Long-Term Incentive Plans (LTIPs) have been a common choice for private companies looking to attract, reward, and retain employees.
Executive talent is often lured away by publicly held companies but employers in private companies can create a robust LTIP for their upper management to win the talent war. So, it is predicted that LTI prevalence will increase in private companies to compete for talent with public companies.
To help private companies to be competitive with compensation packages. Here, we’ll discuss how to design long-term incentive plans for private companies.
Long-Term Incentive Plans: A quick introduction
An LTIP isn’t designed to deliver an immediate reward. Instead, they are typically structured to last three to five years to encourage employees to excel over an extended period of time. The better the business fares over the life of the plan, the greater the rewards will ultimately be for participants.
Typically, time and performance conditions apply with long-term incentive plans for private companies. So, participants are effectively promised shares once the time-based and/or performance-based requirements are achieved.
LTIP: Private vs Public
Due to liquidity, LTIPs are more widely used in public companies than in private companies which lack effective markets to sell shares. But at the same time, their detachment from the public markets brings them some benefits, allowing them to operate under less scrutiny and governance bureaucracy.
In the past decades, LTIP prevalence in privately-owned companies has actually increased in order to be competitive in the talent war.
There also have been some changes in LTIP vehicles in privately-owned companies. The use of equity – following the pattern of public companies – is on the rise although cash is still the dominant LTIP component.
Common LTIP vehicles
- Stock options: They provide participants the right, but not the obligation, to exercise (i.e. purchase) the vested stock options at a pre-set price after the vesting (i.e. the waiting period before receiving 100% of the award ownership). The award depends on the company’s share price appreciation. It’s typically a time-based LTI grant.
- Restricted stock units: Participants receive a promise that they will receive free shares after vesting. Rather than associating the stock appreciation, RSUs are a full-value award. It’s usually a time-based LTI award as well but it could be performance-based – Perf-RSU (or PRSU).
- Stock appreciation rights (SARs): Quite similar to Stock Options, SARs’ value depends on stock price appreciation but they don’t typically require payment upfront. It’s a time-based award.
- 401(k) retirement plan: When an employer matches a percentage of an employee’s paycheck going into the plan, employees are more likely to stay with the company to earn more money for retirement.
- ESOP: Rewarded for long-term tenure, ESOP allows private company owners to sell all, or a portion, of their company to their employees
- Cash bonus: Private companies appear to favor simpler, cash-based long-term incentives
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LTIP Design 1: Maintain 100% control over the ownership of the company
We get that.. You may have a concern about losing control and having to account to minority shareholders in managing the business. The solution is simple – cash long-term incentive plans (e.g. cash bonuses and cash-settled SARs) that provide no rights to management.
This approach also completely avoids any distractions and disturbances created by minority security holders.
Actually, cash is the most common LTI form among private companies (Source: WorldatWork 2021). Besides the benefits just mentioned, companies relying on cash incentives can avoid equity-related complexities such as valuation, liquidity and the dilution of ownership.
LTIP design 2: Be competitive while maintaining control over the ownership
Despite having multiple benefits, cash can’t generate as significant wealth as equity can. So, if you wanted to have a robust LTIP with a more competitive compensation offering while staying in control over the business, you’d probably need to consider long-term equity incentives.
Actually, there has been an uptick in the use of real equity (stock options and restricted stock/units) while cash dominates LTIPs in private companies.
According to SHRM, offering long-term equity incentives can help 1) compete for talent with larger companies, 2) preserve cash flow, and 3) provide employees with stronger motivation to perform in the best interest of the company. The probability that this will take away control can be minimal if you consider the number of shares issued well.
In the situation where private companies decide to offer equity, they typically address the liquidity concerns by providing that they or their security holders will repurchase any shares upon certain triggering events, such as demand by employees after a certain time period has elapsed.
You could also consider having multiple LTIP vehicles to achieve your goals. 40% of private companies use more than one vehicle in their LTIPs (Source: WorldatWork 2021)
LTIP design 3: Transition the ownership of the business
If you’re a private company owner and are looking to retire, there’re multiple approaches you could consider for your business. One of them is to sell your shares to your employee via ESOP which is considered a long-term award for employees.
Let’s look at a hypothetical real-world scenario:
Fred (60), a private company owner, wanted to retire but also take care of his business and employees
Fred runs a large, private company, Tangerine. They specialize in exporting citrus fruit. Over the past two decades, they have been extremely successful. Last year, they nearly broke nine figures in profit.
There was one problem. His morning fitness routine has gotten more strenuous. It made him start to make plans for transitioning the business.
He wanted to retire comfortably, he wanted to make sure his business continued to grow, and he wanted to make sure that his employees were well taken care of.
He certainly had plenty of callers – interested in taking them public or acquiring them. But neither one would guarantee all three things on his list.
Fred came up with an idea: A long-term incentive plan via ESOP
An ESOP (Employee share ownership plan) is most commonly used to provide a ready market for the shares of departing owners of successful closely held companies. At the same time, it motivates employees because as a business grows, so does the value of the shares allocated to employees.
When the employee’s participation in the ESOP ends, they’ll receive their share of the “vested” benefit. Distributions (i.e. benefits) may be made in stock or cash.
With this LTIP, Fred has converted the private company that he owned into an employee-owned company. He can be sure that they’ll be taken care of and Tangerine can continue to grow.
So, What next?
There are many different long-term incentive plans for private companies to choose from, above and beyond the three referred to briefly earlier here. What LTIP makes the most sense for you will depend upon, for example, your location, your industry, and the structure of your company, so it won’t be a one size fits all solution
Your best bet is to go through all of the different designs and plans with somebody who specializes in equity compensation management like Global Shares. Otherwise, you could potentially end up with the wrong LTIP, or at least one that is not the best fit for you and your employees.
At Global Shares, we have helped companies of all sizes to set up and manage award-winning employee share plans. We can take you through setting up an LTIP that will bring out the best in your company. Contact us for a commitment-free demo today.