Long-term incentives (LTI), including stock options, restricted stock, have long been a key element of total compensation plans in public companies. The principle difference between LTI plans in public versus private companies is that the funding for these long term incentive plans comes directly from the private company’s bank account. While public companies have to expense options and restricted stock, the gain that is realized is paid for by outside investors. This is not true in a private company unless the objective is to sell the company to outside investors. If the private company issues stock, and the value grows, when it is time to redeem the shares, the company pays for this directly. Therefore, the design of these LTI plans need greater care and thought than in public companies. In fact, several surveys have indicated that while virtually all public companies use equity or LTI plans, only approximately 60% of private companies use them.
So why do private companies use LTI plans? Our perspective at the Wilson Group is that, if a company can achieve the desired level of revenue and profit growth without LTI plans, then do it. It is just that simple. LTI plans are used because the firm needs a leadership team that care about the growth, sustainable profitability and long-term value of the company; the same concern of most business owners. Do you want your executives to be “hired-guns” or “adopted” into the family business? How you answer this question will tell you what kind of compensation plan you need.
Which executives should be included in an LTI plan? Most private firms start with the CEO. If this person is from the outside, then equity will likely be needed, especially if you want the person to think more like an owner than a “hired gun.” After this is in place, or if the CEO is an owner, these plans are expanded to the senior management or the leadership team. LTI plans usually stop there, but there are a number of firms that use stock options or restricted stock as performance based recognition awards to all or many employees.
In public companies stock options and restricted stock are the most prevalent vehicles for long term incentives. In private companies, the vehicle depends on the purpose and structure of the plan. These may range from 3 to 5 year cash-incentive plans (i.e., if the company gets to $X level, you will receive $Y bonus after Z years) to performance-unit or simulated-stock plans. Of course, private companies can use options or stock, but simulated equity plans can have more flexibility when it comes to performance measures, goals, and payout mechanisms. While most LTI plans in public companies use Total Shareholder Returns as the prime measure, private companies use more operational metrics like revenue growth, profitability and return. Then, the number of units awarded and their value can be determined in relation to factors that drive growth and corporate value.
Finally, a key issue for LTI plans is to determine the share of ownership or value that will be awarded to LTI plan participants. In public companies, the equity value usually represents between 10% – 20% of the company’s total outstanding shares. This is a reasonable benchmark for a private company, but because of the reasons stated above, these plans are usually of less value. If they have significantly less “expected value”, then they will not be competitive enough to retain senior leadership especially if the company grows or becomes a leader in the market. Public companies are always looking for good talent.
We find that small private companies (under $10M in revenues) tend not to use equity plans, unless they are on a direct shot to an IPO, acquisition or are a venture financing backed firm. But, as they get larger, their need for leadership talent also grows and the firm may need someone who has “done this before.” This means they will seek to bring in talent that likely had equity as part of his or her total compensation package. Consequently, private companies growing past $50M start using LTI plans more frequently. When the firm reaches over $100M or $250M, then they most likely have some form of LTI plan as described above. These plans tend to follow the evolutionary growth and development of the company.
There are over 100 decisions needed in putting together an effective long-term incentive plan for a private company. The methodology for making these decisions is almost as important as the decisions themselves. These plans bond the individual and the company for the long-term, and are based on creating value for both. So long term incentive planning is fundamentally a win-win opportunity but needs to be carefully planned and executed to realize desired LTI benefits.
Thomas B. Wilson
President, Wilson Group