Business leaders often wonder whether they can “afford” to have an LTIP. It is a revealing perspective. The assumption is that if you “add” a long-term incentive plan to your pay strategy, you will either dilute shareholder value or lower profits—or both. At a minimum, you’re adding expense to the P&L—and the presumption is that’s not good. Well, the claim I will make (and defend) here is that you cannot afford not to have an LTIP—and you are putting your company at risk if you don’t. Let’s explore why.
Common Perspectives about LTIPS
If you are weighing the merits of a long-term value sharing plan strictly in a cost context, you are evidencing that you do not consider compensation to be a strategic tool. Instead, you see it as an expense that must be minimized and contained at all costs. What if you applied that same logic to product development and marketing? Would ever develop a new product or spend money marketing it if you looked at it strictly from a cost perspective? You invest in your business model and strategy because you expect them to drive company profitability and growth. Believe it or not, your pay philosophy and approach should reflect the same logic.
The other common assumption about incentive plans in general, and LTIPs in particular, is that they don’t “work.” By this, most business leaders mean they don’t improve the behavior of their people; therefore, it’s a wasted effort. This too is faulty thinking. Incentives plans should not be used as a way to get people to behave a certain way or to motivate (or manipulate) them to perform at a higher level. Research has shown that incentives seldom have that effect. Instead, their role is to frame the financial partnership you want to have with your people and get them aligned with the shareholders’ mindset.
If a chief executive looks at long-term incentive plans through either of these lenses, he or she is putting their company at risk. There are at least five reasons for this.
The 5 Dangers
Here is how a company becomes vulnerable by not having a well thought-out, effective approach to helping employees participate in the wealth multiple they help drive.
1. Employees Won’t Think Like Owners
Most business leaders want people who look at the business the way they do and who will assume a stewardship role in protecting owner interests. This won’t happen if your people do not feel like they are partners in driving company success. Why would they?
Think about it. Assume you are conducting meetings with your senior people and talking about the long-term growth goals of the company. You are telling them how much they are needed for those targets to be achieved and that you need their support. In the meantime, those same employees look at their pay package and see nothing that communicates to them that they are considered partners in the growth you are asking them to help create. What do you suppose they conclude?
2. You Will Not Be Able to Attract Premier Talent
If you have been following this blog for any length of time, you know something about the competitive labor market that exists right now. Highly skilled people hold much power because they are in high demand—and they know it. By far, the most important pay element to them is one that rewards their sustained performance. They are strategic leaders who can significantly impact the growth trajectory of your business. As a result, they expect the financial portion of your employee value proposition to reflect that and allow them to participate as growth partners in building the future company.
Sharing value with those who help create it does not mean you have to share equity (necessarily). Employees who ask for stock are usually just asking that there be a mechanism for sharing the value they help create. There are multiple ways of doing that without diluting shareholder value.
Learn more about the options for sharing long-term value by watching VisionLink’s on-demand webinar entitled, How to Choose the Right LTIP.
3. You Won’t Leverage Your Business Model
One of the primary purposes of your compensation offering is to align your employees with the business model of the company. It should help them understand their role in how the company drives revenue and profits (which is what your business model does) and what’s expected of them in that role; how success for them is defined. It should also reinforce their need to leverage the model for growth. You want your people with their nose to the grindstone but with a eye on the future as they assume responsibility for the outcomes you’ve hired them to produce.
When employees participate in both a short and long-term incentive plan, their focus and performance is no longer one dimensional. It becomes well-rounded and enduring. Conversely, if people don’t understand or are committed to leveraging your growth model, your business will not grow. It’s that simple.
4. You Risk Having Bad Profits instead of Good Profits
In his book The Ultimate Question, Fred Reichheld, a Bain Fellow and founder of Bain & Company's Loyalty Practice, offers the following about profits:
Too many companies these days can’t tell the difference between good profits and bad. As a result, they are getting hooked on bad profits.
The consequences are disastrous. Bad profits choke off a company’s best opportunities for true growth, the kind of growth that is both profitable and sustainable. They blacken its reputation. The pursuit of bad profits alienates customers and demoralizes employees.
While bad profits don’t show up on the books [at least they aren’t identified there as such], they are easy to recognize. They’re profits earned at the expense of customer relationships.
Whenever a customer feels misled, mistreated, ignored, or coerced, then profits from that customer are bad. Bad profits come from unfair or misleading pricing. Bad profits arise when companies save money by delivering a lousy customer experience. 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 their wealth multiplier rises or falls on the ability of the company to sustain the right kind of profitability.
Conversely, companies that focus solely on short-term results (in terms of “at risk” pay) set themselves up for bad profits. (Look no further than Wells Fargo.) Leaders of such companies can (and do) talk all they want about building value for the customer and improving return on equity for shareholders; but if they pay people in a way that communicates the opposite, how can they expect employees not to pull them into the bad profit trap? In this sense, long-term value-sharing protects the company’s interest in developing good profits, acting as a kind of insurance policy against a narrow focus on short-term outcomes.
5. You Damage Trust and Slow Performance
One of the reasons you should share long-term value with those who help create it is because it’s the fair thing to do. Your people have an intuitive sense about whether or not the company’s philosophy about pay is reasonable and protective of the interests of all stakeholders, not just shareholders. And everything you do as a business leader communicates to your employees what you value and where they fit in that value system. Pay does this in a very powerful way. It defines the economic investment you are willing to make in them to achieve the results you want.
If employees do not participate in the value they create, their sense is that you don’t have confidence that they are the source of that success. This creates dissonance that lowers trust in the organization. And as trust goes down, so performance and productivity follow. It’s a natural result. Ultimately, this kind of trend leads to higher attrition rates as well as an inability to attract the kind of talent you want; because you have done damage to your employer brand. 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)
An important note: You should not conclude from the arguments made here that cost is not a factor in evaluating the merits of a long-term incentive plan. Rather, what you should conclude is that a well-designed LTIP does not really “cost” the company anything. Built properly, such plans are self-financing; meaning they are paid out of the value that is created. This assumes you’re able to define a threshold at which you consider the value being produced to be attributable to the work of your human assets, not just other capital at work in the business. We call that threshold “productivity profit.”
To learn more about how to measure your return on incentive plans and all other contributions you are making to employee compensation, read: How CEOs Can Measure their ROI on Compensation.
As a business leader, you have an obligation to improve shareholder value by improving the return owners are getting on their investment in the business. Hopefully, what has been discussed here enables you to see why an LTIP will help and not hinder your ability to meet that obligation.