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Why Performance Units Plans Offer Superior Flexibility Over Phantom Stock and SARs (Stock Appreciation Rights)

Overview

The compensation package for key employees and professionals offered by many privately held companies includes an annual bonus tied to financial performance. However, relatively few sponsor a long-term incentive plan tied to the future growth and appreciation of the business.

In contrast, the total rewards package for senior executives of publicly traded companies virtually always includes a long-term incentive plan (LTIP) designed to focus the attention of the leadership team on the achievement of long-term financial and strategic goals. Those programs typically include a balance of retention and performance incentives in the form of Restricted Stock (or Restricted Stock Units) and Stock Options (or Performance Stock Units).

While many owners of privately held businesses tell us that they want to encourage key employees to “think like shareholders,” they are reluctant to (or simply cannot) grant true equity interests to key employees.

As a result, the answer for those privately held businesses that do offer an LTIP is a “phantom” or “synthetic” equity arrangement such as a Phantom Stock or Stock Appreciation Rights Plan (or in the case of an LLC taxed as a partnership, a Profits Interests Plan).

While each of these plan structures has certain advantages in specific situations, EBS has found the Performance Units Plan (PUP) format to be most flexible and effective in encouraging key employees to think and act like shareholders.

Core Principles of Long-Term Incentive Plan Design

The EBS planning process is based on certain fundamental plan design principles:

• Alignment of the interests of the leadership team and the shareholders / owners
• Sharing of Value in the future growth and appreciation of the business
• Balancing Incentives with respect to fixed versus variable pay, short-term versus long-term, performance versus retention, on-going operations versus maximization of potential sale price
• Transparent and Relevant Performance Metrics over which the leadership team has substantial control, and with respect to which there is a direct “line of sight” from performance to compensation
• Frequent Communication to reinforce the potential value of the plan and deliver a clear message that each member of the leadership team is critical to the future success of the business
• Flexibility to adapt to changes in corporate structure, the leadership team, industry trends and the overall business environment

Maximizing Flexibility with Performance Units Plan

In comparison to Phantom Stock or SAR plans, the PUP format provides far greater flexibility to custom design a program that is responsive to the needs of the key employees and creates an opportunity for them to share in the long-term growth and appreciation of the business in a manner consistent with the company’s financial and strategic goals.

One area in which that flexibility is important is the selection of the performance criteria on which the long-term incentive awards are based. With a phantom stock or SAR plan, the only metric is stock value. That approach violates a couple of our fundamental principles of design. Key employees may have a limited impact on share value. While it is important for all key employees to be focused on the long-term growth and appreciation of the business, it may be more effective to base incentives on performance criteria over which they have control, such as revenue growth for Sales executives, Financial criteria for the CFO, etc.  The Performance Units format permits the use of dual criteria – an individual or department metric as well as long-term company value using an EBITDA-based (or other) formula.

In addition, a formula-based approach to valuation of the performance units eliminates the need for an expensive annual appraisal and ensures a consistent comparison of results achieved over the performance period.

Vesting is another area in which the PUP structure provides significant flexibility. Vesting schedules (both time-based and performance based), can be tailored to each participant to reflect varying retention targets or individual goals.

The performance plans EBS designs are also generally linked to a nonqualified deferred compensation program that allows the company and the participants to structure the timing of benefit payments in a manner consistent with corporate objectives (such as with “milestone” awards for strategic goals) and coordination with personal financial plans for the executive.

And finally, the Performance Units Plan format works well in other situations such as:

• A US operation of a foreign owned company
• A Private Equity owned company
• An ESOP owned S Corporation
• A company pursuing exit planning

EBS Planning Process

EBS offers total plan design and management services. The planning process is collaborative and customized for each client, but includes:

• Extensive Factfinding to gain a clear understanding of the nature of the business and the key drivers of long-term value, the shareholders’ financial and strategic goals, and any issues related to the attraction and retention of talent
• Design and Analysis that considers a range of planning options supported by comprehensive financial modeling of the potential benefits for participants and the financial impact on the company and shareholders
• Participant Communication and Education supported by the development of communication materials and programs in a format used by the company for executive benefit programs
• Implementation with holistic support including documentation, regulatory filings (if necessary), and a recordkeeping and reporting system
• On-Going Plan Management including participant and corporate recordkeeping and reporting; compliance and risk management; on-going technical support; and periodic assessment of operating and cost effectiveness

Final Thought

In comparison to Phantom Stock and SAR plans commonly used by privately held businesses, the Performance Units Plan structure provides a framework for a more effective long-term incentive program to:

• Distinguish the company’s compensation and benefits programs from its competitors for talent.
• Provide significant value to participants, subject to the achievement of specific financial and strategic goals and objectives.
• Deliver a message to the key employees that each plays a critical role in the future growth and appreciation of the business and should share in the value created.

EBS has worked with a wide range of privately help businesses with a variety of corporate structures and operating in various industries.

While each situation is different, there is one thing most of our clients have in common – an urgent need to attract, retain and appropriately compensate talented managers and professionals. We are confident that we can help!