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Offset Increased Labor Costs by Adopting an Employee Retention Strategy


3/9/15
 
All indications point to a prosperous 2015 for the restaurant industry. Low interest rates, falling gas prices, and a stable U.S. economy are helping drive sales across the entire industry. Traffic is up, and as a result, same-store sales have followed. Furthermore, valuations for growth concepts are at all-time highs as private equity firms look to put capital to work. Coupled with the success of recent IPOs, a positive outlook for the restaurant industry is most certainly plausible. (For further insight on the outlook of the restaurant industry in 2015, please refer to pages 25 and 26 of CohnReznick’s Momentum 2015: Middle Market Private Equity Outlook.)
 
However, the industry has not avoided all headwinds. Gary Levy, a CohnReznick partner and the Firm’s Hospitality Industry Practice Leader explains, “The cost of labor – a continuous and major concern for the industry – is steadily rising. With more restaurant openings, the Affordable Care Act (ACA), and the increase of the minimum wage, labor has become the top issue for almost every restaurant CEO.” Also of particular concern to the hospitality industry is the potential repeal of the Federal Insurance Contributions Act (FICA) tip credit. With release of the budget in February, the Obama Administration is focused on limiting the FICA tip credit in the future, maintaining that the current FICA tip credit is inefficient and inequitable as it encourages employers to provide income in the form of tips instead of wages and does not adequately address the underreporting of tip income. 
 
In order to lessen the impact of increased labor expenses, it is essential for a restaurant company to find, retain, and motivate their team members. How can this be accomplished? Paying more and offering the most lucrative benefits available is not a strategy most companies are able to adopt, and doing so is not likely to result in a favorable return on investment. Therefore, restaurant owners are faced with the need to differentiate their business to both consumers and their employees. 
 
“Accomplishing this begins at the top,” says Levy. “Successful restaurant companies have attracted a talented leadership team to drive the company forward.” To that end, several leading restaurant companies have adopted a culture and leadership team approach referred to as CIRE: Culture, Incentivize, Retention, and Education. The purpose of CIRE is to motivate all company employees to focus on the same goals, with both short- and long-term economic rewards.
 
Culture 
Restaurant owners should clearly define the company’s culture and goals. What is required in order to do this? First, determine a brand affiliation with which the restaurant’s client base can identify. Is the establishment relevant and a place where employees will be proud to work? Is there an opportunity for an employee to grow? Oftentimes, working at a large chain is no longer the desire of today’s employee. Creating a small, family experience by focusing on the individual unit, as well as the chain, is equally essential. A restaurant owner may consider offering a short-term bonus plan that is linked to individual unit results. Employees are also increasingly concerned with how closely the brand correlates with their values. Moreover, management should seek to develop a winning culture focusing on a company’s core values, which should be disseminated throughout the entire organization. This will go a long way toward attracting employees, lowering turnover, and demonstrating a path for growth.
 
Incentivize
Implement bonus programs that align with the company’s economic and cultural goals. Pay those bonuses quarterly. Take, for example, a director of operations and a unit manager. A bonus program can be designed that aligns their goals. The program can be linked directly to unit level operational performance, employee turnover, and new store growth. At the store level, a bonus pool can be established based on the store operating performance and shared accordingly with store employees. This focuses on short-term rewards and sets the stage for lower turnover and retention. 
 
Retain 
Long-term retention is one of the hardest issues for the industry. Talented individuals want to grow and will continually seek improvement in their career and quality of life. Retention has become even more complicated to address. Several leading growth concepts have created a different class of ownership that focus on retention. These programs allow members of the management team to participate in a future liquidity event of the company. Although such programs can be complicated to design and implement, they have the best success of aligning goals and retaining talent. Moreover, the most talented leaders expect this. Some companies have been very creative about the design and implementation of these programs.
 
Options available that serve to maximize employee retention include:
 
Purchasing Real Equity – Provides opportunity for employee to become a real owner in the company. Although the retention value may be limited, this option offers favorable expense treatment and favorable treatment of employee tax.
 
Purchasing Real Equity with a Put Obligation – Allows employees to purchase real, non-voting shares in the company at current Fair Market Value, while a put obligation – a mandatory buy-back upon termination at an agreed upon price – ends an employee’s participation in company’s growth at time of termination. Retention power is high, though expense of bonus and put are liabilities, and valuation is required for admitting new participants. 
 
Transaction Participation Rights – Grants employees the right to receive a pre-defined portion of proceeds from a qualifying transaction, such as a sale of the majority of equity to a third party. Offers substantial retention incentive that increases over time as company’s value builds. Advantages include recognition of expense as a one-time event at the time of the transaction and no valuation required. However, payment to employee is treated as ordinary income for tax purposes.
 
Stock Appreciation Rights – Company makes cash payment equal to appreciation in value of shares (or member interests) without actual equity ownership. Allows employee to have some feel of equity without common hassles of real equity, including filing a K-1 and paying both the employee and employer share of the Federal Insurance Contributions Act (FICA). Vesting period can provide significant retention incentive, though company will need to provide explanation of valuation to employees. 
 
Phantom Shares – Company makes cash payment in the future equal to full value of shares (or member interests) granted. Vesting period carries strong retention value, while employee has some feel of equity without the common hassles of real equity. Company will need to provide an explanation of valuation to employees.
 
Real Equity Restricted Shares (or Restricted Share Units) – Company grants real shares (or member interests) to employee after vesting period (as opposed to selling shares). Real value to employee at end of vesting period creates strong retention incentive. Considerations include recognition of expense, potential hassles of real equity, and employee as a real shareholder.
 
Real Equity Stock Options – Grants option to purchase real shares (or membership interest) after a vesting period, at price equal to market price on grant date. While presenting several employee advantages, it also bears numerous considerations for the company, including recognition of expense and valuation as a requirement.
 
While no one plan is best for all situations, there are circumstances in which some plans may be more suitable than others. For example, Transaction Participation Rights are often an ideal choice for fast growing chains with a clear exit strategy. Alternatively, stock options and SARs typically provide positive motivation for larger, more stable companies. Sequence is important – walk before running. Short-term plans are easier to implement than long-term plans so deciding on what plans to adopt should be carefully evaluated.
 
Educate
Developing and implementing are only half the battle. Every employee should be educated about these opportunities and what they mean for them. It should be discussed at recruitment, as part of ongoing training, and included in Employee Handbooks. Consistently remind the team about these programs and discuss how they stand to benefit. For short-term bonus plans, reward performance quarterly with a formal review annually for both the short and long-term plan. If your employees have a sense of ownership, they will stay longer and work to achieve the same goals as management.
 
What Does CohnReznick Think?
Numerous hospitality companies have designed and implemented an employee short- and long-term retention program. While there is no one-size-fits-all program, and some come with complicated tax issues, a program can be easily modified to meet management’s objectives. In today’s world where employees are heavily focused on quality of life and brand affiliation, it is essential to analyze whether the restaurant company is in touch with the labor marketplace and whether its compensation and benefit programs align with the desires of today’s employee.
 
Contact

For more information, please contact Gary Levy, a CohnReznick partner and the Firm’s Hospitality Industry Practice Leader, at gary.levy@cohnreznick.com, or 646-254-7403.

To learn more about CohnReznick’s Hospitality Industry Practice, visit our webpage.


This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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