Why You Need a Compensation Strategy, not Just a Plan

You are considering the introduction of a phantom stock plan for your key people. You have decided this is the right concept for your business. You're a private company and don't want to give equity away, but you do want your executive or management team adopting more of a stewardship approach to the future of the business. Ideally, you'd like them to think more like you as the CEO or owner. This led you to speak with the company's accounting firm and they agreed a phantom stock plan would be a good idea. So, with all of that logic and the positive momentum you've garnered, you have contacted your attorney and asked him to draft a plan agreement. He's done so and you're about to meet with your 10 key producers and introduce the plan to them. STOP!! Please don't go any further.

Before you proceed, there are a few questions that really should be answered. Your response to these queries will help you determine whether you're ready to introduce the plan or not. They will also help you know whether what you have at this point is a compensation strategy or just a "plan."

  • What is the plan's purpose? Why are you implementing it and what outcomes will indicate the plan is "working?"
  • What part of your company's compensation philosophy does this plan support?
  • Who is eligible for your plan? How was that list determined--what's the criteria?
  • What is the formula for valuing shares in your plan?
  • How many shares are you going to make available?
  • How will the amount of shares for which someone is eligible be defined? A percentage of salary? A percentage of total shares?
  • What percentage of owner value are you planning to share? What is that based on?
  • How will shares be distributed and at what frequency?
  • What are the performance requirements for earning shares? Have they been tested against any company performance standards?
  • Have you projected the potential value of the plan relative to an increase in shareholder value?
  • What is the level of sharing to be done under the plan based on different company performance results, such as base, target and superior?
  • Do you have a financial model to test, measure and manage your plan?

I could go on but hopefully you get the idea. A legal document is not a compensation strategy. Before your plan is introduced to anybody, you should consider taking the following steps to ensure that a strategic context is created for its roll-out and each of the questions above is adequately answered. These will also ensure that both shareholder and employee interests are properly served.

Write a Purpose Statement

This step should answer the question, why are we doing this? It should make clear to company leadership what the plan will help the business achieve. For example: This plan is designed to share future value of the business in a way that promotes an ownership mindset on the part of key producers. It should build a sense of partnership between ownership and participating employees. It should improve focus on key leverage points (named specifically if possible) in our business plan and accelerate our ability to achieve our growth goal of doubling revenue in the next four years.

A purpose statement should be consistent with the company's pay standards and will be easier to articulate if leadership has developed a clear, written philosophy for compensation.

Draft a Plan Blueprint

The plan blueprint should answer the question, what type of plan will we have and how will it be structured? It is basically the architectural drawing of the specific rewards program you want to initiate. It describes what type of plan it will be--phantom stock, SAR, profit pool, PUP, deferred compensation, etc.--and what performance thresholds it will be based upon. At this stage, a business is determining whether the company wants to tie the reward to the business value or some other financial metric. You are addressing whether you want to give present value away or only future value, whether the reward will be performance-based (employees must achieve a future result before they will receive shares) or have immediate value, and so forth. The plan blueprint creates a framework in which the company's rewards strategy can be manifest.

Develop a Financial Model

With a purpose statement completed and a blueprint in place you now need to answer a critical question: how much value will this plan make available and what will the reward be based on? Such is the role of a sound financial model. Done right, this process projects a future value of the business based upon different performance assumptions--for example, base, target or budget and superior. It attempts to anticipate what level of additional shareholder value will be achieved under each of those scenarios so the company can determine how much of that increase can or should be shared with those primarily responsible for its creation. This step makes clear that compensation design is an outcome-based endeavor. You are envisioning a future result and then engaging in a kind of reverse engineering process to determine how that potential value can be communicated in "today's" terms (percentage of salary, percentage of profits, etc.). It is a "self-financing" approach that allows the company to define appropriate thresholds of performance that must achieved before the plan will either accrue or pay out its value. It also allows a company to envision how it might be able to pay higher percentages of value to participants if increasing levels of results are achieved. Done right, this phase of development brings the plan to life. To get a sense for how this modeling process works, check out the "Picture Your Future Company" tool in our new website, www.phantomstockonline.com.

Document the Plan

Once two to four iterations of the financial model have been worked through, and the metrics for creating plan value have been clearly defined, you are ready to put the final specifications on the plan and document it. This step must produce both a legal document (where applicable) that addresses all of the statutory requirements of the plan, as well as a summary plan description that explains how the plan works to its participants. The plan specifications must address all of the details of the plan--how benefits are earned, when they will be paid out, how they will be treated in the case of early termination, disability, death, and so forth. The production of these documents requires the ability to understand both the legal guidelines associated with the plan (i.e. ERISA or 409(A) issues) as well as the strategic purpose the new program will serve.

Market the Plan

When a company takes a strategic approach to compensation, it doesn't just "announce" a new pay program. Rather, it creates an opportunity to build a sense of partnership with its key people by literally marketing a future to them. This is more than explaining how the new long-term incentive plan will work. It involves framing the compensation value proposition in a larger context that links together the vision of the company, its business model and strategy, employee roles and expectations and the rewards for fulfilling those expectations. Although an initial meeting may be held to explain the plan and "roll it out," that communication is one of many that will occur as the company treats its workforce as a key constituency that needs to be consistently and effectively nurtured.

Each of these steps could be further embellished but hopefully you can begin to see how the building out of a pay strategy differs from just coming up with a plan. Further, when a company seeks to align compensation with the business model and strategy of the company, it has an opportunity to create greater engagement and execution on the part of its key people. It essentially makes those individuals stewards of the shareholders' vision by helping them feel a greater sense of partnership and clarity about the future of the business.

For more information on the strategic role of long-term value sharing arrangements, check out our white paper entitled, "Why Long-Term Value Sharing Matters."

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