Compensation 101: What Are Long-term Incentive Plans?

May 14, 2022
Daily digest

When employees reach goals that lead to increased shareholder values, you can reward them with performance shares and special capped options in addition to stock awards. Such reward systems that improve the employee’s performance are called long-term incentive plans or LTIP. In some cases, it may not be even tied to the company’s share price.

They are a common compensation vehicle in startup companies as a means to attract top talent, employee retention, and to drive performance in the longer run.

Who does Long-term Incentive Plan(LTIP) apply to?

LTIP is specifically designed for executive employees who fulfill certain requirements that contribute to an increase in shareholder value.

Executives know which factors to focus on to improve the business when the company’s growth plan matches the LTIP. While geared toward their incentivization, it also functions to assist the business’ long-term growth.

When do employees receive the benefit of the LTIP?

The performance period for the LTIP usually runs between three to five years, before the full benefit of the incentive is received at the end of that pre-defined period. Now, companies can give these payouts either all at once or gradually over a period of time depending on the vesting schedule.

When companies set up LTIP, they decide on a period of time when the employees will receive full ownership of the asset, stocks or retirement funds, that come as a result of the LTIP. It can either be:

Cliff vesting: The employee receives the full benefit at a pre-defined point in the future.

Graduated vesting: The employee gets a certain portion of the reward, usually a specific percentage, over a period of time until the asset is fully vested.

Employees will be able to reap the benefits only if they stay with the company until the vesting date.

Why is LTIP important?

Hiring new employees is incredibly hard. Replacing an executive can cost up to nine times their monthly salary. This cost comes in the form of recruitment and training, in addition to the time spent by senior employees in the company.

The LTIP is a way to stimulate and retain talent in a highly competitive environment. It rewards employees who help the company achieve its strategic objectives. It makes their contributions acknowledged and makes them feel valued. This, in turn, serves as a motivator for the employee and can lead to job satisfaction.

By offering lucrative rewards such as equity, retirement funds, and options, you reduce the turn over of the company.

Types of LTIP

Depending on your goals, business size, and organizational value, you can choose to offer different long-term incentive compensations like restricted stock, performance shares, stock options, retirement funds, and cash awards.

Restricted stocks

In this LTIP, employees are granted unregistered equity shares that are non-transferable and can not be sold until the vesting date. Restricted stocks can be awarded as:

  • Restricted stock units, with no voting rights and immediate ownership
  • Restricted stock awards, with voting rights and immediate ownership

Employee stock options (ESO)

These are some of the most common kinds of long-term incentive plans. Every five to ten years, companies reward best-performing executives with the right to purchase shares at a pre-determined price. It aligns the objectives of the company’s shareholders and the employees; since when the share price goes up, shareholder value goes up and employees get shares at higher prices.

Since there’s no cash outflow, it can reduce expenses. On the flip side, the earnings per share for shareholders can get diluted.

Performance shares

Performance shares are when companies allocate stocks to employees when company-wide performance objectives are met, based on certain metrics, like earnings per share. They’re meant to drive activities that directly impact the shareholder value. They are different from stock options in that the executives receive the actual shares as opposed to receiving the option to purchase shares.

Cash awards

This is a popular option in private companies where stock options are non-existent. When employees achieve pre-defined performance objectives over a long period of time, they become eligible to receive cash awards that reflect the company’s gratitude.

Phantom stocks

Phantom stocks are contractual agreements between the organization and the executive employees that gives the benefit of stock ownership without actually transferring the ownership of shares. Like regular stocks, phantom stocks also follow the rise and fall of the share price and employees are compensated with profits incurred from the shares’ appreciation.

In addition to these LTIP, there are other reward systems like extended vacation days, paid sabbaticals, and more.

What are the drawbacks of LTIP?

Alexander Pepper, in his article on the Harvard Business Review titled The Case Against Long-Term Incentive Plans says companies are better off using that cash to pay larger salaries and annual cash rewards to incentivize desired behavior. There are several theories that suggest LTIPs do not work.

Here are some of the disadvantages of long-term incentives:

  • LTIPs are so far into the future that it may not actually serve as an incentive.
  • Performance metrics may depend on external, non-controllable economic conditions. This can demoralize executives when things don’t go their way.
  • It can lead to deception, i.e. to falsify reports to cover their own poor performance, such as the infamous VA scandal.
  • Stock options can dilute the profit per share and reduce the number of allocated shares.

Closing thoughts

When designed properly, long-term incentives can be a great vehicle to promote retention and to align the employee and shareholder interests. It’s a win for everyone involved:

  • Employees get rewarded handsomely
  • Company’s performance is improved
  • Shareholder value is increased

There is no one perfect LTIP that’s appropriate to all companies. You need to assess your culture, strategies, and goals to select the right mix of amounts, stocks, and vesting mechanics.

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