Retail Business Lifecycle

As retailers navigate difficult operating conditions, they need to ensure their compensation programs are flexible and supportive.

Retail Business LifecycleIf a retailer is in a turnaround or a restructuring, preparing the reward and benefit programs early can reduce administrative costs in the bankruptcy proceeding, speed adoption by the creditor committee and the bankruptcy court, and help retain employees in pivotal roles needed to drive the restructuring and emergence.

Ensuring that reward programs align with remedial actions some retailers now face requires difficult but necessary steps.

Balance Sheet Restructuring?

If a balance sheet restructuring or bankruptcy filing is on the horizon, certain immediate changes to the retailer’s incentive plans should be considered to motivate and retain key talent.

Because the debtor’s equity will generally become worthless in the event of a bankruptcy filing, a common defensive approach is to collapse the annual and long-term incentive programs into a single cash-based incentive program that pays out over shorter measurement periods based on hitting established performance metrics.

Annual incentive programs should be modified to incorporate performance metrics commonly utilized in bankruptcy and acceptable to the creditors. Thus, such plans can be transitioned into a Key Employee Incentive Plan (KEIP), to reduce disruption, in the event of a filing.

Heading Toward Bankruptcy

In the event of a bankruptcy filing, the range of changes to the compensation plans will be influenced by the time anticipated to perform a restructuring or emergence from bankruptcy.

In a “free fall” situation (where the debtor enters bankruptcy in response to a significant liquidity event without having restructuring arrangements in place with its major stakeholders), the entire incentive compensation program will generally need to be revamped.

In a prepackaged bankruptcy (where the debtor has negotiated, documented, and disclosed to creditors a plan of reorganization that has been approved by creditors before the bankruptcy case is filed), there might be fewer changes to existing incentive programs and more of an emphasis on equity upon emergence from bankruptcy.

Many bankruptcy filings fall somewhere in between these two extremes; the annual and long-term incentive programs still need to be adjusted or overhauled.

During bankruptcy, the common treatment of the annual and long-term incentive plans is illustrated in the following table:

Impact of Bankruptcy on IncentivePlans

KEIP-ing Executives Engaged in Recovery

Companies under financial stress want to retain key executives to help ensure continued operational success. Prior to 2005, companies entering bankruptcy typically implemented key employee retention plans (KERPs) whereby executives were paid for simply remaining on the job through specified dates.

However, changes to the bankruptcy code effectively ended the use of KERPs for “insiders” during bankruptcy. Today, many companies implement KEIPs, performance-based plans designed to fall outside of the bankruptcy code restrictions on the use of KERPs, for the “insiders.” Retention plans or KERPs are generally utilized for “non-insiders.”

Accordingly, one of the first exercises to perform includes identifying the organization’s “insiders.” A recent trend for “insiders,” however, has developed to pay retention bonuses prior to bankruptcy filing with a clawback if an executive quits prior to emergence.

KEIP Considerations for Retailers

To avoid classification as a KERP, a KEIP covering “insider” participants should incentivize performance rather than simply induce retention. Common performance metrics used by retailers in bankruptcy include:

  • Store closures or rent concessions
  • Other expense reductions such as inventory liquidation
  • Financial metrics (EBITDA, EBITDAR)
  • Budget compliance
  • Confirmation of plan of reorganization/emergence from bankruptcy by a specified date; and/or
  • Amount of proceeds realized from sale of company or designated assets

The performance metrics must be sufficiently challenging and coincide with the company’s business plan or objectives. Bankruptcy courts have refused to approve KEIPs where performance metrics are easily attainable, finding such arrangements to be impermissible retention plans.

Brian Cumberland

Brian Cumberland

Companies should consider the timing of payments and the length of performance periods. Quarterly performance periods are common. The amount of potential payout is also a consideration, as it should be sufficiently motivating but comparable to other similar payments made in bankruptcy, as well as market compensation levels

In addition to the company’s board approving the plans, several other parties will weigh in on the design and payout amounts of the KEIP. Creditors’ input should be anticipated, since there will be a focus on cash flow/profit, and the company should expect negotiations. It is less of a challenge to get a KEIP approved in bankruptcy court if it is supported by the creditors.

Finally, there will usually be negotiations with the U.S. Trustee relating to the KEIP. These discussions focus on the plan’s performance metrics and the value of potential payments.

Timing of Implementation

Generally, an incentive plan with KEIP-like features should be implemented as soon as possible, incentivizing executives and deterring attrition. Implementing such plans prior to entering bankruptcy is much more efficient, as instituting a KEIP during bankruptcy is a lengthy and contested process.

Furthermore, implementing the framework of a KEIP before a bankruptcy proceeding is contemplated may lead to less distractions for key employees, allowing them to focus on aiding the company’s overall turnaround effort.

Post-Emergence Incentive and Retention

Unfortunately, the battle to retain and motivate key employees does not end upon exit from bankruptcy. When emerging from bankruptcy, most pre-bankruptcy company stock, along with unvested equity awards, have lost their value. Lack of meaningful equity ownership in the go-forward entity, coupled with an uncertain company future, can lead to post-emergence retention and motivation difficulties. Emergence equity grants ensure that companies retain motivated personnel vital to a successful post-emergence entity.

Important considerations for emergence grants include:

  • What percentage of the new company’s equity should be reserved for employee equity awards?
  • What portion of the equity pool should be granted at emergence?
  • Who should be eligible for emergence grants?
  • How will the emergence grants be structured?

As the creditors will generally become significant shareholders, companies work closely with the creditor committee in determining key post-emergence executives for post-emergence grants.

Conclusion

Retail companies in an unhealthy financial condition, regardless whether a bankruptcy filing is anticipated, are especially challenged with retaining and motivating key employees. Well-thought-out and implemented incentive programs can help bridge the compensation gap between the onset of financial ills and a healthy go-forward restructuring.

Just as incentive plans may be effective tools prior to and during the bankruptcy process, equity granted by companies upon emergence from bankruptcy helps drive long-term organizational value to maximize retention programs’ return once the bankruptcy process has concluded.

When a company’s financial health is not optimal, retaining a qualified compensation specialist is critical. A properly developed executive compensation program is one of the most important levers in a restructuring.

Brian Cumberland is a managing director with Alvarez & Marsal in Dallas, where he leads the firm’s executive compensation and benefits practice. Jon Goulding is a managing director and co-head for the West Region with Alvarez & Marsal’s North American commercial restructuring practice in Los Angeles.

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