Given the strategic importance of long-term incentive plans in privately held companies, the board needs to be involved when a long-term incentive plan (LTIP) is being designed, implemented, or monitored for its effectiveness.
The board’s role differs significantly depending on the board structure and whether an LTIP exists or is being considered. For example, the directors may be independents, employees or owners, and an LTIP may or may not be in place. However, one tenet that holds true for all boards is that the components of a well-constructed LTIP are board responsibilities, whether there is a current LTIP or not. That is because, at the highest level, the goal of a LTIP is to retain, reward and attract key talent while achieving strategic alignment of critical long-term financial and business-specific quantitative and qualitative goals.
While generally, the impetus for an LTIP may come from the CEO, other key executive staff or the compensation committee chair, all board members must ask proactive questions and understand how an LTIP can be developed. Here are some questions when developing an LTIP for your company:
What are the types of LTIPs, and do they support performance or retention?
By their very nature, LTIPs have a multiyear time horizon versus the one-year horizon of a short-term incentive/annual bonus. Certain LTIPs support key organizational performance/financial metrics or retention of key leaders to a higher degree. Whether the company chooses a plan that is more performance- or retention-focused, reward of overall organizational long-term performance is critical. This would be measured by equity value or financial/strategic measures over a defined period. There are various types of LTIPs that have distinctive characteristics, as well as certain advantages and disadvantages.
Plan types that focus more on performance include incentive stock options, nonqualified stock options, stock appreciation rights and performance units. Those that focus more on retention include restricted stock and full-value phantom stock.
When selecting or evaluating a plan, directors must understand the features as well as the advantages and disadvantages of each plan to ensure the LTIP design meets both the company’s and the participant’s needs.
Does the LTIP support strategic objectives and an aligned management
succession/leadership transition plan?
One of the primary goals of an LTIP is to support the financial measures and strategic/business objectives aligned to the life cycle of the organization. Where does the organization expect to be in three, five or even 15 years? For example, we would expect private equity-backed and family owned businesses to have different expected life cycles and objectives. Most privately held companies have a time horizon for sale, while some multigenerational businesses have no intention of selling. Also, some businesses and industries mature with limited growth potential while others have significant growth potential. Key board responsibilities are to ensure successors are in place for the key executive roles to achieve those objectives and ensure those successors are attracted, retained and competitively rewarded.
The vesting provisions are also important components of the plan design, since the unvested funds — and the value of those awards —create the holding power that long-term incentives are intended to accomplish.
How does the LTIP compare to competitive benchmarks?
While market data on LTI eligibility and rewards is not as transparent and available for privately held companies as it is for publicly traded companies, there is enough available information and expertise to provide reasonable guidance on both eligibility and competitive dollar amounts. As the LTIP is a critical competitive advantage for the attraction and retention of individual executives, providing a meaningful market-competitive financial reward is key. It is important for board members to understand and be current on the competitive total cash compensation (the base and annual bonus) and total direct compensation (total cash plus LTIP) in the marketplace for key executives.
How does the LTIP manage risk?
Risk management, in its broadest definition, is about protecting the assets and future value of the business — including key human capital. LTIPs typically have post-employment restrictive provisions that protect the company. This helps ensure the company’s value will stay intact. As such, LTIPs could pay for themselves in the future. These provisions can include any or all the following:
- Non-competes to reduce the risk of losing an executive to a competitor
- Reduction of the risk of a terminated executive who recruits key employees
- Provisions ensuring non-solicitation of customers (if there is no noncompete)
- Protection of intellectual property
Note that non-competes may not be enforceable in certain states and situations as they may not prevent someone from going to work for a competitor. However, depending on the provision of the agreement, they may forfeit some or all of the money owed to them. This is significant financial leverage if the dollars are meaningful.
In addition, the retention features of the plan are critical to reducing the risk of losing key talent and disrupting the business and succession plans noted above.
Who approves the LTIP?
If a formal compensation committee exists, then certainly that is the avenue to develop and present the plan to the full board for approval. If there is no compensation committee, in management committee, comprising HR and finance, may be an option to support the CEO in the development, approval and administration of the plan. This depends on the level of involvement desired by the CEO and senior executives.
LTIPs offer both strategic and competitive advantages for privately owned companies. Board members can and should be actively involved in both the development and implementation of multifaceted plans that can positively impact their organizations and bring value to shareholders.