Best Practices for Long-Term Incentive Planning

Written by Kelly Wells and Teresa Foltz

Many elements go into the formula for attracting, retaining and developing the right talent for your organization. In assessing how you’re doing across each of these elements, one of the questions you’ll undoubtedly want to explore is “What kind of long-term incentive plan should our business have in place?” It’s an exercise that often requires more work than you might expect, especially when trying to anticipate trends and not-yet-visible barriers.

In this post, we break down incentive planning best practices to help you minimize employee turnover, encourage development, and support goal achievement with the right collection of incentives and benefits.

Doing your homework

Before you begin to look at long-term incentive plan options, it’s important to stop and ask yourself foundational questions such as:
• What strategic objectives are we aiming to support with our incentive program?
• What kind of behavior are we trying to incentivize in our employees?
• What is the makeup of incentive programs for others in our industry?
• What incentives are valued most highly by our employees and candidates?

One can see how these questions are linked to, and inform, one another. For example, if emphasizing revenue growth and increasing company value for an eventual sale is a strategic objective, the behaviors and efforts you incentivize should be aligned accordingly. After all, if you tell sales managers that the company is focused on long-term value but then tie their incentives to near-term profitability, they will inevitably focus on profitability. The key takeaway here is that there is no such thing as a one-size-fits-all long-term incentive plan. Ensure that yours is tailored to the specific goals and circumstances of your business and its employees.

Understanding the options

One of the main objectives of long-term incentive plans is to create milestone-based enticements (e.g. bonuses, vacation time increases, commission jumps) that encourage employees to stick around. When speaking with clients about their long-term incentive plans, many are already convinced they need to give some form of equity, which may include:
• Offering stock grants (i.e. employees receive a fixed number of shares with a strict vesting period)
• Allowing employees to immediately buy in (i.e. employees can pay cash to take on partial ownership in the company)
• Providing pure stock options (i.e. employees can purchase shares of stock at a preset price at a later date)

The problem with such incentives is that they come with baggage. Giving equity introduces potential control issues as well as fiduciary obligations to shareholders (more on that shortly). Fortunately, other options come with fewer management headaches, such as:
• Stock Appreciation Rights (SAR)—employees receive an equity equivalent that is awarded based on company performance
• Performance incentive plan—these non-equity plans take many forms and involve rewarding employees for good performance with “points” of defined cash value (note: points must vest before they can be cashed out)

Hitting the Pause Button

In our experience, the reason decision-makers usually gravitate toward equity is that employees ask for it. Understanding the motives behind these requests is important, so it’s worth asking employees why they want the equity and what they are trying to accomplish. Chances are they simply want to participate in the success of the company. It also may be that an employee wants to obtain a “partner” or “principal” title. It’s usually in your best interest to pursue a non-equity option. Why? Consider two ramifications of giving up your shares:
• Potential control issues—selling shares or ownership gives the purchasers voting rights, which can complicate management challenges (this could be solved by creating a separate class of shares which are non-voting);
• Fiduciary obligation to minority shareholders—the moment you give up shares, you also take on a fiduciary duty to minority shareholders and impose legal obligations on yourself.

The points above are why equity equivalents such as SARs or some form of performance incentive plan are more ideal for business owners. A performance incentive plan is especially convenient because it’s a non-equity plan tied to specific metrics that don’t require releasing financials or any additional fiduciary responsibilities. The big caveat with SARs, however, is that they require the business to release full financials to participants on an annual basis and complete some form of annual valuation. Therefore, being realistic about your comfort level regarding transparency is important.

Vesting and distribution considerations

The success of an incentive plan often depends on setting the vesting period appropriately. For example, structuring it so that the awards vest in a year or two is risky because people may feel comfortable leaving sooner than they would have otherwise. Similarly, setting the horizon ten years out would also be a risk because employees may not attach much value to such a distant incentive.

It’s also important to consider how payouts will be handles. If you don’t, you could suddenly be on the hook for a huge payment to an employee. For example, take an employee who decides to leave or retire after ten years with $500,000 vested. Big and unplanned payments like these can hurt and getting a loan to meet them is never a good option. That’s why you want to ensure that long-term incentive plans are set-up to pay out over multiple years at a reasonable, affordable rate.

Getting started

Now that you understand the key considerations around long-term incentive plans, what should you do next? A good place to start is by exploring key questions such as:
• Do our current incentive programs have gaps that are impacting employee motivation and retention?
• Are there areas of the business where new incentives could improve performance or overall value?
• When is the last time you’ve actively gauged employee perceptions of your long-term incentive programs?

In our work with companies across virtually every industry, we know the importance of long-term incentive planning and how much time and energy is invested in getting them right. Attracting and retaining the right talent in a way that’s rewarding for both your business and your employees makes it time well spent.

Are you facing challenges in attracting or keeping the right talent? Have questions on how to strengthen your incentive plans and broader HR functions? Request a free consultation from a vcfo expert who can help.