Long Term Incentive Plans (LTIP's) and LTI 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?
Long-term incentive compensation (LTIC) plays a pivotal role in shaping an organization's compensation strategy and fostering long-term success. It is a method through which companies incentivize and retain key employees, typically senior personnel, by offering them compensation tied to achieving specific, forward-looking objectives that span several years. Unlike short-term incentives, which focus on immediate goals, Long-term incentive compensation encourages employees to commit to the organization's long-term vision and strategy.
One of the primary functions of Long-term incentive compensation (LTIC) is to align the interests of employees with those of the company. This alignment is achieved by linking compensation directly to the attainment of long-term goals, such as revenue growth, profitability, or market expansion. When employees have a personal stake in the company's success, they become more dedicated to achieving objectives that contribute to sustainable growth, shareholder value, and overall competitiveness.
Long-term incentive compensation (LTIC) typically takes various forms, including stock options, restricted stock units (RSUs), and performance-based awards. Stock options grant employees the right to purchase company stock at a predetermined price, aligning their interests with shareholders. RSUs provide employees with actual shares once vesting conditions are met. Performance-based awards are contingent on achieving specific performance targets, reinforcing a results-oriented culture.
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 should get Long term incentive (LTI) in an Enterprise?
Long-term Incentives (LTI) are typically granted to individuals who hold key positions within a company, especially those who have a significant impact on the organization's long-term strategic vision and performance. The rationale behind targeting certain employees for LTI grants is to align their interests and motivations with the company's long-term success and growth objectives. Here are some key points to consider:
Top Executives: Senior executives, such as the CEO, CFO, and other members of the executive leadership team, are often prime candidates for Long term incentive (LTI) grants. These individuals play a crucial role in shaping the company's overall direction and have the power to influence its value and profitability.
High-Level Managers and Directors: Individuals in leadership positions, including department heads, directors, and managers, may also receive Long term incentive (LTI). Their decisions and actions can have a significant impact on departmental or divisional performance, contributing to the organization's overall success.
Employees with Strategic Influence: Beyond senior management, employees who possess specialized skills, domain expertise, or strategic influence over specific aspects of the business may be eligible for Long term incentive (LTI). For example, a top engineer in a technology company or a leading salesperson with a track record of driving revenue growth may receive LTI.
Performance-Based Criteria: In many cases, LTI eligibility is tied to performance-based criteria. Employees who consistently meet or exceed long-term performance goals, whether related to financial metrics, market share, or other strategic objectives, may be rewarded with LTI.
ESG Incentives: In recent times, some companies have incorporated Environmental, Social, and Governance (ESG) criteria into their LTI programs. This aligns the interests of employees with the company's sustainability and social responsibility goals, making LTI more inclusive and focused on broader organizational objectives.
Why do Businesses Utilize Long term incentive (LTI)?
1. Emphasis on Long Term Growth
Businesses use Long term incentive (LTI) to encourage employees to prioritize the company's long-term success and growth over short-term gains. Short-term incentives can sometimes lead to decisions that prioritize immediate results but may not be in the best interest of the company's long-term health. LTI helps instill a sense of stability and forward-thinking in employees, aligning their actions with the organization's strategic goals.
2. Alignment of Interests
Long term incentive (LTI) align the interests of employees, shareholders, and the company itself. When employees have a vested interest in the company's performance through LTI, they are more likely to make decisions that benefit the organization as a whole. This alignment promotes a sense of shared purpose and collective responsibility for the company's success.
3. Retention and Recruitment
Employee turnover can be costly and disruptive. Long term incentive (LTI) often include vesting periods, which require employees to remain with the company for a specified duration to receive the full benefits of the plan. This retention component helps reduce turnover rates. Moreover, LTI can be an attractive incentive for recruiting top talent, especially at the executive level, as they offer the potential for substantial rewards without requiring large upfront cash payments.
4. Accountability and Continuous Improvement
Long term incentive (LTI) typically tie rewards to specific key performance indicators (KPIs) and longterm goals. This creates a sense of accountability among employees, motivating them to actively contribute to achieving these objectives. The focus on longterm success encourages a culture of continuous improvement, innovation, and efficiency within the organization.
5. Enhanced Organizational Stability
High turnover rates can disrupt business operations and hinder longterm planning. Long term incentive (LTI) provide a strong incentive for employees to commit to the organization's goals over an extended period. As a result, businesses can maintain a more stable and predictable work environment, reducing the need for frequent hiring, training, and onboarding.
Taxes for long-term incentive plans
Taxes for long-term incentive plans (LTIPs) involve potential tax liabilities at different stages of the plan. Initially, when LTI are granted to employees, there are typically no immediate tax consequences. However, when LTI vest, the value of the vested LTI may be subject to income tax, particularly for non-qualified stock options (NSOs) and restricted stock units (RSUs). Upon exercise of stock options or settlement of RSUs, additional tax implications arise, where the difference between the exercise price and the fair market value of the shares may be taxed as ordinary income. Finally, when employees sell the shares acquired through Long Term Incentive Plan (LTIP), they may incur capital gains tax. Tax treatment varies based on factors such as the type of Long term incentive (LTI) and the duration of share ownership, making it essential for participants to seek professional tax advice for effective financial planning.
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.
1. What are Long-term Incentives (LTI) and why are they important?
Long-term Incentives, or LTI, are a crucial component of employee compensation packages designed to reward and motivate employees for achieving long-term goals and outcomes. They are important because they provide a means to align employees' interests with the company's long-term success. LTI typically have a longer time horizon, often spanning several years, which encourages employees to stay committed to the organization and its objectives.
2. What are the different types of LTI vehicles and their pros and cons?
Appreciation-based LTI: These are tied to the growth in the company's value, often reflected in the stock price. Pros include potential financial benefits if the stock price rises, flexibility in award timing, and no upfront cost. Cons include the need to buy shares at a predetermined price and the risk of options becoming worthless if stock value falls.
Stock-based LTI: These provide employees with company stock, often without upfront costs. Pros include no upfront payment, vesting schedules, and alignment with stock performance. Cons include taxation upon vesting and limited control over the timing of taxation.
Cash-based LTI: These offer cash payments based on service or performance goals. Pros include liquidity and simplicity, suitable for private companies. Cons include the potential impact on cash flow and potentially lower employee engagement compared to stock-based incentives.
3. How does vesting work in Long-term Incentive Compensation?
Cliff Vesting: In this approach, there is no gradual vesting during the vesting period. Instead, employees gain access to the entire LTIC award all at once, typically at the end of the vesting period. However, if an employee leaves the company before the cliff date, they may forfeit the entire award. Cliff vesting can serve as a strong retention tool, as employees are motivated to stay until they reach the cliff date to gain their full award.
Ratable Vesting: With ratable vesting, employees gain ownership of their LTIC awards incrementally over the vesting period. For instance, if the vesting period is four years, employees might vest at a rate of 25% per year. If an employee leaves the company, they typically retain the portion of the award that has already been vested. Ratable vesting provides employees with some benefits even if they do not stay for the full vesting period.
4. Who is eligible for Long-term Incentives, and how are they granted?
Eligibility for Long-term Incentives (LTI) is typically determined by an employee's job level, performance, and tenure within an organization, with a focus on individuals who wield influence over long-term strategic goals. The granting process involves setting specific criteria for eligibility, determining the amount of the Long term incentive (LTI) award for eligible employees, communicating the terms and conditions to them, establishing vesting schedules, and tracking compliance. Long term incentive (LTI) are commonly used to motivate and retain key personnel, aligning their interests with the company's long-term success.
5. What is the tax treatment of Long-term Incentive Plans, and how do they affect employees?
The tax treatment of Long term incentive (LTI) can vary based on the type of award. For instance, ISOs (Incentive Stock Options) are typically taxed when sold, while NSOs (Non-Qualified Stock Options) are taxed upon exercise. Understanding the tax implications at different stages of LTI ownership is essential for employees, as it can affect their overall financial planning and decisions.
Find out how Compport can help you manage all your Long Term incentive Compensation process, book a demo today!