What is a long-term incentive plan?

Under a long-term incentive plan, a company rewards those employees who can reach goals which result in an increase in the shareholder’s wealth.

The employees must fulfil specific requirements and conditions in LTIP. There are different types of LTIPs, and recipients obtain capped options along with the stock rewards.

LTIPs are geared towards employees, however, the policy is a function of the organisation itself aiming to achieve long-term growth. After creating a match between the company’s LTIP and the growth plan of the company, the employees ascertain the areas which require the most attention to improve the business growth prospects and the earning potential of the employees through compensation.

By employing the incentive plans, a company can retain the top talent in the evolving and highly competitive business environment.

Frequently Asked Questions (FAQs)

How does a Long Term Incentive plan work?

What are the categories of long-term incentive plans?

LTI can be divided into three broad categories namely:

• Appreciation based: The incentives are extended to the employees based on the value of the company which is reflected through the share prices in the case of the public companies. The employees will obtain the difference between the value of the underlying unit in the future and the value of the underlying units when the stocks appreciations rights were received.
• Stock based: The value is given to the employees in form of the company’s stock. The incentive might be tied with the achievement of specific goals, but the employees will gain the company’s share ultimately. The company might grant the phantom shares in which the value of the underlying shares is tracked but cash is used for payout purposes.
• Cash based: The value to be delivered is not tied with the company’s shares and delivered in the form of cash. The cash payout will be received by the employees based on the services extended by them or the achievement of the company’s goals or both.

What are the long-term incentive vehicles?

Stock options: This incentive vehicle gives the right to the grantee to purchase the company’s share at a pre-determined price in the future. The fixed price is generally the closing price of the stock on the date of the grant. After the completion of the vesting period, the grantee can exercise the right to purchase the company’s stocks.

The time frame during which the grantee can exercise its option to buy the share is known as the term. Generally, the term is 10 years. In case, the value of the shares is lower than the predetermined price (decided during providing grant), then the options do not have any value and these options are termed as underwater.

Stock Appreciation Rights: SARs performs like the stock option. The only difference is that the grantee will receive the change in the value of shares in the form of cash. The grantee is not required to purchase the shares but will receive the cash in exchange for the value of the shares.

Restricted stocks: These LTIP vehicles are based on the fixed length of the time. The equity can be granted based on the number of the shares or based on the value.

Performance units: They are full value shares, and the vesting is dependent upon the predetermined performance goals. The goals can be relative, absolute, internal, external or both. They are popular because they can be easily linked with long-term performance and payout.  

Long term cash units: These are long-term non-equity-based grants and the payout is made in cash. The cash will be received by the grantee faster the completion of the vesting period.

Performance cash units: These are long term cash-based grants which are based on performance achievement. These vehicles are most common in the private companies because it has share valuation difficulty.

What is vesting?

The long-term incentives are granted with a vesting period. Chiefly, the grantees are granted equity conditionally, and the employees do not own it until the vesting period on the LTI expires. It is a retentive feature of LTI, the grant is forfeited until the grantee fulfils all the requirements related to the vesting. For example, the employee is required to remain an employee of the company till a specific time after meeting the performance goals.

The vesting period can be divided into two types namely, ratable and cliff. In the cliff vest type, the whole awards are paid out at once after the completion of the vesting period. In the retable vest type, the awards are paid out in portions. For example, paying 25% of the award after 4 years only.

In case the employees end their employment with the company before the completion of the vesting period then the employees still have the ownership of the wared that has vested.

Who should receive long-term incentives?

LTI holds more significance for the employees who are at a higher level as the organisation’s value is affected by those employees whose vision aligns with the long-term vision of the organisation. For example, the policy of the company extends performance shares grant after the achievement of the net income target. The CEO of the company will be able to influence the profitability, however, the entry level account will not be able to achieve the targets. The performance based LTI is not suitable for the lower-level employees as they cannot impact the performance significantly. LTI for lower-level employees should focus on retention.

Lastly, LTI has more prevalence for publicly listed companies because of the ease of valuation and liquidity.