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Why Your Company Needs a Long-Term Incentive Plan (LTIP)

October 19, 2017 • By Ken Gibson

For ages, business leaders have struggled with whether or not they should have a pay plan in place that rewards long-term value creation.  They wonder if they need a plan in order to attract the right kind of people.  They wonder whether it will have an impact on the performance of that talent once it’s at work in the business.  They wonder what kind of plan is appropriate for their company.  They wonder who should be included in the plan.  They wonder what performance metrics should drive plan payouts.  They wonder if they can “afford” such a plan and what it will “cost” them.   All that wondering creates paralysis—often leaving the company with no plan at all.  And the wondering cycle starts all over again. 

Exacerbating that “wonderment” are articles and research that emerge periodically that suggest long-term incentive plans are unproductive.   For example, a 2016 article from Harvard Business Review highlighted a study conducted by Alexander Pepper that carried the headline:  The Case Against Long-Term Incentive Plans.  The title makes the conclusion of the study apparent.  Here is the summary statement that underlines the study’s findings: 

“My research suggests, somewhat perversely, that companies would be better off paying larger salaries and using annual cash bonuses to incentivize desired actions and behaviors,” he says. Additionally, they should require leaders to invest those bonuses in company stock (or should pay the bonuses in the form of restricted stock) until a certain share of leaders’ net worth, or some multiple of their annual salary, is invested.  As long as executives hold substantial equity, Pepper says, their interests will be aligned with those of shareholders—and this arrangement would achieve that aim without the confusion and inefficiencies of long-term incentive plans.

Why do I raise the argument against long-term incentives in an article whose title asserts your company should have one?  I do so because I want you to be aware that there are theories that suggest such plans are over rated and too prevalent.  However, most of those studies are of public not private companies and a majority of them look at LTIPs through the lens of motivation.  They try to answer the question: Does a long-term incentive plan inspire greater performance?  When they can’t draw a straight line between results and what people are paid, they set out to gather data that supports that premise.  And it’s not hard to find.  (Just read the full article to see what I mean.)

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The problem with these studies, however, is the premise.  At VisionLink, we don’t disagree that you can’t draw a direct correlation between incentives and results, yet we still strongly recommend every company have a plan that is tied to long-term outcomes and business growth.  The reason is because behavioral modification is not the role of an incentive plan—whether it be long or short-term.  Rather, there are five reasons why we believe long-term value sharing matters. 

Before enumerating those reasons, let me first clarify an issue.  In discussing the importance of rewarding long-term performance, is important that we make a pivot from the term incentive plan to the concept of value-sharing.  There is a subtle but important distinction between the two.  The term “incentive” implies a company will reward certain “behaviors”—and that the plan is the chosen mechanism to influence those behaviors.  Too often, this becomes manipulative and the plan backfires.  When it does, both employees and owners are left frustrated.  That’s the conclusion of the study referenced earlier.  

Value sharing, on the other hand, rewards certain defined “outcomes.”  It has a different philosophical foundation.  Through this approach, ownership makes assumptions about what kind of value increases can be realized through the achievement of certain targeted or superior performance results.  It then decides how much of that value it’s willing to pay out or “share” with those who produce those results.  It shares “the wealth,” if you will, from additional value that has been created (beyond the ongoing performance levels needed to sustain the business) with those who help produce it.  It’s a self-financing approach; no value is distributed unless that value has been first defined and produced.   All of this should be part of a compensation philosophy an organization creates to articulate how the company defines value creation and what it believes about how and with whom it should be shared.

Every company must determine for itself which plan or combination of plans will best encourage the outcomes it wants to achieve and will meet the criteria set forth by its philosophy.  It is not the intent of this article to make a judgment about which is most effective or to describe the advantages and disadvantages of different value-sharing approaches.  Instead, we want to consider why such plans matter and how they make companies more productive while multiplying wealth for all stakeholders.

With that understood, let’s now move on to why long-term value-sharing matters.

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#1: Value-Sharing Protects Owner Interests

Those who argue that incentive plans don’t motive higher performance are missing the point.  They don’t understand one of the primary roles of compensation.  Shareholders have significant capital tied up in the businesses they own.  They deserve a return on that capital and, therefore, a return on the compensation investment they make in their people.  The design of rewards, therefore, needs to ensure that pay holds employees accountable (those individuals in a position to influence the growth trajectory of the business) for improving shareholder value and driving productivity profit.  If employees are not financially “a risk” in this regard, then the growth partnership owners should be nurturing with their people is out of balance.  There is no “incentive” to adopt an ownership mindset about “what’s important” to shareholders if there is no part of an employee’s pay that is tied to the future company.  As a result, shareholder value is vulnerable.

#2: Value-Sharing Attracts the Best Talent and Magnifies Results

Those of superior talent are attracted to the value-sharing concept because they recognize they will participate financially in the growth they help create.  I’m talking here about “catalysts”—those possessed of abilities that can literally accelerate the growth of the business.  Catalysts represent the kind of talent most businesses should be trying to attract.  There is competition for them in the marketplace because there is a shortage of these kinds of highly-skilled individuals.  And you are not just competing against other companies for them.  Most catalysts will start their own business if the opportunity with your organization doesn’t mirror the entrepreneurial experience they’re looking for—including and especially financially.   

In an interview with TV talk show host Charlie Rose not long before Facebook went public, Mark Zuckerberg said this:

I actually think the biggest thing for us is that a big part of being a technology company is getting the best engineers and designers and talented people around the world.  And one of the ways that you can do that is you compensate people with equity or options.  Right?

So you get people who want to join the company both for the mission because they believe that Facebook is doing this awesome thing and they want to be a part of connecting everyone in the world.  But also if the company does well then they get financially rewarded and can be set.

… we`ve made this implicit promise to our investors and to our employees that by compensating them with equity and by giving them equity that at some point we`re going to make that equity worth something publicly and liquidly -- in a liquid way. Now, the promise isn`t that we`re going to do it on any kind of short-term time horizon. The promise is that we`re going to build this company so that it`s great over the long term. And that we`re always making these decisions for the long term.  (From a transcript of an interview on Charlie Rose, PBS, on November 12, 2011. Emphasis added.)

The point Zuckerberg is making has little to do with whether or not a company plans to share equity or go public.  There’s a larger principle he’s defining.  When companies can attract and retain the kind of people that think and perform as he describes, they are in a unique position to sustain results.  This is because a distinct and lasting interdependency emerges between the employees’ skills and the company’s resources that extend those skills (capital, co-workers, suppliers, products, technology, etc.).  Talented contributors soon learn that their skills are not as unique and applicable outside the company (that is providing the laboratory for nurturing and magnifying them) as they are within the enterprise. That’s a good mindset for company talent to have because of the mutual dependency it creates.  Long-term value sharing reinforces that interdependence. 

#3: Value-Sharing Reinforces the Company’s Business Model

A sustainable business model depends, in large part, on a culture that is committed to and, ideally, “invested in” that model’s reinforcement and success. This is foundational to a competitive advantage.  As a result, having key members of a workforce aligned financially with the business model makes both common and strategic sense.  The importance of this concept stems from the nature of the virtuous cycles the model is intended to produce. 

Four Seasons, Verizon and Amazon all have distinct business models and, by extension, unique virtuous cycles.  So, it only stands to reason that their compensation strategies will be equally distinct.  While they may share some common approaches to rewards (giving equity for example), the metrics and measures that act as gate keepers to payouts (or earned shares, as the case may be) must reflect and reinforce the virtuous cycles relevant to each business.  Companies that don’t have a long-term plan for value-sharing that does this can’t expect their workforce to treat those cycles as the sacred sources of sustained success they are intended to be.

Long-term value-sharing reinforces a business model by communicating to key people where the leverage points are and what those employees’ roles are in the model’s fulfillment.  If they understand that connection, and their long-term pay holds them accountable for achieving those outcomes, the virtuous cycle is protected.

# 4: Value-Sharing Protects against Bad Profits and Promotes Good Profits

In his book The Ultimate Question, Fred Reichheld, a Bain Fellow and founder of Bain & Company's Loyalty Practice, offers the following on the subject of 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 everyone’s 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 strictly short-term focus.

#5: Value-Sharing Builds Trust and Trust Accelerates Results

At its core, value-sharing is about turning a company’s workforce into partners in building the future company.  Such a philosophy presumes ownership feels that sharing value with those who help create it is as much a matter of fairness as one of strategy. Truth is, fairness is smart strategy. Why?

Companies that want to effectively compete must have a culture that is capable of perpetuating success, and has that expectation.  The culture of confidence that takes root in such environments is the ultimate source of a competitive advantage, because culture is not “copyable.”  Another company may be able to replicate your products but it can’t reproduce your culture.

Confidence is rooted in an environment of trust.  Value-sharing communicates and builds trust because, in part, it is a fair approach to rewarding those responsible for value creation—and trust is the key to accelerating results.  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)

When you pay people in a way that communicates you want them as partners in building the future business, you are, in essence, saying: “I have confidence in you and trust your ability to get results.  To prove it, I’m willing to share some of the value you help create.”  Unfortunately, many business leaders don’t think about compensation as a trust conduit.  As a result, they often view long-term value-sharing arrangements as an additional cost that needs to be minimized or eliminated.  They fail to recognize that trust accelerates value creation…and value-sharing builds trust.

In summary, every company should have a long-term incentive plan—and now you know why.

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When it comes to building a compensation strategy, you can trust that VisionLink knows what works and what doesn’t. We are ready to share that knowledge with you.

Ken Gibson

Ken is Senior Vice-President of The VisionLink Advisory Group. He is a frequent speaker and author on rewards strategies and has advised companies for over 30 years regarding executive compensation and benefit issues.