As businesses evolve, so do their compensation strategies. It may be challenging for some private companies to attract and retain top-tier talent, and that’s why long-term incentive plans play a pivotal role. The idea is clear: offer a market-competitive long-term incentive that enhances the retention and motivation of the recipient over the long-term all while shifting the total compensation to greater pay for performance. While this approach sounds direct, crafting effective long-term incentive plans for private companies is intricate. Here are some key considerations to keep in mind.
Determining The Right Type Of Compensation Element
In the vast landscape of long-term incentive compensation, choosing the right type of compensation element – equity, phantom stock, long-term cash, deferred compensation, etc. – is paramount. Different alternatives cater to varying business needs, executive expectations, and tax consequences. A few of the more prevalent long-term incentive plans are:
- Restricted Stock Units (RSUs): RSUs represent a company’s promise to give shares or cash equivalent to the value of its shares at a future date. Unlike stock options, RSUs have inherent value upon vesting, ensuring that the executive receives something enhancing the retention value to the executive.
- Stock Options: These grant the executive the right, but not the obligation, to purchase a company’s stock at a predetermined price. They can be particularly appealing because they allow executives to benefit from the company’s future growth.
- Phantom Stock: Phantom stock is designed to mimic actual equity ownership, and can look and feel like a stock option or RSU, however it is designed to settle in cash upon vesting. Phantom stock is frequently used in private company environments as it can make recipients feel like owners without diluting the company’s shareholders.
For a more comprehensive review of all private company long-term incentives with associated pros and cons, see our quick guide for cash based LTI plans.
Setting Clear Vesting Schedules
Vesting schedules serve as the timeline and conditions under which executives can claim their long-term incentive compensation. They ensure executives are committed and contributing to the company’s growth over an extended period.
Common vesting provisions:
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- Cliff Vesting:
Here, the executive must wait for the full vesting period (typically 3 years) to complete before the award vests. Cliff vesting is a common approach in private company environments, as it pushes out a company’s liabilities related to long-term incentive awards to a point well in the future.
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- Graded or Ratable Vesting:
This vesting schedule allows for a portion of a granted award to vest periodically, say annually over a four-year period, over the lifecycle of the vesting term. A recipient would need to complete the vesting period to become fully vested, but contrary to the cliff vesting approach, such vesting schedule would allow a recipient to realize some value of the granted incentive even if they didn’t continue employment through the full vesting period.
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- Performance-Based Vesting:
In this approach, the vesting of a granted award is tied to achievement against performance metrics. These could be companywide financial goals like revenue targets or individual executive performance measures. Payouts are tied to 3 or 4 year goals and ensure alignment with company strategy.
Evaluating The Potential Dilution Impact
While long-term incentives serve as an excellent incentive, there’s a balance employers need to strike when designing such plans. Offering too much incentive, whether it be in the form of equity or cash, can dilute existing shareholders’ stake or interest in the company and its profitability, potentially leading to friction and governance challenges. It’s essential to calculate the potential dilution impact of any incentive and ensure it’s sustainable and feasible over the long run.
Keeping An Eye On Tax Implications
Long-term incentive compensation, while lucrative, also comes with its share of tax impacts. Both the company and the recipient can face tax implications, be it during the grant, vesting, or liquidity event, and they can vary based on the currency used to provide the incentive. Collaborating with a compensation consultant and tax advisor can help navigate these complexities, ensuring that all parties maximize the benefits of such awards.
Communicating The Plan Clearly
Even the most meticulously crafted long-term incentive plans for private companies[GU1] [GU2] can fall flat if not communicated effectively. It’s imperative to ensure that recipients understand the nuances of their compensation — the type of award they’re receiving, its potential value, vesting schedules, and what triggers might alter that schedule. Clear communication builds trust, ensures alignment, and maximizes the plan’s effectiveness as an incentive tool.
As private companies continue to thrive and compete for top executive talent, the role of long-term incentives in compensation packages becomes increasingly prominent. Navigating the complexities of these incentives requires a deep understanding of both financial instruments and human behavior. It’s not just about offering a “piece of the pie”; it’s about crafting a motivator that drives performance, retains talent, and aligns with the company’s long-term vision.
For companies on this journey, it’s invaluable to collaborate with professionals who specialize in designing long-term incentive plans. Zayla Partners bring to the table a wealth of experience, insights into industry best practices, and a holistic view of the valuable role long-term incentives play in broader compensation strategy.
