Long-term incentives, the basics

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A long-term incentive, as the name suggests, is a vehicle that has an extended time horizon (generally greater than one year) and that can be a strategic compensation vehicle to promote long-term retention and alignment with company goals. LTI can be a win-win for all participants:

For employers, LTI present an opportunity to reward the achievement of long-term plans, promoting buy-in to corporate performance.
For employees, LTI can be a reward for outstanding performance and are a vehicle for capital accumulation.
For shareholders, LTI are a vehicle that aligns employees with the performance of shares (for market-based equity vehicles) and the long-term vision of the company. When employees become shareholders themselves, they have incentive to increase company value as the performance of the shares directly affects their own compensation.

What are the types of long-term incentives?

LTI can generally be broken down into the following three types:

Appreciation-based:

Value is delivered based on the increase in the company’s underlying value, which in the case of a public company, is reflected in share price. Per unit, employees will receive the difference between the value of the underlying unit at some point in the future, and the underlying value when the stock options/stock appreciation rights (SARs) were granted.
Stock-based:

Value is delivered in shares of the company stock. Payout may be tied to achievement of performance goals, but ultimately, employees will receive a share of company stock. Note that some companies may grant “phantom shares.” Which track the movement of value of the underlying shares but pay out in cash.
Cash-based:

Value is delivered in cash and is not tied to the performance of shares; employees will receive a cash payout, based on service, achievement of predefined performance goals, or both.

What are common long-term incentive vehicles?

Stock Options

A stock option entitles the grantee the right to purchase shares of a company at a fixed price (known as the exercise price) in the future. Generally, the option’s exercise price will be the stock’s closing price on the date of the grant. Once a stock option vests (see “What is Vesting?” below), the grantee can exercise the right to purchase stock at the exercise price. For example, if a share is trading at $10, and the exercise price is $5, the grantee can purchase a share at $5 and sell at $10 in the open market, resulting in a $5 profit per unit.

The window of time that a grantee can exercise the option is referred to as the term. Most companies grant options with 10-year terms. An option has no value if in the future the share of the company is below the exercise price (since the grantee would be paying above-market price, and there would be no impetus to exercise the option). These options are referred to as being “underwater.”

Stock Appreciation Rights

Stock Appreciation rights, or SARs, function very similarly to a stock option in that a recipient of a SAR will receive the value of the increase in stock price in cash (though sometimes it is received in stock). The major distinction between a SAR and a stock option is that a SAR does not require the actual purchase of shares.

Time-based Restricted Stock/Restricted Stock Units

Time-based restricted stock/units vest based on a predetermined length of time. A company can choose to grant equity based on a predefined value on the grant date or predefined number of shares (the former is more popular). Unlike an appreciation-based award, a restricted stock will still have value upon vesting even if the per-stock value decreases.

Performance Shares/Units

These are also full-value shares; however, the vesting of these types of shares is contingent upon meeting predetermined performance goals. These goals can be internal or external, and can be measured on a relative basis (compared to other companies), absolute basis (compared to predefined achievement levels), or both. These have grown in popularity over recent years due to the ease of linking payout to long-term performance. Metrics used by companies differ but are generally consistent within each industry, since the metrics that define good performance tend to be similar. One of the most popular metrics is total shareholder return (TSR), which measures the increase in share price over a predefined period (most commonly three years).

Companies will generally grant 100% of shares at a target level and give the shares both downward and upward leverage (meaning shares can vest at less than 100% for poor performance, and shares can vest at greater than 100% for outstanding performance).

Long-term Cash Units

These are non-equity-based long-term grants that pay out in cash. The grantee will receive a cash payout after the vesting period.

Performance Cash Units

These are cash-based long-term grants that vest based on performance achievement. These are more common at private companies, due to the difficulty of share valuation.

What are the Pros and Cons of Different Incentive Strategies

Incentive strategy	Pros	Cons
Appreciation-based awards	Offers significant upside in the case of share price appreciation	Units can potentially be worthless
Time-based full-value share awards	Extended vesting period promotes retention and ties to company value Guaranteed to have value at vesting even if underlying value decreases	Not tied to any metrics; may encourage employees to "put in time" until vesting period lapses
Performance-based awards	Can be tied to desired company performance in order to increase alignment with corporate strategy	Requires diligent goal-setting Potential for zero-payout; could cause discontent among employees who expect to receive a certain amount of compensation on an annual basis
Cash-based awards	Can be granted in cases where share valuation is difficult	Less ideal for companies trying to manage cash flow Employees may not feel as invested in the company

What is vesting?

LTI are typically granted with what is known as a vesting period. What this means is that grantees are conditionally granted equity, but they do not actually own it until the vesting period expires. This is the retentive feature of LTI; unless the grantee fulfils the applicable vesting requirement (e.g., staying with the company for three years after grant or meeting a performance goal), they forfeit the grant.

There are two types of vesting: cliff and ratable. Awards that cliff vest are paid out all at once, at the conclusion of a predetermined time period. Awards that vest ratably vest a portion at a time (e.g., an award that vests 25% each year for four years). If an employee terminates prior to the end of the final vesting period, the employee still owns the portion that has vested.

Who receives long-term incentives?

Commonly, LTI are more prevalent for employees at higher levels of an organization because the value of the company is predominately affected by those with line-of-sight into the long-term strategic vision of the company. Let’s say a company grants performance shares that are contingent on achieving a net income target. Would the CEO be able to influence corporate profitability? Yes (at least we hope so). But an entry-level accountant? Probably not. There is less value in administering performance-based LTI to lower-level positions, since these roles do not have the impact that effect that type of change. For this reason, LTI for lower-level employees typically focus more on retention.

LTI are more prevalent at public companies because of their liquidity and ease of valuation (i.e., a share of a public company is valued by and can be sold on the open market, whereas the value of a share at a private company can differ widely based on valuation methodology).

Conclusion

The appropriateness of an LTI vehicle ultimately varies from company to company. No one LTI vehicle is superior to another, and it typically requires an overall assessment of culture, company strategy, and goals to select the right mix, amounts, and vesting mechanics. Mercer consultants have experience in every industry and can help you determine the right approach when it comes to utilizing long-term incentives as part of the total rewards package for your employees.

If you are trying to determine the best long-term incentive solutions for your employees check out the MBD: LTI and Equity Report. You can also discover a detailed report into short-term incentives as well, with our MBD: Short-term Incentive Report