Most of the work VisionLink does for its clients falls in two categories. We either help companies initiate new pay plans or we help them fix the ones they already have. In either case, business leaders turn to VisionLink when they figure out they are not compensation experts and that mistakes they make in paying their people can be very costly. This is especially true of their long-term incentive plan.
The reason LTIP errors are so expensive is because you are making a long-term commitment to those who participate in these plans. If you over commit, you end up paying disproportionately for the value created. If you under commit, you run the risk of employees feeling they are not being paid adequately for the business growth they help drive. In contrast, if you make a mistake with the metrics of your bonus plan (for example), you can adjust them the next year so you don’t end up paying out more than you intended to. Changes in your long-term rewards plan are not so easy.
The 3 Mistakes
So, let’s discuss how you can avoid making costly errors. In our work at VisionLink with hundreds of business clients over the past 20 (plus) years, we have seen three mistakes made over and over again by companies large and small. Let’s look at each and discuss why they are so costly.
Mistake #1: Not Having a Long-Term Incentive Plan
Okay, that’s unfair—right? Not really. Not having a way to share long-term value with those who help you create it could be the costliest compensation mistake of all. If you envision a future company that is bigger and better than the one you have today, you will need people around you that are as passionate about its realization as you are. These people can’t be viewed as mere employees. They need to be considered growth partners. And they won’t see themselves that way (and perform accordingly) if there is no unified financial vision for growing the business.
In addition, an LTIP acts as an insurance policy against “bad” profits. These are profits that are here today and gone tomorrow because they were generated at the expense of building long-term value. This happens when the way employees are compensated rewards only short-term results. Employees may sacrifice a relationship with a customer, a vendor or the community at large in order to drive the highest possible value for their pocketbook right now. Yes, you want your people to focus on the revenue engine year to year, but but you need them to balance that with an eye on the future company—and building sustained business value. This will only happen if they participate in the long-term wealth multiple they help create.
Mistake #2: Sharing Equity
Too many companies begin sharing stock with employees without properly considering the long-term implications of doing so. A few years down the road, they realize they have new shareholders that are not creating sufficient value to merit the ownership position they have. In the meantime, founding owners have diluted their own equity position and have no simple or affordable means of buying back the stock they’ve now given away.
Many business leaders share equity because they assume it’s their only option for tying rewards to the long-term value increase of the business. It’s not. In fact, there are at least six other ways to share value with employees without sharing stock. I’m not suggesting there is never a time when it’s appropriate to give away shares. It’s just important to understand fully the implications of that choice, as well as what your options are, before you go down that road.
In most private companies, equity sharing is seldom necessary or a good idea. Sometimes business leaders feel pressured into sharing stock by long-time employees who want a “piece of the action.” Again, too many immediately relent because they can’t afford to lose the person and they assume there are no other viable options. In most cases, when an employee is asking for stock, what he or she really means is they want to participate in the value they help create. More often than not, an alternative such as phantom stock or a bonus pool is better for them and for you--and will address their core concern. Give yourself some room to explore those options before deciding to bring on new shareholders.
Mistake #3: Giving Away Too Much Too Soon
Many times, businesses will set up a long-term value-sharing plan for their employees and then distribute most or all of the potential grants in the first year or two of the plan. This has several negative implications for the company.
First, when employees are loaded up with (for example) phantom stock shares at the outset of the plan, you’ve taken away some of the leverage this kind of offering should carry. Part of the “incentive” associated with an LTIP should be the urgency to perform over a period of time to earn more shares, not just to drive up the value of those you already own. In addition, you may decide to change the performance requirements for earning additional shares after you’ve lived with the plan for a year or two. If you’ve given everything away up front, you leave yourself no opportunity to make that adjustment. In short, grants should be distributed over a period of years, not all at once.
The second negative effect of front-loading the grants is that all of them are valued the same. As a result, any significant dip or increase in the company value can adversely impact either company owners or plan participants, depending on which direction the value goes.
The third reason you want to avoid giving away too much at the outset is because you leave employees with little incentive to stay past the vesting period of the plan. If they know they have all they are going to get, there is less chance of them staying around to collect on the remainder of their benefit—because there is no remainder. Staggering share distribution over a number of years similarly staggers the maturity periods of those shares.
Finally, giving away too much too early leaves you with a payout obligation coming due all at once somewhere in the future. You want your plan to mature at different intervals for both cash flow and retention reasons. Phantom stock plans, for example, typically have a payout window of five to eight years. It is preferable to have differing maturity dates for each share award period. So, this year’s shares will be cashed in seven years (for example) from now, next year’s will be redeemed seven years from then—and so on.
Given what’s been laid out here, you may be thinking: “Geez, is it even worth it to have a plan?” The answer is yes. More than that, you need a plan because you need to attract and retain growth partners, not just employees. So, just focus on picking the plan that makes the most sense for your company and reflects your pay philosophy—then avoid making the three mistakes just discussed. If you do that, you should be fine.