Family businesses have unique characteristics that certain candidates appreciate: a close-knit culture, nimble business processes and liberation from SEC and investor scrutiny that often introduce inefficiencies into public-company operations. Some candidates are also attracted by respect for the family members and the business success they have achieved. And family businesses often have interesting challenges that appeal to the right executives.
Yet those inducements may not be a sufficient “lure” for top talent. Savvy family businesses use creative approaches to compensation to help non-family executives decide to join — and to stay long enough to be effective. The wealth-accumulation opportunity provided by a competitive long-term incentive plan (LTIP) can be the extra incentive required to seal the deal. A long-term wealth accumulation opportunity delivered through a well-designed LTIP has proven to be a powerful magnet to attract and retain non-family members to family-run businesses.
Hurdles When Recruiting
On the surface, many family businesses appear to offer a non-family executive an unattractive option:
• No Ownership Stake. There may never be an opportunity for a non-family executive to have a real ownership stake in the success of the business.
• Fixed-Cost Aversion. Family-run enterprises frequently have an aversion to high fixed-cost pay structures. That tends to mean non-family executives earn base salaries on the low side of market value combined with a variable pay opportunity tied to aggressive performance achievements.
• Uncertain Future. The family-run business may have only a very vague succession plan in place. Consequently, when there is a change in the family’s leadership, the non-family executive’s future employment at the company can become uncertain and often is subject to the whim of the family member who serves as the new leader.
• Impact. The non-family executive’s decision-making autonomy and ability to have an impact on the businesses success can become limited when caught in the cross hairs of family dynamics and disagreements.
• No Room at the Top. The evidence suggests another challenge for non-family executives who hope to advance in a family-run business. According to The Wall Street Journal, the average tenure of a CEO at a family business is 25 to 28 years vs. four to six years at a publicly traded company. Advancement to the top for a non-family executive may never be possible. By the time the CEO reaches the end of that long tenure, the next generation of family members may be ready to assume the top leadership roles.
Some combination of these hurdles is either apparent to or assumed by candidates. The right LTIP can often help candidates see past the hurdles, addressing the financial aspects of “Why should I join?” and “What will motivate me, as a non-family executive, to stay?”
What is an LTIP?
An LTIP typically allows selected executives to participate in the financial rewards associated with the business’ long-term success. Such plans offer a significant financial award, payable in the future. The award is contingent on completion of a specified extended period of service, and the size of the final payout may be modified up or down by the company’s financial performance.
Just Released: Chief Executive’s 2019-20 CEO & Senior Executive Compensation Report for Private Companies. With data from over 1,600 private companies, it is the most authoritative resource in the U.S. for private company executive pay. Know more, pay smarter. Learn more.
Often referred to as non-qualified deferred compensation plans, LTIPs differ from qualified plans, like 401(k)s and employee stock ownership plans (ESOPs) because the company can select who is eligible for the plan. An LTIP generally is subject to the Employee Retirement Income Security Act of 1974 (ERISA). However, non-qualified plans like LTIPs typically satisfy what’s known as the “top-hat” exemption and, therefore, are not subject to many of ERISA’s more onerous requirements. A top-hat plan is limited to certain highly compensated employees typically in management, and they are exempt from certain ERISA requirements such as the participation, vesting, and fiduciary responsibility provisions.
Despite those attractive characteristics, there are distinct downsides to non-qualified plans: participant awards are subject to creditors of the employer in the event of a bankruptcy. In contrast, assets in qualified plans are protected from both employer and participant creditors.
What Types of LTIPs Are Available?
Long-term incentives can be delivered through a variety of vehicles.
This is the simplest option both to administer and to understand. A participant is granted a cash award and then receives a cash payout at a designated point in the future. For instance, the executive is granted an award worth 100% of base salary that will vest and be paid out five years in the future. The award amount is modified (up or down) depending on the achievement of a specified financial metric over the five-year period.
- Pro: Cash is the simplest concept and is typically related to performance.
- Con: Inflation and time value of money erode cash value over time. Companies may compensate by paying interest on unpaid awards or allowing participants to use deferred compensation accounts where they can invest the cash similar to 401(k) style investments.
Phantom Stock Units
Phantom Stock Units (PSUs) are a cash vehicle with the “feel” of real stock. Each unit has a value equivalent to X% of the company’s value. The PSUs vest after a significant period of time and are paid out in cash based on the company’s value at the time of payout. There are no voting rights associated with PSUs.
• Pro: Phantom stock is effective in family situations where the family does not intend to broaden ownership beyond the family but needs a means of retaining a professional management team. Another advantage is that the executive can share in the company’s financial success with the family.
• Con: This LTIP vehicle can be more complex than a simple cash plan because it will require periodic external valuations of the company. Some companies overcome this issue by defining the value of the unit for purposes of the plan as a multiple of EBITDA – earnings before interest, tax, depreciation and amortization – or the company’s book value. A detraction from the executive’s perspective is that there is also the risk that the share price could drop over time, and the value of the original grant could drop.
Phantom Appreciation Rights
Phantom Appreciation Rights (PARs) are cash vehicles with the “feel” of a stock option in a publicly traded company. Each PAR provides the right to the appreciated value of a share of the company’s stock between the date the appreciation rights are granted and the company’s designated payout date in the future. (Unlike stock options, the recipient is not allowed to choose a payout date.) If on the designated payout date the company’s stock price is below the grant date price, the PAR has no value. As with PSUs, There are no voting rights associated with PARs.
• Pro: The management team is motivated to increase the share price over time. The company has no downside risk for payouts if share value drops below the grant price.
• Con: Like PSUs, PARs require periodic external valuations of the company or the definition of the value of a share for purposes of the plan as a multiple of EBITDA or the company’s book value. From the executive’s perspective, PARs are worthless if the share price falls below the grant price and thus there is no appreciation to be gained by the executive. This can seriously demotivate the executive and create a retention risk.
Real Equity Grants
Family businesses on a strong growth trajectory may make the strategic decision to offer real equity share grants to non-family executives. That decision may be difficult to execute because of family dynamics, the desire of the family not to dilute their earnings and voting rights, or both. Typically, to avoid “family drama,” family businesses use PSUs to attract and retain star talent. However, under certain circumstances, the star talent wants “real ownership” and will not join without a grant of real equity. Usually, these circumstances are related to a situation where the business wants to create an ownership transfer as part of a management succession plan involving a non-family member.
A real equity grant LTIP does not require performance contingencies (although many companies do require the executive to earn the grant based on performance against a predesignated measure). The company simply allocates real stock after a designated time period has passed (and, if applicable, the performance contingencies have been met).
• Pro: Real Equity Grants transfer actual ownership to executives. Real equity grants to non-family members may facilitate ownership transfer and management succession.
• Con: Family harmony may be seriously threatened by differing views about a non-family in the ownership group.
Which Type of LTIP Will You Choose?
Any size family business can use LTIPs to attract and retain non-family executives as well as to facilitate ownership transfer or management succession. It is important to give serious consideration to which vehicle is best for your business today and is consistent with your long-term vision for the future of the organization.
There is no reason a different LTIP vehicle cannot be adopted at a future date. However, each change in your business’ executive long-term wealth accumulation strategy can detract from the reserve of good will and stability that current executives feel and potentially value.
The competition for talented executives continues to increase in intensity. A LTIP can help family businesses create a total compensation package that not only attracts non-family executive talent the business needs but also retains that talent to drive long-term business success.