Long-term Incentive Plans for Private Companies

Closely-held businesses often rely heavily on a few key employees who are not owners or shareholders to perform roles critical to the company’s long-term success.  They aren’t always easy to find or keep. How you compensate these key employees is one important factor in successfully attracting, retaining and motivating them for the long haul. A long-term incentive plan is an integral part of the compensation package, and there many different types of plans from which to choose.

Many of our clients and business owners voice similar concerns about key employees:

  • “We have difficulty competing for talent with public companies”
  • “We need a “talent upgrade” of our management team to get to the next level as a company”
  • “We want to have our executives make and execute decisions as if they have the same economic interests as the owners”
  • “We don’t have any family members ready and/or willing to step in and run the business”

Privately held companies have addressed these issues by implementing a long-term incentive plan (LTIP) for their key employees. Typically these plans have some or all of the following objectives:

  • Align the economic interests of key employees and the owners
  • Retain key leadership through the use of “golden handcuffs”
  • Support owners’ liquidity and/or succession planning objectives
  • Lengthen the time horizon of management decision-making
  • Respond to competitive labor market pressures
  • Provide wealth creation opportunities for key employees as the company succeeds
  • Provide tax advantaged deferral of income

The design of these plans is very flexible; they can focus on performance or retention, or in combination. We are going to focus on LTIPs, which are primarily designed to align performance, vs. non-qualified deferred compensation plans, which are primarily intended to strengthen retention or supplement retirement benefits above what can be achieved via a qualified benefit plan.

Plan Design Alternatives
There are three general categories when considering plan design – equity plans, phantom-equity plans that mimic equity but pay out in cash, and non-equity performance-based cash plans. Equity plans include market-value stock options or restricted stock, and formula-value stock purchase. Phantom-equity plans include stock appreciation rights (SARs) and phantom stock. Finally, non-equity plans performance-based cash plans are long-term cash bonus programs. See the informational table below for a brief summary of each of these alternatives.

LT Incentive Alternative Pros Cons
Market-Value Stock Options
  • Creates market-based ownership opportunity
  • Fixed book expense
  • True ownership opportunity
  • Strong value creation vehicle
  • Employee controls purchase and tax timing (upon exercise)
  • Annual appraisal may be expensive and have unintended estate consequences
  • Employee must fund the option exercise (may be accompanied by a promissory note)
  • Company may not control timing of cash-out
Market-Value Restricted Stock
  • Similar to stock options except is a stronger retention vehicle and does not require an outlay of cash to acquire the stock
  • Employee has less control over tax timing vs. stock options
Market-Value Stock Purchase
  • Aligns interests of management and owners through investment in company
  • Potentially significant capital gains opportunity for executive
  • Can be structured to potentially avoid book expense
  • Requires employees to make upfront investment
  • Loan terms may be risky and complex in order to meet accounting/tax standards
  • Generally no company tax deduction
Stock Appreciation Rights
  • Aligns interests of management and owners
  • Simulates the value-creation of stock options
  • No annual independent appraisal required
  • Deferred payouts can mitigate company’s cash obligation
  • Variable book expense until SAR is exercised
  • No real ownership
  • Cash payments may deplete the Company’s cash resources
  • If deferred payouts used, plan must be compliant with Sec. 409A
Phantom Stock
  • Similar to SARs, except is a stronger retention vehicle
  • Similar to SARs
  • Plan must be compliant with Sec. 409A
Long-Term Cash Bonus
  • Reward management for multi-year operating performance
  • No transfer of ownership to management (easier to market company)
  • Motivates executives to focus on financial metrics that are critically important to the Company
  • Does not compete effectively with public companies that provide ownership opportunities
  • Can be difficult to establish long-term performance goals
  • Aligning program with potential exit event requires trust of executives
  • Variable book expense until payout

Plan Design Considerations
Selecting and designing the right plan requires consideration of three primary factors.
1. Competitive reality – what is the labor market for talent? This requires knowledge of total pay levels and mix between base salary, annual cash bonuses and long-term incentives. Too often companies jump in to the LTIP without understanding where they stand in terms of total pay.  The amount of long-term incentives should consider whether or not the executives are already compensated well in cash.  For example, one client’s annual bonus plan was so rich that the answer was to “carve out” the long-term opportunity from the cash already being paid to their executives, as opposed to layering an incremental amount on top of the annual compensation.  This saved the client cash, and has resulted in better alignment between the executives and the owner’s long term goals as well as no executive turnover.

To know whether or not you are paying your key people competitively, you would benchmark the pay for the executives to market practices.  There is quite a bit of data and resources, including published competitive salary surveys, proprietary data from previous studies and finally SEC proxy data for top executives.  This information can be customized to the industry and size of the company. From this information, it is possible to determine competitive salary levels, pay “mix” (i.e. the allocation between annual cash and long-term compensation, and so on. With this information in hand, it is much easier to set base pay levels, short-term incentive targets and long-term incentive targets.  This is better than “recruiter data” in that you get a range of compensation levels from objective data sources.  Recruiter data tends to be at the high end of market, because that is what it usually takes to attract someone from a competitor, and may not be necessary or appropriate for every key employee.

2. Business and ownership strategy.  The program needs to properly align the executives’ goals and objective to the owners’/shareholders’ financial interests. If the goal is a liquidity event, real equity vs. phantom stock may be appropriate.  For example, pre-IPO and private equity-backed companies almost always grant stock options and restricted stock to their employees. On the other hand, if the company is to remain closely held and the goal is to retain and motivate several key people, then a phantom equity plan can be very effective.  Phantom stock and stock appreciation rights are the vehicles of choice for such companies, whether an S- or C-Corp. Finally, it may be that certain long-term performance objectives, such as growth and profit improvement are clearly desired, in which case a multi-year performance cash plan is the best answer.  For example, a company with a new growth strategy recently implemented a long-term cash plan that rewards the non-owner leadership team for increasing EBITDA over the coming 3 to 7 years.  Valuation was a messy proposition given that the company was going through a restructuring.  Of course, whichever plan is selected should be tested to see how it would payout and how dilutive to earnings or the shareholders it may become, along with the accounting and administrative costs and liability to the company.

3. Technical and regulatory compliance.  The plan needs to properly address the personal tax impact on the employee and the company’s tax return. It is very important to understand how certain sections of the Tax Code, particularly Sec. 83, Sec. 409A and employment tax withholding rules apply to the LTIP. Both the plan document and administration of the plan must adhere to these rules to avoid  unfavorable tax consequences. Failing to comply with these rules can result in significant tax penalties or a tax timing surprise to the employee, as well as amended personal and corporate tax returns, which of course negates the intended goodwill of the plan.

Final Thoughts
A long-term incentive plan may or may not make sense for your company. We can note, however, that the old sayings – “you get what you pay for” and “what is rewarded is what gets done” – certainly apply to how you compensate your key employees. If the goal is to have certain employees think and act like owners, take a view of the business beyond the current year, or be retained long-term, then having one of these plans in place will significantly increase the odds that such objectives will be met.

 

About FGMK

FGMK is a leading professional services firm providing assurance, tax and advisory services to privately held businesses, global public companies, entrepreneurs, high-net-worth individuals and not-for-profit organizations. FGMK is among the largest accounting firms in Chicago and one of the top ranked accounting firms in the United States. For more than 40 years, FGMK has recommended strategies that give our clients a competitive edge. Our value proposition is to offer clients a hands-on operating model, with our most senior professionals actively involved in client service delivery.

 

Please visit our website for our complete list of services.

Search


Thought Leadership
Press Releases
Tax & Estate Planning Guide
Subscribe to Newsletter