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Having served as legal counsel to hundreds of sales representatives, perhaps the worst type of call that I receive is from an owner of a successful sales rep agency who has waited too long to think about — let alone implement — a succession plan, but who now has an urgent need for one.

In many instances, the urgency for having a succession plan is compelled by one of the agency’s principals (manufacturers), which has threatened termination unless an acceptable succession plan is in place by a given (typically short) deadline. But, what if you (as the owner) are not yet ready to give up any ownership interest in your company or to retire? In such cases, you may wish to consider a “Convertible Stock Appreciation Rights Plan,” which, as discussed below, provides a very flexible alternative to more customary succession plans.

The Two Goals of Succession Planning

Successful succession planning has two goals:

1. To assure the continued operation of the company after your retirement (or other departure).
2. And to assure that you (or your family) will receive the proper return on your investment of many years in building your successful agency.

These two goals are intertwined because the return on your investment will depend on the agency’s continued success in your absence. As such, in addition to choosing the right successor(s), you also will need to structure the succession plan so that the payments made to you won’t deprive the agency of the resources it will need to thrive both for your benefit and the benefit of its new owner(s).

The Problem: You Are Not Yet Ready to Share the Ownership of Your Business

There are numerous ways to achieve these goals. The most typical succession plan involves either the company or you selling stock to one or more key employees. Concurrent with the issuance (sale) of stock, the stockholders and the agency will enter into a Stockholders’ Agreement, whose terms will be the basis of the succession plan. Under a Stockholders’ Agreement, a stockholder (or his/her estate) typically will be obligated to sell his/her stock in the company upon his/her retirement, death or disability. In turn, the agency or the remaining stockholder(s) will then be obligated to buy all of those shares for a purchase price that will be determined and paid in accordance with the terms of the Stockholders’ Agreement. The “problem” inherent with this type of succession plan is that the agency will have a minority stockholder(s) who will have the right to inspect the company’s financial books and other records and to whom the majority owner(s) will have certain fiduciary and other legal obligations.

The Solution: Convertible Stock Appreciation Rights Plan

One way to avoid this “problem” is to use a succession plan that does not result in the immediate transfer of an ownership interest in your company, but which provides for the transition of ownership upon your death, disability or preferably upon your richly deserved retirement — even if that is not for many more years. That is exactly what a Convertible Stock Appreciation Rights Plan accomplishes.

In its traditional form, a Stock Appreciation Rights Plan (a “SARP”) is not a succession plan. However, it does allow you to accomplish a number of goals, such as:

1. Giving employees whom you select to participate in the SARP an added benefit of “sharing” in the increase (appreciation) of the company’s value.
2. Giving them the incentive to stay and to contribute to the success of the company.
3. And, (where permitted by law) binding participating employees to restrictive covenants (non-compete/non-solicitation).

Again, in its traditional form, a SARP actually is just a deferred compensation plan through which a participating employee or his/her estate may receive additional income at that employee’s death, disability or retirement based on the growth (appreciation) of their employer. Also, despite its name, under a traditional SARP, no actual stock is ever conveyed to the participating employee.

A Convertible Stock Appreciation Rights Plan Is Different

While the traditional SARP can provide benefits to the participating employees and to you as their employer (by retaining good employees), it does nothing with respect to succession planning. Therefore, to address the needs of owners who need a succession plan, but who are not yet ready to transfer any ownership interest to his/her employees, we have developed a “Convertible SARP” as the basis of a succession plan. The particulars of a Convertible SARP are as follows:

1. The company issues Stock Appreciation Right Units (“SAR Unit(s)”) to one or more participants equal to a percentage of the company’s common stock. The SAR Units typically vest over time, such as over three-five years. The initial value of each SAR Unit is based on the company’s value as of the date it is granted. For example, if the value of the company as of the date of grant is determined to be $1,000,000 (which can be calculated pursuant to a stated formula, such as one-times the company’s average annual gross commission income and gross profit from any buy/sell business), and if you grant the participant one SAR Unit that corresponds to one percent of the outstanding stock of the company, the SAR Unit would have an initial value of $10,000. Unlike issuing actual shares of the company’s stock, the recipient of a SAR Unit is not an owner of the company and does not have any of the rights as an owner, such as the right to review the company’s books and records, and also has no involvement in the management of the company — absent whatever duties you assign to the participant as part of his/her job.
2. If a participant dies or becomes permanently disabled (or possibly upon retirement or approved departure from the company if so provided in the SARP), his/her vested SAR Unit will be valued as of the date of his/her death, permanent disability, or retirement based on the then value of the company. This value will be determined using the same formula that was used to determine the initial value of the SAR Unit. The participant is only entitled to the appreciation in his/her SAR Unit over the initial value. This amount will then be paid to the participant (or his/her estate) by the company over time. As an example of how such a plan works: if a participant dies while owning a one percent SAR Unit that had an initial value when granted of $1,000,000, and the value of the company at the date of death is $2,500,000, the participant’s estate would be entitled to $15,000, representing one percent of the $1,500,000 appreciation in the company’s value. If the value of the company on the date the SAR Unit was granted was $1,500,000, he/she would only be entitled to $10,000, which corresponds to one percent of the $1,000,000 appreciation in the company’s value.
3. In a traditional SARP, a participant will only be eligible to receive payment upon his/her death or disability, approved retirement, termination by the company without cause, or if the company is sold. Except in the event of the sale of the company, the participant (or his/her estate) will be paid over a period of time, such as over five years. If the company is sold, the participant will receive the value of his/her SAR Unit(s) at the time of closing based upon the purchase price for the company. If the participant quits or is terminated for cause, the value of the SAR Units will be forfeited. A SARP is an unfunded deferred compensation plan; there is no need to deposit amounts owed to participants into a special or trust account. Also, to the extent permitted by applicable law, the participant can be bound to restrictive covenants — non-solicitation, non-compete and non-disclosure.
4. The difference between the traditional SARP and the Convertible SARP is that under a Convertible SARP, should you die, become permanently disabled, or retire, each participant will automatically vest in all of his/her SAR Unit(s), and these SAR Units will automatically convert to a corresponding percentage of the company’s actual stock. For example, if the SAR Units issued to all participants equaled five percent of the Company’s stock, those SAR Units would convert to the same percentage of shares and your ownership interest would be reduced by the same percentage. As part of a Convertible SARP, the company would then be obligated to redeem (purchase) all of your shares at a purchase price using the same valuation formula that is used to determine the value of the SAR Units. The resulting purchase price would be paid to you (or your estate) over time. In addition, the company’s obligation could be secured by the personal guaranty of each participant or a lien on the company’s assets or both.

How It Works

Here is how a Convertible SARP works: if there is a single participant who owns one SAR Unit equal to five percent of the issued shares, upon your death, disability or retirement, he/she would immediately own five percent of the stock of the company, and you (or your estate) would own the remaining 95 percent, which the company would then redeem. Upon the redemption of your shares, the participant’s five percent would immediately equal 100 percent of all shares (because you no longer would be a shareholder) and he/she would automatically become the sole owner of the company. If there are multiple participants, they each will own their respective percentage interest in the company. Although the participant will have a tax liability based on the value of the company, that value will be determined taking into consideration the company’s liability to pay you, and, in any event, such tax liability will be a lot less than if the participant had to pay the fair market value of 100 percent of the company. Further, as the new owner of the company, the participant should have additional resources through which to fund payment of any resulting tax obligation.

Convertible and traditional SARPs are extremely flexible. As the company’s current owner, you set the formula for determining the fair market value of the company; you decide who and how many participants will be in the SARP; you decide the terms of the SARP; you decide how many SAR Units to issue to a participant; you can add participants in the future; you can give different number of SAR Units to different participants; you can still sell the company to a third-party or merger partner or issue actual shares to an employee, and you can terminate the SARP at any time (but will still be obligated to pay any accrued value upon a participant’s departure in accordance with the SARP). At the same time, you still own the company.

A Convertible SARP can provide you with a “succession plan” that will help you retain key employees, will address and should satisfy the concerns of your principals, and, most important, will enable you (or your family) to eventually realize the value of what likely is your single largest investment.

MANA welcomes your comments on this article. Write to us at [email protected].