How To Design an Effective Long-Term Incentive Plan For Employees

Long-term incentive plans (LTIPs) are compensation strategies used to attract and retain top-tier talent, especially in competitive industries like tech, manufacturing, and finance. They're powerful tools designed to align employee goals with company objectives.

However, designing a long-term incentive plan requires careful consideration. You also need a good understanding of which long-term performance bonus you want to offer your employees before you start, such as performance shares, restricted stock units, or cash-based LTIPs.

Fortunately, we'll cover all of this and more in this guide, ensuring you are well informed to make the best decision for you, your employees, and your business.

What Is A Long-Term Incentive Plan?

A long-term incentive plan is a compensation strategy used to motivate, attract, and retain key employees. It is specifically designed to reward executives and key personnel within an organization.

Employees are rewarded based on their performance, and compensation is paid after an extended period—known as a vesting period—typically with a three to five-year duration.

Offering LTIPs helps lower employee turnover, as workers are more inclined to stay at your company to reap the financial rewards at the end of this vesting timeframe.

Unlike short-term incentives like bonus plans and commissions, LTIPs focus on long-term company success. They bridge the gap between employee efforts and your company's future, rewarding workers at set increments for a job well done.

These appreciation-based awards are a win-win for your business:

1. They help foster collaborative teamwork, aligning staff with company goals.
2. Employees are rewarded for individual contributions tied to these specific goals.

LTIPs vs. Profit Sharing

• LTIP: Employees are given company equity, such as stock options or performance shares, with vesting schedules ranging between three and five years. These incentives are designed to reward employees based on individual performance over a longer period.
• Profit sharing: Employees are given a slice of the company's profits, with more frequent payouts, such as monthly, quarterly, or annually. The amount shared is based on the company's overall profitability and generally involves collective rewards (i.e. team efforts) correlated with organizational performance.

Both LTIPs and other types of incentive models like profit sharing offer unique benefits for businesses. However, LTIPs can be particularly beneficial when aligning long-term company goals with employee interests.

For instance, a start-up tech company wants to attract and retain key employees and align their interests with its long-term goals.

The startup can effectively retain top executives by offering LTIPs that include stock options (vested over three to five years). LTIPs foster a sense of ownership and accountability, as employees' performance directly translates to the company's success in the long run.

On the other hand, employees may only receive profit sharing payouts when the startup turns a profit, which isn't always guaranteed. However, if the startup's primary goal is to incentivize collective efforts, profit sharing might be a more suitable option.

Types Of Long-Term Incentive Plans

You can choose several long-term incentives to form part of your employees' compensation plans, each designed to align with team interests and company goals.

Let's look at five options:

1. Performance Shares

Performance shares are a form of equity pay given to employees or executives when they meet certain performance benchmarks.

They are usually non-dilutive, meaning they don't alter the shares or percentages other stakeholders own within the company. Employees also won't pay tax on their shares until they are fully vested.

Performance share targets can be tied to various metrics:

• Revenue growth: Increasing sales over a certain timeframe.
• Profitability: Improving the company's bottom line (net income).
• Operational: Improving and streamlining business operations.
• Market share: Gaining market growth in a specific industry.
• Product launches: Successfully launching new products or services.

Example

A manufacturing company might tie performance shares to meeting predetermined goals like production efficiency. Employees granted performance shares will receive a payout if the company exceeds its production targets.

2. Restricted Stock Units (RSUs)

Restricted stock units (RSUs) are a company's equity shares given to employees.

However, these shares are not immediately owned by the employee. Instead, RSUs are subject to a vesting period—a predetermined timeframe (usually around three to four years) during which the employee must remain employed by the company to earn ownership of the granted shares.

Employees only own the shares at the end of the vesting schedule and are subject to pay income tax.

Example

A tech startup may offer RSUs to attract high-performing developers in competitive markets as a way to reward their long-term commitment to the company.

3. Stock Options

Stock or equity options allow employees to buy company stock at a fixed price (often discounted) after the vesting period. The company's stock price is referred to as the "strike" or "exercise" price.

When employees purchase shares, it shows they are more invested in the company and are prepared to stick around for the long haul—a win for employers.

In general terms, there are two types of stock options companies sell:

1. Puts - a bet that a stock will fall.
2. Calls - a bet that a stock will rise.

Employee stock options (ESOs) are typically "call" options.

However, keep in mind that stock options have pros and cons. When the market is high, employees' shareholder value increases, and they can profit from their shares. However, when the market is down, employees' share values decrease.

Example

If a company sells stock options to an employee at a strike price of $50 and the market price rises to $100, the employee can exercise the stock and purchase company stock for $50. They can then sell the stock on the open market for $100, profiting $50.

4. Cash-Based LTIPs

Cash-based LTIPs involve deferred cash payments tied to individual or company performance. They are given to employees or executives when certain benchmarks have been met.

Cash-based LTIPs can be structured in various ways:

• Performance-based awards - paid out when specific targets have been reached.
• Time-based awards - paid out after a specified period.

Example

A financial services firm may offer senior managers cash bonuses tied to client retention rates. If a manager successfully retains a high percentage of clients for X number of months (or years), they will receive a cash payout.

5. Creative Incentives

In addition to these traditional LTIPs, here are other employee incentive ideas you can use:

• Sustainability-based LTIPs: Linking rewards to sustainability metrics, such as achieving environmental, social, and governance (ESG) goals.
• Hybrid plans: Combining stock and cash rewards to offer a more flexible and tailored incentive package.

Example

You can tie rewards to performance metrics based on your company's sustainability goals. For instance, a car manufacturing company offers employees X restricted stock and Y cash bonuses when they consistently reduce waste during production after a specific period.

Benefits Of Long-Term Incentive Plans

LTIPs have many advantages, from improving employee retention to attracting top talent.

Here's the breakdown:

Employee Retention

LTIPs are powerful tools for retaining workers within your organization. In fact, studies show that the presence of a corporate incentive program motivated 66% of employees to stay at their jobs.

By offering rewards that vest over time, LTIPs encourage employees to stay with your company long enough to realize the full value of their incentives. This reduces staff turnover, which can be costly in terms of lost productivity, recruitment fees, and disrupted workflow.

Alignment with Company Goals

LTIPs are designed to align employee interests with your company's long-term performance and success. When rewards are tied to their efforts over time, employees are more motivated to hit predetermined performance metrics.

A 2022 Harvard Law study revealed that long-term performance rewards translate to a:

• 95% chance of achieving threshold performance goals
• 70% chance of achieving target performance goals
• 20% chance of achieving maximum performance goals

This alignment creates a shared sense of ownership and accountability, encouraging your workers to think beyond individual roles and consider the broader impact of their efforts on the company as a whole.

Attraction of Top Talent

A well-put-together incentive plan is great for companies looking to attract high-performing individuals, with 42% of employees considering rewards and recognition programs when seeking employment.

By offering substantial long-term rewards, LTIPs can make you a more attractive employer, especially in industries with skill shortages, such as tech, manufacturing, and finance.

Shareholder Alignment

For public companies, stock-based LTIPs ensure employees are invested in the company's success. By offering shareholders stock appreciation rights, these executive compensation plans incentivize employees to work toward revenue growth and profitability improvements.

Challenges And Considerations

Long-term incentives offer many benefits but also have several challenges that companies need to consider. These include:

Complexity in Design

LTIPs can be overly complex, leading to confusion among employees regarding how the plans work and what they need to do to achieve their LTIP benefits. This complexity can demotivate staff and hinder engagement if your workers don't fully understand the terms, metrics, and vesting periods.

Tax and Compliance

Navigating tax implications can also be a challenge, especially for companies operating globally or in different jurisdictions across the US. LTIPs depend on the components of each individual's plan and the country or state in which the plan is set up. For instance, tax rates may differ widely between different US states and European countries.

Also, different types of LTIPs, such as stock options, restricted stock units (RSUs), and performance-based awards, have varying tax implications, such as:

• Stock options may be taxed at the time of exercise.
• RSUs are typically taxed when vested.
• Bonus plans are taxed as additional income (at the ordinary income tax rate).

Furthermore, the Federal Insurance Contributions Act (FICA), payroll, and capital gain tax also require careful consideration from both the employee and employer.

Valuation Difficulties

Private companies do not have publicly traded stock, making it difficult to determine a fair market price for their shares. The value of stock-based LTIPs can also fluctuate—especially in volatile markets—even when a valuation is calculated.

Perceived Inequity

Poorly structured LTIPs can lead to perceptions of favoritism or inequity among employees. If performance-based awards are not clearly defined or if rewards are not distributed fairly, your workers may feel that the plan is unfair or lacks transparency.

Best Practices For Designing And Implementing LTIPs

Designing and implementing long-term incentives requires a strategic approach and shouldn't be created on a whim. Here are a few best practices you can follow:

Define Clear Objectives

Ensure the LTIP directly supports your company's long-term growth and goals within a predetermined time period.

For example, if your goal is to boost innovation by 2028, your LTIP could reward employees for developing or improving new products.

Set Measurable Metrics

Determine a base benchmark against which future improvements are compared and measured.

Use specific, measurable, achievable, relevant, and time-bound (SMART) goals to measure company performance metrics and determine reward eligibility. Monitor and track your employees' progress over time to gauge the effectiveness of your long-term incentive programs.

Communicate Transparency

Provide clear information about the LTIP to all eligible employees, including:

• Vesting schedules
• Performance criteria
• Reward amounts

Provide regular updates to ensure everyone understands the plan, its implications, and the company's long-term goals.

Consider Flexibility

Adapt and pivot LTIPs where necessary to align with your company's evolving needs and market conditions. Review the LTIP regularly to assess its effectiveness and areas for improvement.

Industry-Specific Examples

Technology

• Reward employees for launching new products successfully, developing innovative features, or achieving milestones in product development.
• Incentivize workers who increase your company's market share in competitive niches.

Energy

• Reward eligible employees for achieving sustainability goals such as reducing carbon emissions or improving energy efficiency.
• Incentivize research and development (R&D) efforts in renewable energy technologies.

Healthcare

• Reward healthcare professionals who focus on long-term objectives that enhance patient care, such as reduced readmission rates or improved patient satisfaction.
• Compensate R&D efforts in new medical treatments and technologies.

Simplify Long-Term Incentive Plans With ShareWillow Today

LTIPs are commonly used to drive long-term company growth and success and are a brilliant way for both public and private companies to attract, motivate, and retain top talent for the long haul.

Whether your company grants performance shares, cash-based LTIPs, or a blend of the two, you can use ShareWillow's top-class incentive software to streamline the entire process.

We're passionate about motivating employees to act like owners without complicated equity. Request a free demo today!

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