In today’s economic and regulatory environment, privately owned companies have many competitive advantages compared to their publically traded counterparts. But with the lack of public scrutiny comes some restrictions when considering incentive compensation alternatives.
One major distinction between public and private companies is the equity component of compensation; whereas public companies can use stock as a compensation tool, those choices (stock grants, restricted shares, stock options, stock appreciation rights, etc.) are typically not available in privately owned firms. The absence of a readily available market makes it difficult for privately owned companies to describe the potential value of any equity to the participant.
Nevertheless, the use of long-term incentives is extremely important since they account for at least one-third of the typical corporate executive's total compensation package. For this reason, more privately owned companies have come to realize the need to maintain some alignment with their publicly traded counterparts with respect to long-term compensation. And even though market-valued equity is not available for private businesses, there are several options for long-term incentive plans (LTIPs) that can mimic stock programs and help private companies to be competitive with pay.
A recent study indicated that 98 percent of public companies provide some form of long-term plan (which is typically stock-based), while 63 percent of private companies offer LTIPs, almost all of which are cash-based. This is a significant increase from 15 years ago, when less than 27 percent of privately owned companies used LTIPs.
Plan Design Considerations
Privately owned companies that are considering the design of an LTIP (or the modification of a current plan) should be able to answer each of the five key questions indicated below.
What are LTIPs?
Long-term incentive plans are performance-driven incentive programs covering multiple fiscal year cycles that can provide a potentially significant award in addition to the base salary and annual incentive or bonus. LTIPs fall into two major categories:
- Multi-year plans covering fixed or rolling performance periods of three to five years.
- Career-based plans in which the benefits accrue over the individual’s working career, to be paid on termination or retirement.
LTIPs provide for a broad view on performance, since they require the executive to focus on goals that extend beyond the immediate (annual plan) timeframe. Many LTIPs are tied to a company's strategic plan, with performance metrics that match specific milestones related to compounded growth, operational effectiveness, market share, etc.
How do LTIPs work?
The design feature that is most attractive to private companies is that the awards are typically paid in cash. Although there is nothing preventing privately held companies from using nontradable equity shares, usually it is a lose-lose proposition—participants are not attracted to a device that is restricted, nonliquid and has a capricious value, while most owners are not interested in creating minority shareholders.
The primary attraction of LTIPs is that privately held companies have tremendous freedom in their design. Unlike a myriad of government regulations associated with stock plans, nonequity LTIPs can be designed to meet the company's philosophy, objectives, existing systems and capabilities. Both the performance periods and measures are extremely flexible, and typically relate to the company's strategic plan and vision.
What are the impediments to LTIPs?
Since it is considered nonqualified deferred compensation, the only requirement in designing an LTIP is that it comply with Internal Revenue Code section 409A. Noncompliance with any part of section 409A by any participant will make the entire plan unenforceable for all participants, in which case the funds must be given back and become fully taxable, plus incurring a 20 percent excise tax.
While not necessarily a deal-breaker, the implementation process, including definition and tracking of performance metrics, becomes an important consideration in how the plan operates, and ultimately on how the plan's rewards are perceived by its participants. If the relationship of pay and performance cannot be ascertained, or if the value of the reward is not commensurate with performance, then the impact of the LTIP will be diminished or lost, or the plan could become detrimental.
What are the benefits of LTIPs?
There are a number of significant advantages inherent in LTIPs:
- Employee retention. Regulations require that LTIPs must contain a "substantial risk of forfeiture." Along with the attainment of performance metrics, the most common requirement is continued employment. Therefore, the LTIP acts as a "golden handcuff," which subjects the participants to the loss of a portion of (or all) accumulated LTIP awards if they voluntary terminate their employment or are fired "for cause."
- Focus on desired results. Clearly, the objective of any incentive plan is the successful achievement of one or more pre-defined performance goals. Establishing goals upfront allows the participants to look over the horizon and "focus on the target."
- Balance of short- and long-term decision-making. A common criticism of incentive programs is that nonowner participants are only concerned with short-term (annual) results. An LTIP allows participants to share in the long-term results, and therefore almost mandates that participants consider the consequences of their short-term decisions on developments over the long term.
- Sharing in the company's growth. A very important concern of many executives is that the work and investment (sweat equity) they make in the company's long-term success will not accrue to them. The LTIP allows them to share in the company’s value proposition by tying their rewards to that success, as though they were owners. This is particularly significant when a privately owned company needs to recruit from the outside for a member on its leadership team.
The long-term incentive component can serve as an attraction tool, especially in a turnaround situation. Conversely, the absence of this pay element may detract from the company's ability to hire well-qualified leaders.
How do we develop LTIPs?
Designing an LTIP requires a number of items. These include:
- Commitment by the owners (including equity shareholders).
- Acceptance of a compensation philosophy covering the what, who, why and how of compensation.
- A strategic plan or at least an understanding of what is expected in the future.
- A well-thought-out approach.
- The willingness to communicate targets and results to incentive program participants.
Paul R. Dorf, ADP, is the managing director of the New Jersey-based consultancy Compensation Resources, Inc., which specializes in providing services for executive and sales compensation, salary administration, performance management and litigation support. © 2013 Compensation Resources, Inc. All rights reserved. Republished with permission.