The Case for Long Term Incentives in Private Companies

This blog is written with our compensation partner and long time collaborator Kieran O’Reilly of Flintlock Consulting.

When the need arises to attract an executive from a public company, when the owner decides to step back from the CEO role, or wants her executive team to focus on strategy, are typically events that cause private companies to consider whether they need a Long Term Incentive (LTI) for their executive team.

Public companies began awarding equity compensation because it represented minimal cost; there was no requirement to expense the NPV upon award and the eventual, deferred payout was funded by “market” increases in the stock price. The negative was dilution of existing shareholder ownership positions.

The principle argument for equity based awards is to align executive compensation with the financial returns experienced by investors. While executives do not place their wealth at risk by making the cash investments that investors do, their compensation will fluctuate in line with an owner’s return as share price and dividends change.

Over the years the introduction of reporting requirements and expensing rules have made awards more transparent and they are here to stay and executives, whether in large public or private companies have come to expect that an LTI will feature prominently in their compensation package.

Private companies do not have the daily pricing mechanism or the liquid market for their shares that public companies do, nor do they have the flexibility to freely issue stock to provide LTI awards. Most importantly and because of these restrictions they are unable to rely on the market to eventually fund the payout when the executive sells the stock underlying the award.

Owners are often reluctant (or are unable) to dilute ownership because this is in conflict with the ethos behind the formation of the company. Other owners we have worked with argue that any form of employee ownership creates misdirected motivation, with executives subconsciously envisioning potential sale of the business when the proprietor’s intention is to pass ownership to the next generation.

In their efforts therefore to retain executive talent, private companies tend to focus on base salary and annual incentive but this impedes longer term planning and in the worst cases encourages “burning of the furniture” to improve annual awards. This too as a compensation philosophy has its downside for owners.

Companies concerned with ownership dilution and motivating the wrong behaviors often forgo the generation of the necessary focus on long-term business strategy (spanning more than the year ahead) and indeed may as a consequence, attract the wrong skills.

The challenge then is how to motivate multi-year investment strategies and retain an executive team who are likely to have expectations that a part of their reward will be some form of capital accumulation. An executive team without a financial interest in the long-term success of the company will not be committed to developing a meaningful long term strategic plan, motivated to stay with a company or exposed to the financial effects of their long term capital allocation recommendations. Capital investment decisions will therefore remain the responsibility of the owners.

While the leverage at the disposal of public companies with widely available equity is not a facility available to private companies, they can motivate long-term strategic performance without equity ownership and its associated concerns. In fact, private companies have an advantage in being able to design long term incentive compensation plans that do not have the exposure to the macro-economic influences that affect share prices in the market. In other words, volatility is reduced enabling more effective long term performance rewards.

Well-constructed long term incentives attached to achievement of long-term business objectives will relieve owners of sole responsibility and commit management to long-term strategic decisions. When aligned with internal objectives compensation remains an effective and powerful motivational tool.