How Do You Incentivize Contributions to Growth Without Sharing Stock?

This newsletter is about building partnerships with employees that make them want to be as committed as shareholders to company growth. A natural question that business leaders confront in that pursuit is: “How do I pay my people in a way that will make them want to contribute to achieving our financial targets?” Most private company heads stumble over this issue because they assume that achieving this outcome means they’ll need to share stock.

Business owners are reluctant to share equity because it will dilute current shareholder value. So, their dilemma is that they want to incentivize growth without giving away stock. They wonder if it’s possible to achieve both objectives. A large percentage of enterprise leaders end up sharing equity with employees because they assume there aren’t any other options. They also assume equity sharing is essentially a requirement for compensating certain positions or attracting certain kinds of talent. And in some instances, that may be true. ?

However, more often than not, when a current or potential key person asks for stock, what they’re really requesting is a means of participating in the value they help create. In doing so, they, too, assume equity sharing is the only solution because no one is talking to them about alternatives. So, pay negotiations get fixed on the subject of equity sharing, and many stall because of it.

The good news is that there are alternatives to sharing stock that are often better for both company owners and employees. So, if you lead a company, here are six long-term value-sharing strategies you should consider before deciding to give away stock.

Profit Pool

A Profit Pool is the simplest of all long-term incentive plans. The sponsoring company selects a percentage of annual profits to contribute to a pool that will be used to pay benefits to employees. The percentage allocated to the pool may reflect an amount above a minimum profit threshold—what some call “productivity profit” (value creation attributable to the performance of employees). The pool contribution is then allocated among the plan participants.

The company can be discretionary in determining the allocation formula in a profit pool. The contribution period continues annually for several years before payouts begin. (The pool may or may not be credited with interest.) Three years is common. If that’s the period chosen, the company would pay one-third of the accumulated value to each participating employee at the end of year three and carry the remaining two-thirds forward.

The profit pool's idea is to help drive company growth. The pool grows as profits grow. Likewise, the annual payout to employees (beginning after the third year) would increase as the pool gets larger. When employees leave the company, they customarily forfeit any remaining balance they’ve accumulated in the pool, which helps to retain key contributors.

Performance Unit Plan (PUP)

A Performance Unit Plan (PUP) is a long-term incentive that awards units to employees who meet certain value creation standards. At the time it’s granted, each unit has a “par” value that is expected to grow based on two or more financial metrics the company uses to determine the benefit participating employees will receive. The units will be converted to cash payments at a future date (commonly three or four years).

For example, a company may establish a PUP with a unit price (par value) of $100 (determining the starting value is completely arbitrary). After it establishes the initial unit value, the company will next create a table that illustrates targeted improvements in two important metrics - such as margin improvement and sales growth (any metrics will do - even department level ones). The table will show the employees how much the value of the PUPs will grow if the specified metrics are achieved. The employees are then rewarded for meeting the targets outlined. Commonly, the company will award new PUPs each year with either the same or different targets. Alternatively, new PUPs may be issued at the end of the first payment, thus beginning a new cycle.

Each year’s units are redeemed at the planned period (typically three to five years in the future). ?Employees must still work at the company to receive the PUP payout. Consequently, PUPs have a built-in retention element. If an employee walks away from a company, he or she is walking away from a certain amount of PUP value.

Strategic Deferred Compensation

A Strategic Deferred Compensation Plan is a performance-based retirement program. Individual non-qualified retirement accounts are created for the plan participants (typically executives and senior managers). The company establishes an annual performance target, which, if achieved, leads to contributions to the participants' accounts. Better results lead to higher contributions.

Once the contribution has been made, participating employees are given the ability to self-direct their account allocation among a variety of investment options. The investments are handled the same way as a standard deferred compensation plan and are subject to the same limitations and risks. Plan accounts are also typically subject to vesting schedules.

Full Value Phantom Stock

A Phantom Stock Plan is essentially a deferred cash bonus program tied to the business's value increase. “Full value” simply means that the phantom equity shares that are distributed have value from day one. Full-value phantom stock creates a similar result as a restricted stock plan.

In establishing a plan, the sponsoring company determines a phantom stock price through either an internal or external valuation of the company. (Most private companies create their own formula for determining phantom share value.) Participating employees are awarded some number of phantom shares with specific terms and conditions. At a future designated time, active plan participants will receive a cash payment equaling the value of the original shares plus appreciation.

For example, assume an employee receives 100 phantom stock shares with a starting price of $100. At a pre-determined future date, the company will calculate the phantom stock price (usually based on a formula) and pay the employee the full value. If the share price (in our example) grows to $180, the company will pay the employee $18,000 (100 shares times $18 per share).

Phantom stock plans do not result in shareholder dilution because actual shares are not being transferred. Employees do not become owners. Instead, they are potential cash beneficiaries in the underlying company value. Phantom shares result in ordinary income taxation to the employees when a plan distribution is made.

Performance Phantom Stock

A Performance Phantom Stock Plan is one that grants shares based on the achievement of certain value contribution standards. Inherently, it contains two distinct performance-based elements:

1. To receive shares, employees must hit certain pre-determined performance targets. If they do so, they are awarded phantom shares. The number of shares may vary by employee and by the degree to which the targets were achieved. Financial targets might include measures such as company pre-tax income or EBITDA.

2. If employees want to see the value of their shares increase, they must continue to contribute to company growth. This is because the potential improvement in business value translates to phantom stock share appreciation.

Once awarded, the performance phantom shares may remain subject to vesting schedules or other restrictions. The tax effect on employees is identical to that of phantom stock.

Phantom Stock Options

A Phantom Stock Option Plan mirrors the results of a regular stock option plan but with fewer complications and without the transfer of real equity shares. In this type of plan, the sponsoring company determines a phantom stock price through an internal or external valuation of the company, just as it does with a traditional phantom stock plan. As with a regular plan, employees are awarded a certain number of phantom options that carry specific terms and conditions.

However, as opposed to a regular plan, in a phantom stock option arrangement, should the share value appreciate over time, employees will receive a cash payment equaling the difference between the original and appreciated prices. Using our previous example, let’s assume an employee receives 100 phantom stock options (PSOs) with a starting price of $100. At a pre-determined future date, the company will calculate the current value of the phantom stock price and pay the employee any positive difference between it and the original share value. In this example, if the share price grows to $180, the company will pay the employee $8,000 ($18,000 current share value minus the $10,000 original share value).

As with regular phantom stock. PSOs result in ordinary income taxation to the employees when benefits are distributed.

There is certainly no “one size fits all” when creating a plan that rewards long-term contributions to value creation in a business. The primary role of any value-sharing approach is to define and clarify an employee's stewardship for outcomes upon which sustained company performance depends. Therefore, if you start by identifying those roles and outcomes, the type of plan that best reinforces them will become more apparent. If improved profits are the priority, then perhaps a profit pool is the best solution. If you have senior people who need to drive the business model and strategy on multiple levels that, in turn, fuel the company's growth trajectory, then some form of phantom stock might be most suitable. And so on.

It’s important to understand that private company leaders and owners do not have to share stock to incentivize sustained employee performance. There are other ways to share value with key contributors. And more often than not, one or more of the six alternatives just discussed will work better for both shareholders and employees.