We’ve all heard about “golden parachutes” and if you’ve only ever been exposed to them through mass media, you’re likely view them as an odd little tool used by companies to help the richest of the rich get richer. And while that has certainly happened in a very public way more than a time or two, these prearranged severance agreements can be a very useful and strategic tool even for small companies when dealing with key employees.
Let’s look at a few common questions and misconceptions:
What is a golden parachute really?
A golden parachute is a risk management tool – one that helps manage risk for employer and employee simultaneously. Golden parachutes are agreements that describe the handling of a yet unplanned but reasonably feasible outcomes before those outcomes becomes likely. Examples include acquisitions, terminations, and re-organizations. The most common such agreements define severance payments in the event the company terminates the individual (usually with some caveats around circumstance). Agreements can address a variety of other situations for a variety of reasons, but fundamentally the goal is to constrain the unavoidable uncertainties of the business so that the risk is manageable for both company and employee and the individual joins or stays with the company for a mutually desirable period of time.
Why do employees seek golden parachutes?
As employees get more senior, there are fewer and fewer opportunities available to them in the job marketplace because there are simply fewer and fewer jobs at their seniority and earning expectations. The option to start one’s own business typically also becomes more feasible in the later years of one’s career. Consequently, there is a persistent opportunity cost embedded in any job related to not pursuing other opportunities. There is also a substantial cost (in time and money) to pursue other opportunities when forced by circumstance to do so. A golden parachute reduces the risk and impact of these costs encouraging an employee to commit to a long-term role with the employer.
What do employers like golden parachutes?
When a particular employee has substantial direct impact on the performance and sustainability of a business, the risks to the business associated with losing the employee can be substantial. While increased earning potential and quality of working relationships regularly drive employees to switch employers, uncertainty and risk play a key role as well. Compensation and (to some degree at least) working relationships are directly controllable by management, but the future can only be imagined, not fully controlled by employers making uncertainty and risk unavoidable. Golden parachutes lessen the impact on employees and help businesses retain their most important assets.
Why wouldn’t a business just use equity to retain key employees?
Many businesses create an incentive to remain with the business by including equity or equity-like instruments where some or all the benefits from the equity are forfeited upon departure. While this creates an incentive to ignore outside opportunities, it does nothing to address issues of uncertainty in the case of an acquisition or unexpected change in business strategy that render the employee ill-suited for the role they occupy. It also creates a perverse incentive to other shareholders to see newly issued shares not vest lest they dilute their own positions.
Furthermore, the distribution of equity (even in pseudo forms) adds complexity to the administration of the business. Voting rights, distribution of earnings, allocation of funds during monetization, collection of funds during recapitalization events and addressing liabilities are among the management activities that grow in complexity with increased number of shareholders. Furthermore, these burdens are on-going rather than discreet burdens. For many employees, not all aspects of equity ownership are desirable or even wanted so it is very possible to add headache without receiving benefit.
Why would a business want to incur the additional cost of a golden parachute?
Golden parachutes are designed without the expectation of ever being executed. Like insurance policies, there is value in having them even without invoking them. They protect the employee from adverse events which neither the employee nor employer expect to see happen while simultaneously protecting the employer from unexpectedly losing the employee due to concern about such events. If an employee leaves on his/her own terms, the golden parachute never gets invoked. If the adverse events never happen, the golden parachute never gets invoked. It is common for golden parachutes to generate no realized costs while producing significant benefits.
Golden parachutes get executed based on conscious and intentional decisions by the company. In these cases, the company will have determined that the cost to the company of not invoking the parachute (usually an opportunity cost) is greater than the cost of executing the agreement. While in that moment, the parachute may seem costly, those costs should have been more than offset by the contributions of the employee during the period where the parachute plan was in place but not yet invoked.
How does a business design an effective golden parachute?
There is no single template for a golden parachute plan. Each should be crafted to specifically address the unique risks and objectives for both the company and the individual. However, the following are generally good guidelines:
- Be thorough and specific in defining the trigger criteria for invoking the plan
- Size the value of the plan in relation to the long-term impact on the business from losing the employee not the immediate run-rate impact
- Grow the value of protections over time and with increasing contribution
- Cap the benefits included in the plan
- Don’t make the plan so lucrative that it is more attractive to underperform than to perform at or above expectations