What can smaller companies do to keep valued employees happy? All of the standard answers have drawbacks.

Raises can bring diminishing returns; the higher the salary, the greater the individual tax bite. Fringe benefits help attract employees but seldom help retain them. Such perquisites as company cars and club memberships work, but high cost limits their application. Pension and profit-sharing plans offer no immediate reward. Furthermore, almost all plans are qualified under the Employee Retirement Income Security Act (ERISA) to make the contributions tax-deductible for the employer. Consequently, the plan must meet the fairness requirements of ERISA, making it difficult to vary benefits to reward job performance.

The solution is a compensation plan that lets valued employees participate in the company's profits -- that is, receive a "piece of the action." The plan must:

* Be directly tied to profits.

* Have an immediate, favorable impact on the employee.

* Increase in value over time. An employee who quits loses the appreciation.

* Be considered a valuable reward by the employee.

Such a compensation plan must also be attractive to the owners of the business:

* Cost must be minimized.

* The ownership interest mustn't be significantly diluted.

* The company mustn't be subject to such significant further regulation as that of the Securities and Exchange Commission, Internal Revenue Service, or state.

* The reward must be applicable to many employees.

* The amount of the reward must vary: more for the more valuable employees than for those who are just acceptable.

While management of large, publicly held companies must consider the cost of any employee compensation program, it often ignores other criteria. Such companies can offer a number of programs tied to the distribution of stock, including incentive stock options and employee stock purchase or ownership plans. Stock is available for such reward programs, and, since it is publicly traded, its value is readily ascertainable.

Giving valued employees a "piece of the action" is not quite as simple for smaller, closely held companies. Capitalization is usually too small to permit a stock-based reward program, and, more important, owners frequently don't want to reduce their ownership interest. They also don't want additional governmental regulation. Since the stock has no public market, the value isn't easily ascertained, and an employee's shares would be highly illiquid. Thus, a compensation program that gives or sells stock wouldn't function as intended.

The best choice is a security for sale to valued employees that gradually converts into an ownership stake. An unsecured long-term debt instrument -- a debenture -- is preferable because it won't affect the existing ownership interests, and it offers greater flexibility than other securities. The debenture would pay interest and have a conversion price equal to the book value of the company's common stock when the debenture was issued. Initially, a small part of the debenture would be convertible into common stock. Increasing amounts would be convertible in time, with full convertibility at maturity.

To ensure employee participation in company growth, the employee would be able to redeem the debenture, in cash, at a price equal to the book value of the common stock at redemption. Thus, as profits rose, so would the book value of the common, the redemption price. However, the debenture would also provide that thc employee lose all rights to participate in the appreciation if employment ends for reasons other than death or disability.

Such a convertible debenture has four major advantages:

1. It gives the employee a strong incentive, because the value of the reward the debenture -- rises and falls with the company's profits and losses.

2. It offers immediate reward because portion of the debenture is convertible a once into the company's common stock.

3. The debenture's value to the employee further increases in time because more of it becomes convertible. As profit increase, so does the employee's share.

4. The debenture would be valued by the employee as an investment. It not only increases in value, but it also accumulates interest.

The convertible debenture meets the employer's needs in several ways. First, it costs little to implement and infuses cash to the company. Second, up to $500,000 of the debentures may be sold to employees without subjecting the company the registration process of federal securities laws. Third, the employer could a greater benefit to valued employees b permitting them to purchase more of the debentures. Last, company principals suffer no immediate dilution of the owner ship interest. In fact, the employer could either redeem the debentures for cash a maturity, based on the book value of the common stock at that time, or require employees to accept shares of common stock, avoiding cash outlay when the debentures mature.

Debentures have further benefits. The employee's gains are capital in nature, taxable at favorable long-term capital gains rate. On the other hand, the company can raise a substantial sum of money at below-market interest rates to finance or expand its operations, and the interest paid is tax deductible. Also, the debentures can be bought through payroll deductions or other periodic payments, not only helping employees make the invest ment, but reminding them of it and of its value. Obviously, because of the tax considerations involved, the design and implementation of such a plan should not be attempted without the advice of an attorney and outside accountant.