What kind of long-term incentive plan should your business have? vcfo breaks down best practices to avoid employee turnover and how to encourage your employees to reach new goals by using long-term incentives and benefits.
The Guide to Long-Term Incentive Planning
Whether you’re seeking to keep good employees in a tightening labor market or desire to strengthen your business, long-term incentive plans are highly effective tools. Take it from a CFO services provider who has experienced this process many times. Creating a long-term incentive plan for your business is more than you’d typically expect, especially when preparing for costly surprises or headaches down the road. In this post, I’ll walk you through the steps you need to take to create a long-term incentive plan for your business.
Doing your homework
Before you begin to look at long-term incentive plan options, it’s important to stop and ask yourself the following questions:
• What is the purpose of what we are trying to accomplish (e.g., steady cash flow, long-term value, rapid growth, or other)?
• What kind of behavior are we trying to incentivize?
For the purposes of this exercise, the first question must inform the second. For example, if you want to emphasize revenue growth and increase company value for an eventual sale, your incentives need to be aligned accordingly. After all, if you tell sales managers the company is focused on long-term value but tie incentives to near-term profitability, they will inevitably focus on profitability. The key takeaway is that there is no such thing as a one-size-fits-all long-term incentive plan; getting employees to stick around and reach new goals takes a strategic plan based on the specific goals and circumstances of your business.
Understanding the options
One of the main points for long-term incentive plans is to provide an eventual “pot of gold” that encourages employees to stick around. Most of the time when I speak with clients about long-term incentive plans, they are already convinced they need to give some form of equity, including:
• Offering stock grants—employees receive a fixed number of shares with a strict vesting period;
• Allowing employees to immediately buy in—employees can pay cash to take on partial ownership in the company; and
• Providing pure stock options—employees can purchase shares of stock at a preset price at some point in the future.
The problem with such incentives is they come with baggage. Giving equity introduces potential control issues as well as fiduciary obligations to shareholders (more on that shortly). Fortunately, you also have a couple of other good options with fewer management headaches:
• 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 some sort of points with a defined cash value for good performance (the points must vest before they can be cashed out).
Hitting the pause button
After exploring the common long-term incentives, let’s hit the pause button and consider the various incentive options.
In my experience, the reason decision-makers usually gravitate toward equity is because employees ask to request it. Understanding the motives behind employee requests is important and it’s worth digging deeper and 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, as the value of the company grows. It also may be that an employee wants to obtain a “partner” or “principal” title. When such a case presents itself, it’s usually in your best interest to pursue a non-equity option. Consider the 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.
For such reasons, equity equivalents, such as a SAR, or some form of performance incentive plan are more ideal for business-owners. The big caveat with a SAR, however, is the requirement to release full financials to participants on an annual basis and complete some form of annual valuation. Therefore, your comfort regarding transparency is important. 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.
Vesting and distribution considerations
Incentive plan success often depends on setting the vesting period appropriately. For example, you don’t want the awards to vest in a year or two because people may leave too soon. Setting the horizon 10-years out would also be a risk because most employees today simply don’t think that far ahead, and you risk employees failing to attach much value to a long-term incentive.
It’s also important to consider how you will handle payouts, or you could suddenly end up on the hook for a huge payment to an employee. Take an employee who decides to leave or retire after 10 years with $500,000 vested. These types of big unexpected payments can hurt, and taking out a loan for 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.
Now that you understand the key considerations around long-term incentive plans, what should you do next? I recommend sitting down and exploring the following questions:
• Are there gaps in your incentive programs that are impacting employee motivation and retention?
• Are there any specific areas of your business where you think incentives are needed to help improve performance or overall value?
If you don’t identify significant gaps then you’re done. We recommend taking a deeper dive into the earlier questions and options, and deciding what type of long-term incentive plan makes the most sense for your business. As a virtual CFO services provider, we know how much is invested in these complex decisions because we frequently help clients work through them. If you get stuck or simply want some help from an outside expert, we provide CFO consulting in Dallas and would love to talk through your options.