There are lots of great reasons to offer your employees a long-term incentive plan (LTIP). One of the main reasons is – you’re giving your employees incentive to remain engaged and focused in the long term.
Today, we’ll discuss how to create an effective LTIP by laying out long-term incentive plan best practices.
Why is my long-term incentive plan not working?
An LTIP fails probably because its designers don’t build an effective plan that fits their company and employee needs.
A professor of Management Practice, Andrew Pepper, makes some interesting points in his study (Source: Harvard Business Review 2016) on why LTIPs fail for executives*. Let’s look at the reasons identified in his study:
- Executives are risk-averse and prefer a safer choice
- Executives discount heavily for time and choose an early pay-out
- Executives care more about relative pay – their pay in relation to their peers’.
- Large incentive packages don’t necessarily create stronger motivation as other aspects matter, e.g. achievement and teamwork
*LTIPs are most often reserved for executive-level employees.
Based on Pepper’s research, the respondents tend to undervalue LTIPs simply because these plans don’t suit them. So, to make an effective LTIP, there’re step-by-step best practices to follow to avoid the pitfalls Pepper mentioned:
Long-term incentive plan best practices
- Set up goals
- Consider design details
- Check your compliance
- Simply your plan administration
Step 1: Set up plan goals
Some common goals are to attract talent, retain key employees and motivate staff to grow the business e.g. increase profit and company stock price. From the start, you should also list out all concerns when it comes to setting up LTIPs. Common concerns are giving up control of the company, valuation of equity, equity transfer to third parties and etc.
The more specific they are, the more effective your plan turns out.
Step 2: Consider your design details
There’re a number of components in an LTIP design – overall competitiveness, types of vehicle, eligibility, vesting schedule, termination rules and etc.
- Overall Competitiveness: LTIP is to incentivize employees to achieve the goals you want, so a competitive compensation offering matters. As Pepper said ‘’Executives care more about relative pay’’, what you need to focus on is the pay package in relation to your peers’ package rather than the absolute earnings.
- Types of vehicle: Appreciation-based (e.g. SARs, options), time-based (e.g. RSUs), performance-based (e.g. PSUs) and cash-based. Each vehicle can help achieve different goals, e.g. RSUs carry less risk which is suitable for risk-averse executives. Check our LTIP guide to see their pros and cons, or simply speak with us. Our software program can manage and administer a huge range of equity forms.
LTIP Design Scenario
If you wanted to achieve stock price appreciation, you could use appreciation-based awards such as SARs and Stock Options to motivate employees to focus on this area.
Some employers would use RSUs to achieve this target. With RSUs, the higher the stock value is, the more an employee can get. But unlike SARs and options, RSUs are a full-value award. So, employees will get the benefit based on the total value of the company’s stock rather than the stock value appreciation.
One of the RSU benefits is that they carry less risk. Do you remember what Pepper identified in his study – Executives are risk-averse and prefer a safer choice.
RSUs are guaranteed to have value as long as the company stock value stays above $0 because employees don’t need to pay for them. In contrast, an appreciation-based award is riskier as there’s a chance that the stock value goes below the purchase price.
If you are trying to incentivize your younger employees – they would probably be more willing to take a risk for a bigger upside. So, an appreciation-based award would motivate them.
- Eligibility: Common criteria for eligibility includes job category (e.g. sales, marketing and production), length of service, and position (e.g. senior managers and executives). If you want to achieve certain goals which involve a broader range of teams, you may want to consider including the managers of the teams in the plan to motivate them to focus on those goals.
Again, go back to your goals when considering the eligibility.
- Vesting Schedule: Vesting is a waiting period before receiving 100% of the award ownership. There’re 2 vesting ways – Cliff vesting (receive the entire award in one go after some time) and Ratable/Graded vesting (receive a portion of the total award gradually).Pepper mentioned ‘’Executives discount heavily for time and choose an early pay-out’’ in his research. His data suggests that executives discount distant payouts at the remarkable rate of 30% a year. It means that executives would rather get $1 today, than $2 in the future.
To help manage this, you can make use of the flexibility of stock vesting to customize the schedule of receiving benefits. Google has shifted to more front-loaded vesting for its RSUs – from vesting 25% evenly each year to vesting 33% per year for the first two years. This can provide a compelling alternative to the standard approach. At global Shares, We’ve designed many vesting rules for our clients. Speak with us today if you want to know how we can help.
- Termination Rules: A shareholder agreement should spell out all the plan details including termination rules, timing, and price for the repurchase of an employee’s LTI awards. Some typical treatments:
Stock Options: Typically, stock options expire within 90 days of leaving the company, so you could lose them if you don’t exercise your options.
RSU: If your employees quit with vested RSU, typically the vested ones will stay theirs as they own company shares after vesting. The unvested RSU shares are likely forfeited.
ESPP: You will continue to own stock purchased for you during your employment, but your eligibility for participation in the plan ends, meaning you’ll no longer be able to buy shares in the plan
Step 3: Check your compliance
Compliance is an important component to consider. Particularly if you have multiple jurisdictions – each of these countries will have its own rules around equity compensation and tax, you will need to find an LTIP that works in all jurisdictions, for all participants.
You also need to ensure that you will be able to gather and retain your employees’ data in a compliant way.
Global Shares is an expert in managing all LTIP compliance matters. Speak with us to learn more about launching your LTIP in a compliant way.
Step 4: Communicate
No matter how great your plan design is, it might fail without a strong comms strategy. So, effective communication is one of the long-term incentive plan best practices.
Your plan needs to be communicated in plain, no-jargon language with examples, so the benefits are clear. Make sure your comms plan addresses their concerns, e.g. risks of each vehicle, and when and how often the awards will be released.
It’s worth noting that sometimes it’s not all about monetary incentives. According to Pepper’s study, on average, executives would reduce their pay package by 28% if it meant a job that was more rewarding in other metrics – achievement, status, teamwork etc. So, the best way to engage your employees is to communicate regularly to get feedback from them.
Step 5: Simply your plan administration
LTIP administration is a complex and ongoing process. It involves everything from tracking and reporting changes in award ownership to updating documents/policies/procedures, communicating with stakeholders, consulting your board of directors, and staying compliant based on each region your employees are based in.
Fortunately, you could simplify this process by bringing in the right partner, like Global Shares. Click the button below to learn more.
So, what next?
Now that we’ve covered all of Pepper’s warnings. But, he just highlights the common pitfalls that companies likely fall into when setting up an LTIP. Now that you have the antidotes, you can be sure that your LTIP accomplishes its goal(s).
Here at Global Shares, we spend all day coming up with ways to help our clients avoid pitfalls that they haven’t even thought of. It’s what has made us an award-winning equity compensation company for 15 years. Contact us for a demo, to see how we can help your company succeed.