Authors
Aneta Samkoff
Bartłomiej Podolski

04. Types of LTIs

There are several LTI vehicles you can offer to your employees. Companies commonly mix various forms in order to instigate certain results aligned with their long-term strategies.

Types of LTIs

1. Stock-based LTIs

Stock-based rewards ultimately convey real equity to employees. This means the transfer of control and dilution of earnings for the current owners. This is a concern to some private company owners, especially family-run businesses, who prefer to offer phantom options or cash incentives instead. However, stock-based LTI plans are the vehicle of choice for venture-backed organizations and startups, who operate in a different mindset and, through offering real ownership, want to create a specific company culture.

If the transfer of ownership and administrative or regulatory tasks are not a concern for your firm, then stock-based LTI plans are, in all likelihood, your best option.

Employee stock ownership plan (ESOP)

This is an LTI vehicle that functions like a retirement plan and is one of the most popular options for stock-based LTIs. The main idea behind it is to offer real ownership in the company by setting up a trust fund and distributing the tax-deductible contributions of new shares of its own stock. The beneficiary cannot do anything with that stock until retirement. Then, usually, the company will purchase the stock back from the employee at the current market rate.

Employee stock purchase plan (ESPP)

This is a type of ESOP where employees can acquire the company’s stocks typically at a discounted purchase price.

ESPPs usually come in the form of a grant to an individual to buy a certain amount of stocks at a strike price. The executive doesn’t have to wait until all the shares have vested before buying stock, instead, they may purchase a portion of the already vested shares at any time.

If the spread is positive and the market price of the stock is higher than the pre-set price of the share being disbursed at the given date, then the employee can immediately benefit from the price difference by selling. However, if the stock price is lower, it doesn’t make sense for the employee to exercise that option.

In this way, granting ESPP based on well-thought-out performance criteria can motivate the key figures in your company to meet or exceed your company’s pre-set targets.

Strike Price - A fixed price at which an employee can buy a set number of shares in the company

Spread - the difference between the value of shares between the date they are granted and the date they are exercised

Incentive Stock Option Plan (ISOP)

This plan resembles the ESPP, but the difference is that instead of awarding the stock the employer compensates with the stock option, which is a right to buy the actual stock at a preset price. Like in the ESPP, the shares are typically offered at a discounted price, although they may also be offered at the market rate.

ISOPs generally provide good alignment between the executives and the shareholders focusing employees’ efforts to contribute to the organization’s growth both in value and share price. Typically firms that push for high performance, such as venture-backed capital organizations and start-ups, tend to make ISOs the major portion of their LTI package.

ISOs have stricter granting rules than other plans, such as they can be issued only to employees of the company and are generally non-transferable. In the US, there are additional requirements for individuals, who are shareholder owners of 10% or more of the firm. For example, the exercise price must be at least 110% of the fair market value price at the time the options are granted.

However, the benefit of this type of plan is favorable tax treatment. The employee doesn’t have to pay taxes on this grant until the date they actually decide to sell the stock. Typically, because of the holding period, at this point, the gain is subject to the capital gains tax, which is lower, instead of the ordinary income tax that would be applied if sold right away.

However, some conditions apply, generally for the US tax-payers:

  • The recipient has to hold the stock for at least one year after exercising the option to buy
  • The stock has to be in possession for at least two years after the date the option was granted.
  • The employee can only exercise up to $100,000 of stock options per calendar year (as per fair market value on the date the options were granted).
  • The exercise price must be equal to or greater than the Fair Market Value of the company’s stock on the grant date.
  • Stock may be sold only in accordance with the written plan, approved by shareholders, indicating all the conditions and restrictions of who can buy the options, etc.

Stock Appreciation Rights (SARs)

This is an award akin to a stock option, except the recipient doesn’t need to pay exercise price to exercise the SAR. SARs, like ISOs, are another LTI vehicle preferred by the companies that especially value performance and growth i.e. startups, and venture-backed firms.

The employee simply receives the amount equal to the appreciation in the value of the share from the date the share was granted until the date when the rights to the share were exercised. The valuation of a SAR works just like a stock option in that the employee profits from any increases in the stock price above the price set in the award. Depending on the plan rules, the employee receives the net amount of the increase in share price, which is typically disbursed in cash, although may also be settled in shares or a combination of shares and cash.

There are two different types of SARs:

  1. Stand-alone SARs are granted as independent instruments and are not issued in conjunction with any stock options.
  2. Tandem SARs are granted in conjunction with a Non-Qualified Stock Option or an Incentive Stock Option, which allows the recipient to exercise it as an option or as a SAR. The election of one type of exercise prevents it from being exercised as another.

Restricted stock

These are grants of unregistered shares of ownership issued to the key employees. They are less dilutive than traditional stocks and stock options, as they are generally non-transferable.

In order to sell an unregistered stock, the individual has to act in accordance with strict SEC (Securities and Exchange Commission), or similar local regulatory body, regulations that govern the insider trading rules, because the figures who hold them are generally considered to have accomplice knowledge of the company.

Restricted stockholders have voting rights of the same type as any other shareholder already during the vesting period, as the unregistered stock has already been issued. This is why some have criticized granting LTIPs in the form of restricted stock as being a “pay for pulse” type of compensation since they are not explicitly tied to the company’s financial performance and provide no leverage.

RSUs (Restricted Stock Units)

Restricted stock units are similar to restricted stocks but differ in some key respects. An RSU is a pledge from an employer to issue a certain amount of shares of the company’s stock at a future date. Since the recipient would not collect the stock until later and it may actually be disbursed entirely in cash, this form of reward has no voting rights and unless the actual stock is awarded at the vesting point, they never gain those rights.

Some RSU plans allow the employee to decide within certain limits exactly when to receive the shares, which can assist in tax planning. Unlike stock options that can go “underwater,” RSUs are less risky as they always carry some value, even when the stock price drops below the set price on the grant date. Interestingly, both restricted stocks and RSUs may not be based on performance criteria or, if so, those criteria are relatively unrestrictive.

Restricted Equity Awards:

REAs resemble RSUs, except the owner owns the stock and has voting rights right away.

Non-qualified Stock Options (NSOs)

This type of LTI option is unique in that it can be granted to anyone, including people who are not regular employees, such as contractors, consultants, board members, and virtually anyone else that the company sees fit.

However, unlike ISOPs, in the US, they come with fewer tax advantages. NSOs don’t qualify for capital gains tax, so the employee has to pay the income price tax when they choose to exercise the option.

Granting NSOs carries tax benefits for the company though, as it is able to deduct the spread of the option exercise. This cannot be done with ISOPs. NSOs are another vehicle preferred by firms that focus on performance.

What is phantom stock plan?

There are two ways an organization may grant the above-mentioned stock-based LTIPs like RSUs, ISOPs, ESPPs, ESOPs, and SARs - either in actual shares or cash. If the award is disbursed in cash, in lieu of actual shares, it is called “phantom.” We can think of phantom stocks as fake stock imitations that track the value of the actual stock on the date of granting until the exercise of the option or the sale, at which point the resulting profits are paid out entirely in cash.

We can divide phantom plans into two types: appreciation only and full value plans. The first ones do not include the value of the actual underlying shares themselves and pay out only the value of any increase in the company stock price over a period of time that starts on the date the LTI is granted. On the other hand, full value plans pay both the value of the underlying stock as well as any appreciation. Moreover, they can deprive recipients of some useful tax benefits that come with holding vested stock awards over time.

Phantom stocks are the means by which the key figures in your organization benefit from the company’s stock ownership without actually receiving any shares. The disadvantage to the recipient is that once the pay-out occurs, the continued upside potential of the actual stock ownership is gone. Cash-settled awards also forgo any tax benefits to the recipients.

However, if your firm prefers not to dilute shareholders' ownership, phantom shares are an ideal option for your executives’ LTIPs, offering similar performance motivating factors as the real share-based vehicles.

What is in-service liquidity?

Another caveat to consider with long-term incentive plans is whether to offer your employees a possibility to cash out during employment, which is called in-service liquidity.

With businesses that focus on retention and have a much longer incentive horizon, in-service liquidity is a standard and expected practice. In fact, its lack may create an incentive for the individual to leave over time.

On the other hand, companies whose strategy is geared towards maximizing value offer plans with a potential future liquidity event. In this approach, key figures in the organization focus entirely on the realization of this goal, and if objectives are not met the reward is forfeited. Offering in-service liquidity in such a case could actually detract your employees from keeping their eyes on the targets. Early big cash-outs might also jeopardize your firms’ financial situation hitting the company’s earnings and valuation.

Hence, whether to provide the option of in-service liquidity really depends on the long-term strategy of your business and the purpose of the LTI plan. A well-designed package can help achieve these long-term goals and keep up the performance and full commitment of the key figures in your firm.

2. Deferred Profit Sharing Plan (DPSP)

Another approach in LTIPs is profit sharing, usually deployed as Deferred Profit-Sharing Plan. In this plan, eligible candidates receive a reward based on a percentage of the company profits during a given period of time, typically once a year. Companies traded on the stock exchange tend to pay these awards out in stocks, while others usually in cash. The share pool is typically divided by weighing according to the employee’s base salary so that the prize distribution system favors top executives and other key figures who receive the larger portion of the profits.

3. Long-Term Cash Incentives

This form of LTIP is entirely awarded in cash. As with other vehicles, the prize is contingent upon the employee’s achievement of performance targets during the vesting period. The company can distribute the award either every year on an overlapping basis or every three years on an end-to-end basis.

Frequently long-term cash incentives are a part of a larger package of the executive compensation, and unlike stock-based grants, are meant to provide liquidity to the company’s material risk-takers by partially insulating them from market volatility. This is important since much of the executive compensation is in the form of stock-based LTIs. Cash incentives are also a solution for companies whose shareholders fret negative effects of overdiluting shares. In certain parts of the world, for example Gulf Cooperation Council, it's a common practice to grant cash awards rather than equity-based plans, even phantom ones, which are typically difficult for people to understand.

4. Performance Shares Units (PSUs)

PSUs are structurally very similar to RSUs, except they are much more heavily based on performance - either of the individual or the company as a whole. If the performance goals are not met, the grantee will lose the award.

PSUs can be viewed as hypothetical shares that track the current fluctuations in the market price of the stock but don’t offer actual ownership in the company or any voting rights until the actual shares are purchased. Like other phantom stocks, they are designed to simply mirror the ownership in the company.

One caveat to keep in mind when granting PSUs is to make sure to correctly position the performance metrics and clearly inform the recipients about the criteria since poor communication and badly set targets may render the award less valuable.

What is clawback?

Clawback is a mechanism that gives a company the right to reduce or entirely retract the award. Such cancellation may take place either during or after the vesting period in the following cases:

  • if the performance criteria are not met
  • if there is some form of misconduct
  • if the employee is terminated

The inclusion of clawback clauses in long-term incentive plans is becoming increasingly popular. The 2020 CGlytics study of five large UK companies - Polymetal International, DCC, Taylor Wimpey, Antofagasta, and Smith & Nephew - whose LTI plans received the highest approval rates from their shareholders, show that all of the organizations included some form of clawback in their contract. Interestingly, all of the five firms added provisions that allow them to adjust the compensation in the case the LTIP award is either excessive or inadequate based on their performance criteria.