By now everyone’s aware that Facebook is preparing to launch its IPO—probably the biggest one ever. Founder Mark Zuckerberg has tried to keep the company private for as long as possible—presumably to preserve its nimbleness.

So why go public now? Obviously there are probably a lot of reasons. But one relates to the complexities of stock-based compensation. In the early stages of Facebook a number of employees received stock options, some of which have been converted to stock. But stock is worthless unless it can be converted to cash. This article summarizes the issue well. And here’s the pertinent quote:

“In 2010, Facebook banned employees from selling their stock, citing legal concerns around insider-trading rules. So, in an odd twist, the only way for early employees to cash out their vested stock options has been to leave the company.”  (Emphasis mine)

Employers are constantly doing this to themselves by not structuring their long-term incentive plans (be they equity or phantom) in the right way. You always want to enable employees to harvest the cash value of their LTIPs.

Phantom stock plans, for example, should have designated pay-out dates and should vest upon other timing events other than separation of employment. LTIPs are an essential part of any balanced compensation strategy. But do it right. Give employees the ability to extract the value from the plan before you discover that the plan is defeating the very purpose for which it was designed–retaining and rewarding premier talent.

The following post is an excerpt from a White Paper (with the same title) that VisionLink recently published.  To access the full article, click here.

Value sharing is an issue that, sooner or later, every enterprise leader must confront.  For example, many responsible for driving business growth wonder whether some kind of long-term incentive will enable higher performance; and if so, which approach is best—stock, performance units, phantom equity or some other value sharing plan.  This article offers five compelling reasons why long-term value sharing is critical for any company seeking breakthrough growth.

It is not the intent of this article to make a judgment about which long-term plan is most effective or to describe the advantages and disadvantages of different value sharing approaches.  Instead, we want to consider why such plans matter and how they make companies more productive while multiplying wealth for all stakeholders.

With that understanding as a “jumping off point,” let’s now move on to why long-term value sharing matters.

#1: Value Sharing Attracts the Best Talent and Magnifies Results

To achieve sustained success, companies must attract and keep talented people that know how to compete and are willing and able to assume a stewardship role in representing shareholder interests towards growth.  For such a relationship to be properly fostered, owners and other stakeholders (in this case, key talent) must share both the risks and the rewards associated with value creation.

Those of superior talent are attracted to this idea.  Individuals best equipped to contribute to the future success of the business will see it as an opportunity to have what amounts to a mini-entrepreneurial experience within the construct of someone else’s business model.  As such, they view the company as a mechanism for wealth creation, not just a place to express their passion and talent.  And shareholders should want employees with that perspective representing their interests.

#2: Effectively designed long-term value sharing plans reinforce the company’s business model

A sustainable business model depends, in large part, on a culture that is committed to and, ideally, “invested in” that model’s reinforcement and success. As a result, having key members of a workforce aligned financially with the business model makes both common and strategic sense.  The importance of this concept stems from the nature of the virtuous cycles (revenue perpetuation) the model is intended to produce.

Four Seasons, Verizon and Amazon each have distinct business models and, by extension, unique virtuous cycles.  So, it only stands to reason that their compensation strategies will be equally distinct.  The metrics and measures that stand as gate keepers to payouts (or earned shares, as the case may be) in each organization must reflect and reinforce the virtuous cycles relevant to that business.

# 3: Value Sharing Protects against Bad Profits and Promotes Good Profits

In his book The Ultimate Question, Fred Reichheld, a Bain Fellow and founder of Bain & Company’s Loyalty Practice, offers the following on the subject of profits:

“Whenever a customer feels misled, mistreated, ignored, or coerced, then profits from that customer are bad…Bad profits are about extracting value from customers, not creating value.” (The Ultimate Question, Fred Reichheld, Harvard Business School Publishing Corporation, 2006, 3-4.)

Long-term value sharing arrangements, if designed properly, become a self-enforcing means of perpetuating good profits.  Everyone has an interest in good profits if everyone’s wealth multiplier rises or falls on the ability of the company to sustain the right kind of profitability.

#4: Long-term value sharing promotes an ownership mindset

Businesses need employees in leadership roles that understand “what’s important.”  Such individuals must be able to embrace a stewardship role in aligning their focus with that of shareholders. They need to define what’s important in the same terms as ownership when they go about fulfilling their responsibilities.  For most companies, a list of “what’s important” would include, but not be limited to, the following:

• Drive growth (revenue, net income, EBIDTA or other measures)
• Improve margins/profits
• Manage costs

Each of those areas of emphasis has long-term implications.  In that context, value sharing plays a key role in communicating “what’s important” and aligns key producers with ownership thinking.

#5: Value Sharing Builds Trust and Trust Accelerates Results

At its core, value sharing is about turning a company’s workforce into partners in building the future company.  A culture of confidence is rooted in an environment of trust.  Value sharing communicates and builds trust because, in part, it is a fair approach to rewarding those responsible for value creation—and trust is the key to accelerating results.  In his book The Speed of Trust, author Stephen M. R. Covey makes the case this way:

“Whether it’s high or low, trust is the “hidden variable” in the formula for organizational success.

“ …A company can have an excellent strategy and a strong ability to execute; but the net result can be torpedoed by a low-trust tax or multiplied by a high-trust dividend.  This makes a powerful business case for trust, assuring that it is not a soft, ‘nice to have’ quality.”  (The Speed of Trust, Stephen M. R. Covey, Free Press, February 2008)

When you pay people in a way that communicates you want them as partners in building the future business, you are, in essence, saying: “I have confidence in you and trust your ability to get results.  To prove it, I’m willing to share the value you help create.”

Start with a Clear Philosophy

Before considering which plan is “right,” wise leaders will begin with the development of a compensation philosophy that addresses how the company will nurture a culture of confidence through its approach to rewards. Such a philosophy should address the balance the company will maintain between short and long-term value sharing, and guaranteed versus at risk compensation.  Determining the plan that will best reflect that philosophy then becomes much easier.

How much financial detail should you provide employees about your bonus/incentive plan? We’ve always preached that for any incentive plan to be effective it needs to be (a) clear, (b) believable, and (c) meaningful.

Clarity relates to both (1) the plan itself, and (2) the results needed to earn the award and to maximize it. Most owners of private
companies are reluctant to disclose specific information about company profit results for fear that employees will misinterpret the information (i.e., conclude that this must be what the owner makes) or under-appreciate it (i.e., fail to realize that profits are the sustaining lifeblood of the organization).

Recently, a relatively new client of ours took the leap and fully disclosed to all employees exactly what the company profit-related goals are. Their new bonus plan is properly referred to as a “value sharing plan.” They explained to employees that the organization creates economic value when everyone works together as a team to achieve desired business results. And when those results are created everyone is eligible to participate in the sharing of that value.

(This is a progressive step forward. The terms “bonus” and “incentive” seem a little dated, don’t they?)

Time will tell how this impacts performance within this organization. I’m betting on continued productivity gains and  improvements. Being honest with employees about what business results are expected and enlisting their partnership efforts in achieving them is a critical step in accelerating business results to the next level.

Last week I attended a fabulous event put on by Chief Executive Magazine in New York at the Stock Exchange.  It was a meeting designed to help CEOs connect with their peers and discuss the issues relevant to their roles in business right now, in this financial and political environment.  If you haven’t attended one of their events in the past, I would highly recommend doing so in the future if you lead a business.  Here are just a few highlights from the New York Conference, in no particular order:

Achieving Growth in a Low-Growth Enrironment

Bob Nardelli, CEO Cerberus Capital (former Chair and CEO at Chrysler and Home Depot)

• Enhance the Core (drive innovation in core business)
• Extend the Business
• Expand the Market

Lynn Tilton, CEO Patriarch Partners

• Break every business down to its variables
• Companies that get left behind are those that don’t innovate
• Companies are just people–you have to have the right talent
• Create a culture of innovation
• Create a culture of appreciation
• Do what’s right; key quote: “Too often we’re thinking about our business interests instead of what’s right and wrong. Doing what’s right will more often than not serve our long-term business interests.”

Fred Hassan, Chairman Bausch & Lomb & Senior Partner, Warburg Pincus

• Some companies get so good they forget to keep getting better
• Look at your trust index; foundational customer question–”would you recommend this company?”

How to Grow When Markets Stall

Ram Charan, Author, Strategist, Former Professor at Harvard Business School

• Put people before strategy–people need to know what’s required to be done
• Remain sensitive to customer–need to be connected to the ground floor of the person that buys your product or service
• Work from the outside in, not inside out–look at the need that must be fulfilled and then work backwards at what needs to be done to fill it
• Devote disproportionate management attention to differentiation
• Remember to pay attention to the basics–look at external trends; remember that the consumer experience is the key differentiator

Next week, I will share some more.  All for now.

If you’ve hung in with me the past couple of months you know I’ve sung the praises of phantom stock for private companies. If you’re new here you can start the series here.

Today, some final thoughts (or final for now, anyway).

Phantom stock plans can be, without a doubt, one of the most important steps you ever take in assembling the team of people who will take your company to new heights. However, there’s something more important that getting the right structure. You need to create the right mindset.

If you create a “perfect” plan but don’t establish the right mindset your plan will flop. You’ll wonder what went wrong with the plan. But it won’t be the plan’s fault. It will be yours. Ultimately, it’s your job to see that the employees not only understand the plan but that they are inspired by it.

Mindset relates to the perception of the plan in the minds of participants. When you make Sally a participant in this plan she should feel like she was just made a partner in the company. She should understand that her financial future is tied to yours (and vice versa). She should realize that you trust her to help produce the results that will create value for both of you.

Always position the plan in a positive light. Explore and discover ways to make your plan one of the highlights of your relationship with your key people. You’re investing in them. Make sure they know how much you value their efforts and how much you trust them to generate great results. Your phantom stock plan is a symbol of your commitment to a partnership relationship. They aren’t getting actual stock but they don’t really want those headaches anyway. They want to know that they have a chance to participate in the value they help create. A phantom stock plan, properly designed, can do just that because it sends the right message about the future:

We’re building a great company.

We’ve got the right people.

We’re united as partners in our financial success.

Let’s go make it happen.

If you’d like a copy of the complete series, click here.

This is actually my 11th blog on doing phantom stock right. If you haven’t followed the series you may want to start here.

For those who’ve hung out until the end…or the near end, congrats.

You now are armed with all you need to build a phantom stock plan. But if you’re trying this on your own, make sure you avoid some of the pitfalls.

As with any rewards strategy, there are plans that work well and others that fail.  To ensure your approach to Phantom Stock has a greater chance of success, here are some “do’s and don’ts” to consider.

1. Don’t do one-time grants. Schedule and award grants annually. Make each grant a celebration. One-time grants always lead to regrets (e.g., “I shouldn’t have given him so many.”)
2. If you’re not sure which type to use, go with phantom options. There’s less risk. No increase in value results in no payments to employees. Even if your share price goes down in some years employees can still come out ok (as long as you’re doing annual grants—see #1).
3. That said, consider some full value grants for the key long-term employees who’ve been with you “through thick-and-thin.” This will give them some starting credit for prior contributions. Perhaps you’ll just do this in the first plan year, and then include them in your annual option awards. (This could be done for as few as one employee.)
4. Start with a small group and expand participation as time goes by. It’s always easier to add participants than to subtract.
5. Schedule payouts every five to six years. (Sooner is ok, but longer is not.)  Unlike regular stock options and restricted
   stock, employees cannot (with some exceptions) choose when they’ll “exercise” or “redeem” their shares. You, the plan sponsor, decide. The temptation will be to push the payment date out too long. This has two negative results: (a) the
   value may compound for a long time resulting in very large payouts, and (b) employees will have no way to access their money unless they quit—not the ideal scenario.
6. Don’t make your formula (for share price calculation) too complicated. We’ve seen plans where the company officers don’t even understand the formula (or can’t remember why some things were included). Keep it simple. “Hey gang, if we grow profits we all make money!”
7. Don’t ignore the rules. Most phantom stock plans will be subject to ERISA (the Fed’s 1974 rules on pensions) and Internal Revenue Code Section 409A. Sorry. There are rules. Fail to know and follow them at your own peril.
8. Don’t try this at home. Get advice. It’s risky to decide upon the best choices for a phantom stock plan without the guidance of someone who’s done it before, a lot. You may intend to give away 10% of the growth of your company to your employees and you wind up giving away 30% via bad design and operation. This is important. Get help.
9. That said, don’t use your attorney as your principal advisor. Your lawyer will be needed in the process—towards the end—to make sure the documents are in order. But, your attorney will not be experienced at the realities of plan operation. Find someone who’s lived with, slept with and eaten with phantom stock over the years. Let them put the structure on your important decisions. Then use your attorney to “cross the t’s and dot the i’s.”

Watch next time for my last tips on how to make a phantom stock plan inspire your employees.

10.  Manage the plan effectively. Don’t start the plan
and forget about it. Keep it fresh. Be flexible. Communicate it. Give the
employees statements that show their value. This is a big investment. Use it
wisely.

The heart of a competitive advantage in an organization is a culture of confidence.  Such an culture emerges in companies that have developed success patterns to a point of such sustainability that the “flywheel effect” has kicked in, as Jim Collins describes in his book Good to Great.  There is momentum and your people know it; they know it because they are in the midst of it–in fact, they are the ones making it happen.  Such a business has a competitive advantage because a culture of confidence is not “copyable.”  It is an outgrowth of having all the human elements working in a unified, passionate fashion within a company.  Think Disney. Think Apple. Think any great company.

The best word to describe the mindset of the workforce within organizations that have developed such a culture is stewardship.  The dictionary describes a steward as “a person who acts as the surrogate of another or others.”  In business, it implies that employees act in the best interest of owners; more than that, they do the things ownership would do because they think like owners.  They think like owners, in part, because they are treated like owners–not because they necessarily own stock but because they have some kind of stake in the company’s success and a shared value system.

Organizations that adopt a stewardship approach to managing their people nurture trust and confidence in their employees by focusing more on  desired outcomes and results than methods and behaviors.  They communicate standards and values, vision and strategy, roles and expectations.  Then they communicate a sense of partnership in the way they share value with those that create value.

Such businesses inherently understand that they can’t use incentives as a tool to manipulate behavior or to reinforce methodology.  It’s not that they ignore those things, rather they recognize that pay is not the way to enforce the spirit of stewardship they want to engender.  To use incentives to “force” certain behaviors is the ultimate act of mistrust.  It undercuts the core sense of personal responsibility and accountability that a workforce must achieve if the “flywheel effect” is going to be realized.  Mistrust erodes a culture of confidence and pay, done improperly, creates mistrust.

To take it one step further, companies that have a culture of confidence don’t even think in terms of rewards as incentives.  Instead, they set up short and long-term value sharing agreements with their associates and consider their relationship to be a partnership, not employee or employer.  Value sharing is about reinforcing outcomes, not forcing behavior.  It’s about recognizing the contribution of all stakeholders in an organization’s success through effectively crafted pay programs.  It’s about stewardship not just employment.

So, as you consider where you are in your journey towards a future company that is not just good but great, avoid eroding your culture of confidence through any act of mistrust–especially as you build rewards strategies. Instead, use them to reinforce the line of sight you want to create between vision, strategy, roles, expectations and pay.

To learn more about a specific type of value sharing program that will encourage the stewardship mindset just discussed, tune into our next webinar broadcast entitled: What Think Ye of Phantom Stock–Does it Work?

We’ve come a long way in the design of our phantom stock plan.

The last thing to do (other than actually enrolling Sally in the plan) is to determine how many shares you’re going to give her. (We’re assuming, at this point, you’re doing full value shares or phantom options.) We mentioned earlier that the number of shares you establish in the plan wasn’t crucial…at least then. Now it becomes important. You don’t want to award too few, or too many. So how do you decide?

Initially, it’s best not to get hung up on the number of shares you award. Focus instead on the potential future value of the shares as a percentage of the growth in the company. This will usually require some spreadsheet modeling. First, project the possible future value of the company over some period of time, given your favorite growth assumptions. Now carve out a percentage (start with 5-15%) of the growth (not the total value) that you’d consider sharing with your leaders. Then, allocate that to the positions or people you’d consider for participation. Now, calculate the number of grants that will produce the targeted values. In other words, the number of grants is
simply a device for generating the dollar value you feel is appropriate for the people who are helping you build the company.

This approach to grants achieves the following results:

• Guidelines for grants are established within a pre-approved budget, thus simplifying the annual award process;
• Shareholders are assured that value dilution is being managed within reasonable limits;
• Employees can receive a forecast of value that demonstrates potential personal earnings tied to company growth.

Only one or two things remain before your perfect Phantom Stock is in place. Stay tuned.

Great compensation solutions come to those who ask the right questions.  It’s as straight forward as that.  And there is a cascading sequence to an effective questioning process as it relates to compensation development and design.  Let’s explore what that might include.

Stage One

The first level of inquiry has to do with broad strategic issues.  Since compensation is a “strategic” tool, not a “tactical” one, the questions must start here.

1. What is the vision of ownership for the “future company?”  In what ways will the company be different three years from now than it is today?  (Be as specific as possible.)
2. What are the potential barriers that could keep that vision from being fulfilled (external and internal)?
3. What key opportunities and initiatives have to be seized and effectively implemented if that vision is going to be realized?
4. Who are the  people that will drive those opportunities and are key to overcoming the barriers described?
5. Do you have all the people in place now you will need to realize the vision you have described or will new people be recruited?

Stage Two

With a clear and compelling vision in mind, you are ready to address level two questions.

1. What is the business model of the company; the performance engine that keeps revenue flowing and will fuel growth?
2. What roles are in place to support that business model and what expectations have been set for those roles?  (Presumably these are some of the same people mentioned above.)
3. If you implement a compensation strategy that works, how should the outcomes produced by this group be improved or changed?

Stage Three

Now that we have addressed the vision and business model, we’re ready to talk more specifically about compensation related issues.

1. What do you believe people should  be paid for primarily?  Time spent working? Outcomes (if so which?)?  Knowledge and experience?
2. In what ways are you paying people now that is supportive both of that philosophy and the business model you described in stage two?
3. How and to what extent should people be paid for maintaining the present performance engine of the company?
4. How and to what extent should people be paid for innovation and contributing to the future growth of the company?

Stage Four

With a working pay philosophy established in stage three, we’re now in a better position to be more granular in our compensation questions.

1. Where do we want to set salaries vis a vis market pay?
2. Where do we want total compensation to be vis a vis market pay?
3. Are those answers the same for each tier of employee in the company?
4. Do we want to share equity?
5. If we don’t want to share equity, do we want some level of pay to be reflective of company value?
6. If we don’t want to tie pay to company value, what financial metrics do we want it tied to?
7. What balance should there be between short-term value sharing (performance over 12 months or less) and long-term (performance over 12 months).

Certainly, there are still many more questions to be asked and answered before your compensation strategy will be ready and complete.  However, hopefully this list gives you a sense for the train of thought that should inform the compensation discussion in a company that wants to grow and realize ownerships’ vision for the future.

So what’s the best way to award phantom stock to employees? In my view it’s through Phantom Stock Options.

This one is my favorite, and it’s the most popular plan we design at VisionLink. Stock options (real ones) are attractive because they’re “win-win.” Employees only win if the other shareholders win (by seeing their stock price go up by a value that exceeds the amount by which they were diluted). In a public company environment there are markets that help to handle the exercise of the option. However, in a private company no such market exists. Instead, the employee and the company sponsor have to work out the cash flow mechanics of the exercise. And there’s no “cashless exercise” arrangement that permits the employee to get a reduced number of shares by surrendering a portion of his options to cover the strike price.

So let’s use phantom options. Easy. Recall that phantom stock is a cash compensation arrangement. Assume we give Sally (remember her–our top sales executive?) 5,000 phantom options with a starting value of $10. What will she really have at that point? Nothing—because the options must go up in value before she realizes any gain. But later, when the phantom share price reaches $18 and it’s time for redemption, Sally is simply handed a check for $40,000 (($18-$10) X 5000). No muss, no fuss. Sally doesn’t need to scrape together the $50,000 to exercise the options. She simply receives a nice payment that reflects a reward for her contribution to growth in company EBITDA.  Sally has tight alignment with the shareholders without the pain and complication of dealing with a stock transaction. (And you have a happy employee without the headaches of another shareholder.)

By the way, what’s described here as a phantom stock option is also known as a Stock Appreciation Right. However, some find the term phantom stock option more appealing and descriptive.

So have you picked the right plan for your company? Next we’ll look at how you begin to set it up.