation methodologies. A number of these methodologies actually utilize price earnings data from publicly traded brokers such as A.J. Gallagher and Poe & Brown.
While stock options, restricted stock, phantom stock and stock appreciation rights can be fairly complicated, we will attempt to present an overview of how these programs operate and the potential benefits of utilizing them.
All of these programs should be considered in light of the features of the plan and its conditions, the tax implications of the plan to the agency and the employee, as well as any accounting impact to the agency.
Incentive stock option (ISO)
An ISO provides agency employees with the ability to profit from the increase in the value of the equity in the agency without the risk and associated costs of actual ownership. Typically ISOs are subject to vesting requirements. Vesting can be based on tenure or the reaching of agency performance goals. The general trend today is to make vesting more performance-oriented.
Restricted Stock
Under a restricted stock program, an agency employee is sold shares of stock at a deep discount from fair market value. For instance, the agency equity could be valued at $100 per share and be sold to an agency employee at $1 per share.
A restricted stock program gives the employee the ability to gain or lose from changes in the value of the agency's stock with no investment risk. The stock issued is typically subject to an agreement under which the employee agrees to resell the stock to the agency for the nominal price per share originally paid by the employee if the employee leaves the agency before the end of a critical period of time. Typically, vesting would take place over a five-year period. An alternative to time vesting is performance vesting where repurchase restrictions disappear when performance goals are met. This could incorporate achieving new business production or increases in agency earnings.
Phantom stock
With a phantom stock plan, the agency would establish a benefit account for the employee equal in value to a specified number of shares of stock. This account would increase or decrease in value as the underlying agency stock increases or decreases in value. The value of the account is paid to the employee over a certain period of time, subject in most cases to non-competition restrictions.
Stock appreciation rights (SARs)
Similar to a phantom stock plan, with an SAR plan, the agency would establish a benefit account for the employee equal in value to a specified number of shares of stock which would increase or decrease in value as the underlying agency stock increases or decreases in value. Like an ISO, the account can be fully vested or subject to tenure and performance vesting requirements. The value of the account is paid to the employee over a certain period of time subject in most cases to non-competition restrictions.
Generally, there are no immediate tax consequences to the agency or the employee as a result of the initiation of any of the above plans.
Other equity structures
In addition to these traditional equity-based compensation programs, special structures can be put in place to handle the more complex issue of producers who currently have ownership rights in their books of business and who desire to convert those ownership rights in the book of business to an equity stake in the agency.
Many agency principals who are willing to consider more traditional plans pull back when the issue of bringing new shareholders on board is raised. There is a sense of giving away some control over the agency's management as well as having new "partners" to deal with. There are several ways of overcoming these obstacles, some of which are issuing non-voting stock or different classes of stock. For instance, new classes of stock can be valued as a function of the profitability of a certain block of business or division, which is being serviced by the new equity partner.
Another potential option is the formation of a new subsidiary with an equity position being given to the existing producer contributing his/her equity stake in a specific book of business. In the case where the producer had more than a minority stake in a book of business, the agency could, for instance, contribute an existing book of business to that newly formed subsidiary, which would generally consist of accounts for which the producer-shareholder had servicing responsibilities but no ownership rights. The goal in these plans is to give the producer a minority equity stake in a newly formed subsidiary. New business generated by the producer may call for additional shares to be issued. A shareholder agreement would contain a buy/sell agreement and possibly a conversion feature, which allows for an exchange of subsidiary stock for stock in the parent agency.
In summary, these equity-based compensation plans give agencies the ability as well as the flexibility to attract and retain talented individuals, giving them the appropriate motivation to succeed and in turn be compensated with appreciating equity. While we have touched on some of the mechanisms to accomplish these goals, one must remember that each agency has its own nuances and an individualized equity-based compensation plan should be structured for each unique agency. These equity-based compensation plans are often included with performance-based plans offered by Harbor Capital Advisors in their OpportunityCOMP package for agencies and brokers. *
The authors
Paul J. Di Stefano, CPA, CPCU, is the managing director of Harbor Capital Advisors, Inc., a national financial and management consulting firm which offers services to the insurance industry. Services include agency appraisals, merger and acquisition representation, strategic and management consulting. G. Edward Kalbaugh, BSE, MBA, is director of management advisory services for Harbor Capital. Harbor Capital Advisors, Inc., can be reached in New York at (800) 858-2732. E-mail: harborcapitaladvisors@banet.net
©COPYRIGHT: The Rough Notes Magazine, 1999