A Deep Dive Into Long Term incentive Compensation Structures | Guide 2023
January 16, 2023
Long-term incentives, or LTI as they're commonly known, are an important component of a complete compensation package for rewarding employees and keeping them focused on desired long-term goals and outcomes. Because the value of the reward is typically not appreciated until a later time, LTI also acts as a retention tool by motivating the employee to remain engaged, focused on the desired outcomes, and employed with the company.
However, because of long term incentive compensation is often only as mall portion of the employee population's reward strategy, not all human resources staff or pay professionals are conversant with different LTI vehicles, their benefits and drawbacks, and the value they provide.
LTIs benefit everyone Involved!
As the name implies, a long-term incentive is a tool with a long time horizon (often more than one year) and can be used as a strategic reward tool to encourage long-term retention and alignment with business objectives. LTI has the potential to benefit all parties:
● Employers can use LTI to recognize employees for achieving long-term goals and strengthening business performance.
● Employees can use LTI as a means of capital accumulation and as compensation for exceptional performance.
● LTI serves as a vehicle for shareholders to align employees with the performance of shares (for market-based equity vehicles) and the company's long-term goals.
● Employees who become shareholders have an incentive to raise the value of the business because the performance of the shares directly impacts their salary.
How is an Long Term Incentive Compensation Put To Use?
An LTI operates by providing employees (often senior personnel) either cash or business stock in exchange for achieving certain objectives. The targets are usually long-term, lasting three to five years, to encourage continuous improvement rather than short-term goals.
In contrast to short-term incentives, LITs have a retention component built in to entice employees to stick around so they can obtain long-term rewards.
What kinds of LTI are there?
LTI generally falls into one of the following three categories:
1. Appreciation based
The delivery of value is predicated on the growth in the underlying value of the business, which, in the case of a public firm, is reflected in the share price. Employees will be paid the difference between the underlying unit's value in the future and its value when the stock options or stock appreciation rights (SARs) are issued per unit.
Pros of appreciation-based LTIs:
● If the firm stock price increases, appreciation-based incentive compensation management software can provide significant financial benefits for employees, especially in startups and developing businesses.
● Additionally, this kind of reward is incredibly adaptable. By tailoring the vesting term (i.e., the time before acquiring 100% award ownership), you can choose when and how often your employees get the awards.
● When SARs become available after vesting, employees typically don't have to pay for them. It implies they do not make any upfront payments and only get the awards.
Cons of appreciation-based LTIs:
● However, when employees choose to exercise (buy) their stock options after vetting, they must do so at the pre determined price (exercise price). "Buy low, sell high" is how they make money.
● There is a risk associated with these awards, such as the possibility that they will become worthless if their value falls below the exercise price (i.e., underwater stock option)
Value is supplied in the form of stock in the company. Although compensation may be based on achieving performance targets, employees will ultimately get a portion of the company's stock. It should be noted that some businesses may issue "phantom shares," which follow the value changes of the underlying shares but are paid out in cash.
Pros of stock-based LTIs:
● Since no upfront payment is required for a time-based full-value award like an RSU, it is an advantage. RSUs are therefore viewed as being less risky than stock options.
● They also have a vesting time, so you can personalize how you give employees access to them.
Cons of stock-based LTIs:
● RSUs do not allow employees to choose when they are taxed because regular income tax is owed after the RSUs have vested. Taxation, however, is only owed when stock options are decided to be exercised.
Employees will get a cash payment based on service, meeting pre-determined performance goals, or both; value is supplied in cash and unrelated to the shares' performance.
Pros of cash-based LTIs:
● The most dependable bonus that doesn't involve ownership dilution is cash.
● Due to their low liquidity and complex share valuation, private enterprises frequently receive this LTI award.
Cons of cash-based LTIs:
● However, as cash flow is crucial to the expansion of your business, it is advisable to avoid these if possible.
● Cash-based compensation may not make employees feel as vested in the company as stock-based compensation.
long term incentive compensation is typically awarded with a time called a vesting term. It means that although grantees are granted equity on a conditional basis, they do not genuinely own it until the vesting term has passed. This is the retentive element of LTI; the grantee forfeits the award if they fail to achieve the applicable vesting criteria, such as continuing to work for the company for three years after the grant or achieving a performance goal.
Cliff and ratable vesting are the two different types. Cliff vesting awards are paid out in full at the end of a defined period. Awards that vest does so in increments (for instance, an award that vests 25% annually for four years). The vested percentage remains the employee's, even if their employment is terminated before the end of the final vesting period.
Who is granted LTI?
Since those with direct access to the company's long-term strategic vision typically have a greater impact on the company's value, LTI generally is more common among personnel at higher levels of an organization.
Let's imagine that a business awards performance shares that are subject to meeting a net income goal. Could the CEO affect the company's profitability? Yes. Nonetheless, a rookie accountant? Most likely not. Since these roles lack the influence to generate that kind of change, administering performance-based LTI to lower-level posts has less benefit. Because of this, LTI for lower-level employees usually places a greater emphasis on retention. One of the more recent ways that LTI plans might increase retention is by including ESG incentives.
Due to its liquidity and simplicity in valuation, LTI is more common in public corporations.
System features for managing LTI
Flexible compensation technology is necessary to keep your LTI plans in check. A handful of the capabilities your system need are listed below:
● Following up on and reporting approvals for incentives
● Managing many con current plans' vesting schedules
● To handle eligibility, awards, and option exercise, provide a rules engine
● Add KPI data sources to the formula used to determine suggested awards
● Adjustments and clawbacks should be made.
● Determine or project the accruals required for deferred compensation
Why do businesses utilize LTIs?
LTIs are a deferred pay strategy that benefits both companies and employees in the following ways:
● Emphasize long-term gains/benefits. While short-term gains are fantastic, they can be expensive. They frequently compromise consumer connections and are unsustainable.
● Over a long period, LTIs can align your company's interests with your employees. In addition to attempting to meet this year's goals, they are also working to advance the business to continue its long-term growth.
● Encourage workers to stick with the business. With LTIs, you can demonstrate to your staff the key areas where continuous improvement may be effected, and their long-term compensation holds them responsible for putting that strategy into practice over the following two years.
● Spend less time and money hiring senior personnel. Studies show that when a company replaces a salaried employee, it typically costs six to nine months' income to educate their replacement. Employee turnover can be a needless drain on your revenues.
Taxes for long-term incentive plans
Based on the type of LTI award, LTIs may be taxed at several points during their life cycle, including Grant, Vesting, Exercise, and Sale. For instance, you normally will only pay tax on your ISO awards once you sell them, but you will be required to pay income tax when you use your NSO awards.
Design of long-term incentive plans
1. Determine the objectives of your business:
As we can see, because their goals are different, private corporations and public companies have quite distinct LTI techniques. So one of the best practices for long-term incentive plans is to identify your goals and create a strategy around them.
2. Select an LTI design:
LTIs are a fairly diverse group of compensation plans. As a result, there are many different designs to choose from. When selecting your plan design, keep the following factors in mind:
● LTI type: Compare the advantages and disadvantages of each incentive in the final section.
● Several LTI types: Private businesses typically only utilize one LTI vehicle, but public firms frequently use many cars.
● Schedule for vesting: Examine the final portion.
● Eligibility: Although LTIs are frequently provided to top employees, some businesses offer incentives to all staff members. Always keep your company's objectives in mind!
3. Verify your adherence:
The most crucial action to take into account is compliance. Finding an LTI appropriate for all participants in all jurisdictions will be important, especially if you have offices spread across several different countries. Each of these countries will have its tax and equity compensation regulations.
You must also ensure that you can collect and store the data of your employees in a compliant manner.
Additionally, you must ensure that you have a staff solely responsible for reporting because LTIs bring a substantial amount of reporting—taxes, payroll, and a great deal more—with them.
4. Make your LTI known:
Effectively communicating the advantages of your LTI to your participants calls for more than just one email or leaflet. You must ensure they are fully aware of the benefits of participating in your plan.
A strong communications strategy begins well before your debut. It would be best if you had short, catchy graphics combined with interesting, jargon-free information that includes examples.
5. Manage your plan:
The management of the LTIP is a difficult and continual procedure. It entails monitoring and disclosing changes in award ownership, revising policies, processes, and paperwork, speaking with stake holders, contacting your board of directors, and remaining in compliance with local laws in each region where your workers are based.
It is crucial to establish a strong compensation system that will enable you to administer the plans efficiently, regardless of how you intend to utilize long-term incentives—to recruit top executives, recognize success, inspire superstar staff, or even promote long-term thinking and value creation. Consider switching to an automated total compensation platform if you are still handling your LTI programs with spreadsheets to streamline administration, connect LTI with total compensation, and enhance compliance.
Find out how Compport can help you manage all your Long Term incentive Compensation process, book a demo today!