Structuring Effective Long-Term
Incentive Plans
Speakers
Compensation & Benefit Solutions, LLC
•
John K. Schultz, J.D., LL.M, Managing Director
•
James A. Deets, J.D., Director
Overview of Long-Term
Incentive Plans
Overview of LTI
a. Purpose
i. The long-term benefit of an effective LTI plan can be invaluable to the long-term success of a company
ii. A well designed LTI plan aligns employee interests with those of the company owners
iii. Long-term incentives can drive employee performance, company growth, and provide a buffer against short-term drivers
Overview of LTI
b. Prevalence
i. Approximately 75% of public companies have LTI plans
ii. LTI plans are less prevalent among private companies; only about 35% iii. Reasons:
1. Lack of sophistication/resources 2. Reluctance to dilute ownership 3. Minority shareholder concerns 4. Complexity
Overview of LTI
c. Award Sizes
i. Awards are typically granted based on a percentage of base salary
ii. Watson Wyatt Survey (under 1,000 full-time employees)
1. Company officers – 102.5% 2. Other management – 51.4%
Overview of LTI
d. Correlation to STI plan
i. Sometimes companies will coordinate their annual short-term incentives with their LTI plans
ii. Annual performance metrics and aggregate target payouts can be established
iii. The individual incentive awards are allocated between LTI and STI (e.g., 75% LTI and 25% STI)
iv. LTI awards will have a multi-year vesting and/or performance schedules (e.g., 3 years, earnings growth, EBITDA, etc.)
Plan Structures
a. Public Company Practices
i.
Equity (as opposed to cash) plans
1. Favorable accounting treatment
2. Simple
Plan Structures
a. Public Company Practices
ii. Equity award form
1. Stock Options
a. The right to buy a number of shares at a price fixed at grant for a specified term
b. Companies use an option-pricing model to calculate the value of awards as of the date of grant and
expense that amount
Plan Structures
a. Public Company Practices
ii. Equity award form (cont’d.)
2. Restricted Stock
a. Provide employees with shares of company stock at little or no cost, subject to a risk of forfeiture (“vesting”)
3. Restricted Stock Units
a. Similar to restricted stock, but employees do not actually receive shares until the restrictions lapse
Plan Structures
a. Public Company Practices
iii. Vesting Provisions
1. Time vesting
2. Performance – either used to determine grant size or vesting amount
a. Company performance b. Business unit performance c. Individual performance
Plan Structures
a. Public Company Practices
iv. Stock Options vs. Full-Value Awards
1. Historically options were preferred because of the
favorable accounting treatment
2. A big shift to restricted stock with FAS 123R – 2005
a. Companies now expense options
Plan Structures
a. Public Company Practices
iv. Stock Options vs. Full-Value Awards (cont’d.)
3. Full-value award concerns
a. Will realize value regardless of performance
b. “Pay for pulse”
i. Because most restricted stock vests on the
passage of time, employees receive benefit
for simply continuing employment
Plan Structures
a. Public Company Practices
iv. Stock Options vs. Full-Value Awards (cont’d.)
4. Stock option concerns
a. Market conditions beyond employee control can
result in awards being worthless
Plan Structures
b. Private Company Practices
i. Equity-based plans
1. Advantages of equity-based plan
a. More closely mirror public company structure
b. People understand the plans
c. Takes care of alignment issues
d. Consolidates all factors into 1
MEASUREMENT-VALUE
Plan Structures
b. Private Company Practices
i. Equity-based plans
2. Private company issues
a. Valuation challenges
i. Difficult/expensive to value
ii. Internal Revenue Code section 409A complexity iii. Skepticism of valuation models
Plan Structures
b. Private Company Practices
i. Equity-based plans
1. Lack of Liquidity
a. Makes it difficult for participants to realize value b. Can lead to phantom income problems
c. Impacts perceived value d. Cash flow issues
Plan Structures
b. Private Company Practices
ii. Cash-based plan
1. Using STI structure (including targets) and stretching terms 2. Adding vesting terms
3. Less favorable accounting
4. Can be difficult to set metrics that work over extended periods
Real Equity or Synthetic Proxy
a. Actual equity grant – 2 basic forms
i. Stock Options
ii. Restricted Stock/RSU
Real Equity or Synthetic Proxy
b. Phantom grants – “stock”/Stock Appreciation
Rights (“SAR”)
i. Acts like real equity, but only cash transferred
1. Phantom stock grants the right to receive cash
based on the future value of the company's stock
2. SARs are the right to receive cash based on the
appreciation in the value of the stock
Real Equity or Synthetic Proxy
b. Phantom grants – “stock”/SAR
(cont’d.)
ii. Closest to true equity plan
1. Avoids minority shareholder issues
2. Company provides the liquidity
3. Still has valuation issues
a. Typically addressed via formula approach
Real Equity or Synthetic Proxy
c. Hypothetical “unit” grants
i. Grant unit based on operations or profitability of company
ii. Create a bucket where value correlates to company performance
1. Example: Contribute a percentage of profits, and use the present value of
cash flows over a particular period for valuation (e.g., seven or ten years) iii. Grant interest in the bucket (hypothetical company)
1. As profits of the company increase, so does the value of the bucket
2. Drives employee behavior similar to equity grant
iv. Eventual payout is in cash based on the value of the units at the time of the payout
Performance Measures
a. Principles for effective measures are
i. Relevant to business objectives
ii. Focus and drive executive behavior to desired results iii. Controllable with little to no manipulation possible
iv. Integrate and recognize cross-functional nature of business processes
v. Accurate and cost-effective reporting as well as a currently audited and disclosed measure is best
vi. Sensitive to changes in business environment vii. SIMPLE
Performance Measures
b. Some examples of performance measure types are:
i. Top-line growth (revenue growth, operating margin, etc.) ii. Bottom-line growth (EBIT, EBITDA, earnings per share, etc.) iii. Ratio measurement (ROA, ROE, ROI, etc.)
iv. Operating (operating efficiency, debt management, etc.) v. Value-added (cash-flow management, return over cost of
capital, etc.)
vi. Shareholder return (EPS, TSR, etc.) vii. Discretionary
Performance Measures
c. Measures can be expressed in a variety of ways
including:
i.
Achievement of budgeted performance goal
ii. Improvement over prior or previous year(s)
iii. Relative to comparator group or index
Performance Measures
d. Measures should:
i. Focus on line-of-sight
ii. Integrate success of company and that of its business units, segments or divisions
iii. Be quantifiable and measurable (easy for participants to understand)
iv. Be limited in number (three or less measures is best to focus attention to key or critical objectives for the
Performance Measures
e. Weightings
i. Weightings should:
1. Reflect the importance of the measure within the incentive plan 2. Be rounded to a 10% or 5% figure
3. Not be less than 20% (if three or two measures in total) or participants will only focus on the heavier weighted measures
ii. “Triggers” can be implemented if helpful
1. A trigger is a hurdle that must be reached before any portion of the incentive award is paid out and is usually tied to some
Performance Tiers
a. Tiers are typically defined at three levels
i. Threshold reflects the minimum level at which incentive payments begin. This level gets participants “in the game” and typically has payment levels that are below achievement levels to contribute more to the company bottom-line until profitability starts (usually this level of payout would be 50% or less of target)
ii. Target reflects “stretch” performance and is generally equal to the “planned” or “budgeted” level of performance with a moderate level of difficulty (100% achievement equals the target incentive level) iii. Maximum reflects the maximum level of payout based on an
Performance Tiers
b. Design Considerations
i. Setting appropriate performance goal levels is the most critical part of the design process (and will get the most scrutiny from
shareholders and outsiders if not done correctly)
ii. It is important to incorporate overall company performance into the incentive program to mitigate some overall risk issues
iii. Discretionary goals are typically very subjective and should be limited in use
Award Opportunity
c. Award opportunities should be:
i. Expressed as a percentage of a participant’s base salary or set
dollar amount (most programs incorporate percentages) ii. Based on salary level and also the contributory and strategic
nature of the position
iii. Tiered by level and role to streamline administration and communication of the program
iv. Expressed in terms of minimum, target and maximum (or other reference points as useful)
Finalizing the Program
d. Program Analysis
i. Many different elements should be analyzed prior to finalizing an
incentive program, but some key issues to review are:
a. Total payout of awards as a percentage of company profit to ensure it is at an acceptable level, especially at each award opportunity level
b. Review elements of risk and how they could impact each of the measures and the respective payouts at each award opportunity level (list the types of risk categories reviewed and what the potential impact might be)
c. Review the incentive program and how it fits into the total compensation program and company pay philosophy
Implementation and Communication
a. Key considerations
i. Create a design and implementation team prior to
designing the program that would include compensation, HR, finance (accounting and tax), legal and IT to ensure you can design a measurable and easily administered program ii. Simplify as much as possible, the program has to be easy
for the participant to understand or it will not motivate properly
Implementation and Communication
a. Key considerations (cont’d.)
iii. Pick measures on which you can regularly report results to participants to continue the excitement throughout the year iv. “Brand” your communications so participants will easily
recognize them and make them as brief as possible or they will not read them thoroughly
v. Show how this incentive plan ties into total compensation and specifically links to business objectives and provide ideas on how participants can impact results
Implementation and Communication
b. Remember
i. If you communicate often and clearly, your program will be successful regardless of whether it is the best “theoretical” design or a poorer design
ii. If participants understand the program (not necessarily like it) they can more actively affect their compensation and the positive results of the company
Traps & Tricks
a. Know your shareholders!
i. If you’ll be seeking shareholder approval
1. Understand the implications of shareholder
groups
2. Stay up to date on their guidelines
3. Consult with them in advance if you are not sure
Traps & Tricks
b. Beware of the “qualified” option!
i.
Disqualifying dispositions of both Incentive Stock
Options and Employee Stock Purchase Plans means
they are taxable based on the spread at EXERCISE, not
sale
ii. And the spread at exercise is subject to Alternative
Minimum Tax
1. Exercise high and sell low can yield a very bad result
Traps & Tricks
c. Wages or Wages?
i. The definition of wages for income tax is different than wages for FICA
ii. If there is a deferral feature in the plan (e.g., RSU) the value will be subject to FICA when vested but income tax when paid
iii. Make sure you have a FICA tax payment provision built into the plan
Traps & Tricks
d. What’s my grant date?
i.
The grant date is the measurement date for both
accounting and tax, but what is it?
ii. Picking wrong can result in erroneous accounting
charges, SEC and Exchange violations and penalties,
and/or retroactive taxation plus penalties
iii. Make sure that the rules, the documents, and the
PROCESS are in sync
Traps & Tricks
e. Accelerated Vesting – is it worth it?
i. Accelerations are common but can be tricky ii. They can result in unexpected:
1. Accounting charges
2. Lost deductions under Internal Revenue Code (“IRC”) section 162(m) 3. IRC section 409A violations and penalties
4. IRC section 280G penalties and lost deductions 5. Impacts on the potential transaction
iii. Understand the application of each trigger under various scenarios
Traps & Tricks
f. IRC section 409A – since when is equity deferred
compensation?
i. It is not just the grant date that can get you (FMV at grant requirement)
ii. Any modification is a potential disqualifier
iii. Do not grant stock options on anything other than plain vanilla common stock
iv. Be careful of anti-dilution provisions
v. Especially careful with deferred Restricted Stock Units
1. Distribution triggers
2. Change in control definition
3. 6 month delay for public company Named Executive Officers
Traps & Tricks
g. Why all the fuss over IRC section 162(m)?
i.
With the trend from using stock options to
RSAs/RSUs, qualifying for the performance-based
exception has changed
ii. Now cannot just rely on the stock plan exception, but
need to comply with ALL the requirements
iii. And the IRS changed some of the rules, so improper
accelerators can taint the whole plan
Examples
a. Actual equity award – ABC Co.
i.
Facts
1. $10 million manufacturing company
2. 35 employees
3. Private equity backed
4. Some financial statement sensitivity
5. Short term focus; 3-5 year exit strategy
Examples
a. Actual equity award – ABC Co.
ii. Plan Design
1. Individual incentive awards are allocated 25% to STI and 75% to LTI
2. For the LTI portion, the Participants are granted restricted stock units and/or stock options, which vest over a three-year period 3. The target size and make-up of the award is based on the
individual’s position, responsibilities, compensation level, performance, historical contribution, and market practices
Examples
a. Actual equity award – ABC Co.
ii. Plan Design (cont’d.)
4. Funded by the LTI award pool of approximately 15% of fully diluted common stock
5. After the pool has been exhausted, the company may reassess whether additional funding of the LTI plan is in the best
interests of the company, shareholders and participants
6. Payout terms are linked to owners; i.e., participants get paid when the shareholders get paid
Examples
b. Phantom Plan – XYZ Co.
i. Facts
1. $20 million services company 2. 100 employees
3. Founder-owned
4. Sensitive to minority interests 5. Long-term hold mentality
Examples
b. Phantom Plan – XYZ Co.
ii. Plan Design
1. Phantom shares and SARs
2. Annual awards based on salary, market practices, and subjective performance
3. Annual formula valuations
4. Three year vesting, but payout upon separation 5. Cash flow restrictions on payouts
6. Funding/hedge out of profits
Examples
c. Hypothetical unit grant – Public company subsidiary
i. Facts
1. US subsidiary of very large, publically traded, foreign parent 2. Service company with related company activities
3. Need to evaluate performance on a combined-entity basis 4. Some financial statement sensitivity
Examples
c. Hypothetical unit grant – Public company subsidiary
ii. Plan Design1. Private company creates an LTI plan that grants “units” in a pool that consists of company earnings
2. This LTI pool is treated like a separate entity that is divided into “units” (similar to stock)
3. One percent of consolidated-company profits is allocated to the pool
Examples
c. Hypothetical unit grant - Public company subsidiary
ii. Plan Design
(cont’d.)4. Growth of the pool is based on company profit
growth-similar to valuation of private company
5. Employees have the option to defer payouts from the
plan, and in return receive a 20 percent company
match on those deferrals
Examples
c. Hypothetical unit grant - Public company subsidiary
iii. Employee grants
1. Employees granted “units” based on a percentage of salary 2. Each grant of “units” to the employees is subject to a three
year graded vesting schedule, with payout occurring in year four
3. This will drive employee behavior and create the desired retention effect
4. Grants are made annually to increase retention and smooth out unforeseeable changes in earnings
Examples
c. Hypothetical unit grant - Public company
subsidiary
iv. Attempt to keep it simple so employees
appreciate plan
1. Well developed education up front
2. Annual statement to communicate value
Examples
d. Multiple Equity Plans
i. Facts
1. 500+ employees
2. Desire to build ownership culture
3. Maximize tax efficiency
4. Conserve cash in the short term
Examples
d. Multiple Equity Plans
ii. Multi-plan design
1. Omnibus equity plan structure
a. Allows for stock, RSUs, options, SARs,
performance units, etc.
i. Provides maximum flexibility
Examples
d. Multiple Equity Plans
ii. Multi-plan design
(cont’d.)
2. Nonqualified deferred compensation plan
a. Permits deferral of equity plan awards
b. Permits target employees to buy stock with
pre-tax cash compensation (base & bonus)
Examples
d. Multiple Equity Plans
ii. Multi-plan design
(cont’d.)
3. Qualified plan – “KSOP”
a. Allows company to make stock
contributions, including 401(k) match, in
stock
b. Permits participants to direct investment in
company stock
Questions?
John Schultz [email protected] 303-779-2084 James Deets [email protected] 214-683-6918Compensation & Benefit Solutions, LLC 2633 McKinney Avenue, Suite 130-517
