Use the carrot, the stick, or both?
By Paul J. Welk, PT, JD
Successful physical therapy private practices have a number of common characteristics, one of which is a strong management team. Given the high demand for skilled management, these individuals may find themselves tempted to leave their current employment situation for other opportunities, whether that be for another employer or some type of “better” opportunity. When considering ways to avoid the loss of management team members, the retention methods tend to fall into two categories. First, there are mechanisms to incentivize management to remain in their current setting and to work toward achieving a particular goal or “carrot.” Second, there are mechanisms that are designed to have a negative effect on departing individuals and serve as a “stick.”1 This article examines a few common carrots and sticks used to retain upper level physical therapy management teams.
One common carrot for management retention is a “phantom stock program.” Phantom stock is a form of compensation whereby a practice agrees at some point in the future to pay an employee a certain dollar amount based on the value of the shares of the practice’s stock. In a phantom stock program, the recipient does not actually receive an equity or ownership interest in the practice, but has the ability to benefit from an increase in the value of the practice. Retention through a phantom stock program is typically promoted by including a vesting period, which requires the employee to remain at the company for a set number of years to be eligible for the additional compensation. A phantom stock program may also be a good option because it can serve as a mechanism for an individual who cannot legally own the practice (e.g., a chief executive officer of a professional corporation who is not a licensee, and therefore cannot own shares under the state’s corporation law) to benefit from the financial success of the business. It is also a mechanism to allow a closely held business to remain closely held while incentivizing key management to grow the business. Participation in phantom stock programs is generally limited to top level management and other highly compensated employees and is subject to certain Internal Revenue Service (IRS) requirements as described below. From a legal standpoint, two key issues arise with phantom stock programs: (i) drafting a compliant phantom stock program and award agreements for issuance to participants; and (ii) analyzing, in cooperation with the practice’s tax advisors and accountants, the tax effects of implementing the program.
Compensation itself can obviously be a great retention mechanism. However, with declining payment and concerns over alignment of incentives between ownership and employees, there appears to be a general trend away from strict salary-based compensation with an increased emphasis on incentive compensation programs. While there is significant variability among incentive compensation programs, common elements include mechanisms to avoid paying incentive bonuses while the practice is losing money (e.g., consider the benefits of basing incentive compensation on profits rather than revenue targets) and implementing incentive programs in which management has direct control over whether the incentives are achieved. From a documentation standpoint, incentive compensation programs are often included within an individual’s employment agreement. In preparing such a program, it is important that the program be well defined to avoid disputes about whether certain performance-based targets and other prerequisites to payment have been satisfied.
A third retention mechanism to consider for top level management is nonqualified deferred compensation. Deferred compensation, as the name implies, is compensation paid out at some point in the future after the date it is earned. Due in large part to past abuses of nonqualified deferred compensation programs, the IRS stepped up its regulation of nonqualified deferred compensation programs in 2005. Failure to comply with these regulations, as set forth in Section 409A of the Internal Revenue Code, can lead to significant tax consequences and penalties. To comply with IRS requirements a number of restrictions must be placed on the timing of deferred compensation payments, and the events that trigger a deferred compensation payment obligation. For example, such a program may provide for a payment to an employee following a change in ownership of a practice, the sale of a substantial portion of the assets of a practice, or a separation from service. Similar to certain other employee retention mechanisms, nonqualified deferred compensation programs are generally limited to key management level and other highly compensated employees. From a legal drafting perspective, a key in drafting a nonqualified deferred compensation program is to be certain that the program satisfies the applicable IRS requirements so as to avoid unexpected tax liabilities.
In contrast to the above examples of “carrots” to promote management level retention, there are also a number of “sticks” that can be used to discourage management employees from terminating employment. First is a mechanism likely familiar to most readers, the restrictive covenant. Restrictive covenants may include noncompetition covenants, which restrict the employee from working in defined physical therapy settings within a certain geographic area for a specified period of time following the termination of employment. Depending on the specific terms of the non-compete, it can obviously serve as a significant deterrent by limiting future employment opportunities. As a general matter, those jurisdictions that enforce non-compete agreements will permit greater restrictions on a higher level management employee than they would for a staff physical therapist. In addition to the traditional non-compete provision, another restrictive covenant is the non-solicitation provision, which limits a departing employee from soliciting patients or other employees of the practice from receiving services or being employed elsewhere. The inability to solicit other employees to also leave the original employer can often serve as a strong disincentive to a potentially departing employee. From a legal perspective, the enforceability of a restrictive covenant is heavily dependent on state law and relates to issues such as the timing and reasonableness of the restrictive covenant and whether the employee receives something (e.g., an initial job offer, a promotion, or a bonus payment) in exchange for agreeing to the restriction.
In connection with the restrictive covenant itself, another large deterrent can be the penalty associated with violating it. The traditional remedies for violation of a non-compete are either injunctive relief or liquidated damages. Injunctive relief is generally an order issued by a court that prohibits an employee from working in violation of the non-compete. Liquidated damages require a payment to the employer of an agreed-on amount should the employee breach the non-compete. For example, if an employee violates a non-compete, he or she may be obligated to pay one year’s salary to the employer as liquidated damages, that one year salary representing the agreed-on dollar amount of the damages suffered by the employer on the occurrence of the breach. As with the restrictive covenant itself, the availability of injunctive relief and liquidated damages is based on the state law, which governs the non-compete agreement and the terms of the underlying agreement. As a final “stick” in relation to restrictive covenants, an employment agreement may be drafted to provide for payment of the prevailing party’s legal fees in the event an employer takes legal action to enforce a non-compete.
Finally, employers may seek to retain key management through a severance arrangement that is agreed on at the initiation of employment. Such a severance arrangement may be seen, for example, when a private practice is sold and there is a desire to retain the management of the seller for a period of time. By way of example of a severance arrangement that serves as a “stick,” a severance package may provide that it will be eliminated or significantly reduced in value if the employee terminates employment without cause prior to the end of a mutually agreed time period. On the other hand, a severance arrangement can also serve as a “carrot,” such as where the severance payment due to the departing employee increases as the number of months or years of service increase. The specific terms of this type of severance arrangement are typically incorporated into the employee’s employment agreement.
While the retention of upper level management is dependent on many factors such as compensation, benefit packages, work schedules, and practice culture, practices may also want to consider a combination of additional “carrots” and “sticks” in an effort to maintain key management.
Paul Welk, PT, JD, is a Private Practice Section member and an attorney with Tucker Arensberg, frequently advises physical therapy private practices in the areas of corporate and health care law. He can be reached at firstname.lastname@example.org.
1. The “carrot and stick” approach is an idiom that refers to a policy of offering a combination of rewards and punishment to induce behavior. It is named in reference to a cart driver dangling a carrot in front of a mule and holding a stick behind it. The mule would move toward the carrot because it wants the reward of food, while also moving away from the stick behind it, since it does not want the punishment of pain, thus drawing the cart. http://en.wikipedia.org/wiki/Carrot_and_stick. Accessed March 26, 2014.
Please note that this article is not intended to, and does not, serve as legal or tax advice to the reader but is for general information purposes only.