LTI plans, and which one is right for your company?
Egan Associates have been guiding privately owned and listed public companies with their incentive plan design and review for over 30 years. In this article, we summarise some of the questions that we get asked on a regular basis in relation to long term incentive design.
What are the most commonly used LTI plan types by privately-owned and listed companies?
Long term incentive (LTI) plans are preferred by both listed and privately-owned companies to reward and retain executives and strengthen the alignment between the performance of their business and their executives.
Share based LTIs are particularly popular by start-up companies which are often cash strapped especially in their early stages of development. Share option plans assist start-ups to retain staff who also contribute to capital upon exercising their options.
Privately owned companies offer equity based LTIs for a number of reasons including attracting and retaining high calibre staff and motivating key employees to contribute to the company’s growth.
Alternate LTI plans which are commonly used by privately owned companies include:
- deferred cash incentives which are payable upon achievement of three to five year performance hurdles such as growth in company value, achievements beyond target revenue, profit or return on capital;
- share warrants which provide executives with a stake in the growth of the underlying of value of the business over a specified number of years;
- unitised profit share arrangements;
- phantom shares, and
- cash settled share appreciation rights.
The majority of the LTI vehicles used by privately owned companies are also used in the listed company environment in part arising from the intense scrutiny from shareholders, regulators and analysts.
Performance rights are the most commonly used form of LTI adopted by listed companies in Australia with a vesting period of 3 to 5 years. Performance Rights are contractual rights to receive shares in the future if certain conditions and/or performance hurdles are met.
Options provide the right but not the obligation for participants to buy a parcel of shares in the future at a price fixed at grant date. The most notable difference between a performance right and a share option plan is the lack of risk associated with the performance right. Payment is not required by an executive to gain any benefit from the performance right (subject to meeting performance hurdles) and as such there is no possibility of the performance right having no value when the restrictions are lifted and the share is transferred to key staff.
The dilution of capital is generally greater in case of an option plan as the number of options required to deliver comparable reward to a rights plan would be greater.
The main disadvantage of options and rights in a private company is the lack of liquidity. Unless there is a future transaction or the company enters into an agreement to buy back shares or permit their sale, employees will not be able to convert them to cash. Moreover, if the shares do not become more valuable, options may ultimately prove worthless.
In Australia, option plans are heavily used at the pre-IPO stage whereas, after an IPO, companies tend to switch to other forms of LTI plan and adopt performance hurdles reflective of market practice and/or milestones set out in a prospectus. In a listed company environment, the prevalence of option plans is higher among recently listed companies or companies with high growth potential and high share price volatility. It is our observation that the prevalence of option plans is higher for companies operating in the, mining, energy, healthcare, biotechnology and ICT sectors.
Loan backed share plans constitute another form of LTI plan. Loans granted are usually interest free and non-recourse. Here employees are protected if the value of the share falls below the loan balance. Dividends (after tax) where paid are usually applied against repayment of the loan. Companies will often hold shares granted under a loan backed plan in a trust and apply a service based condition to ensure retention of talent.
Another instrument is share appreciation rights (SARs) which can be settled in either cash or equity at the discretion of the company. The gross financial reward resembles a share option plan and eligible employees benefit from their contribution to value creation of the company.
What is the most prevalent approach when setting up the performance period and vesting schedules?
Typically, LTI performance periods can extend from 3 to 5 years. It is not uncommon for companies to require an additional service period for up to 2 years where vested shares are subject to a holding lock to ensure further retention of LTI participants.
Vesting schedules are either in the form of overlapping awards or cliff vesting where 100% of the LTI award vests at the end of a single performance cycle. The overlapping cycle construct is the most common and reflects a “business as usual” approach allowing for LTI awards to be built up over sequential year allocations. Annual allocations also give Boards the flexibility to adjust both individual allocation values and also the participants in the LTI program from year to year.
What are the most commonly used performance hurdles?
Listed companies predominantly use performance measures which focus on earnings per share and relative total shareholder return (TSR). Both cash and equity based LTIs could be also tied to the achievement of company milestones, sector or company specific financials or an increase in the company’s value. Other commonly used performance hurdles include sales revenue, EBIT or EBITDA, profit targets, return related measures (ROI, ROCE, ROE), cash flow management and customised growth measures.
In essence, these factors are driven by a company’s long-term strategy, relevant accounting and tax implications of each plan type, a company’s business life cycle as well as external challenges such as competition, industry and market specific dynamics and legislative requirements. It is common for companies to use performance hurdles together with service based conditions to maximise the use of LTI awards to the benefit of existing shareholders.
Dilution of shares presents itself as an ongoing pressure point for existing shareholders and is inevitable as a company issues further equity to its employees. As the LTI plan design gets more complicated, the burden of administration also increases.
Egan Associates have been guiding private and both listed and unlisted public companies with their incentive plan design and review for over 30 years. Email us at firstname.lastname@example.org for your queries.