Capital Quarter: Long term incentive plans (LTIPs): what you need to know
What are the benefits of LTIPs, and how are they designed and measured?
LTIPs are a method of rewarding and motivating employees via deferred compensation. They enable a company to align employees with its business growth plan, incentivise staff contribution and boost retention. Generally these plans vest over a three- to five-year period, with cash or equity settled payments linked to the company’s performance.
In private companies, LTIPs can be used to create tax-efficient performance incentives when combined with share buyback schemes, which create liquidity for the recipient. Private equity firms often use these to great effect to incentivise the management team, when a company is building up to an exit event or is pre-float.
In public companies LTIPs, which can be directly linked to increasing shareholder value, tend to align management with the business plan more than bonuses do. This is because bonuses often become part of salary expectations.
UK government-approved schemes include Save As You Earn (SAYE), Company Share Option Plan (CSOP), Enterprise Management Incentives (EMIs) and Share Incentive Plans (SIPs).
In the public market we generally see:
- around 10-20% of the equity pool allocated for management share options
- executive management receiving up to 50% of total remuneration in share-based incentives
- schemes with multiple vesting tranches based on financial targets, business milestones and shareholder return.
The LTIP of the iceberg
When it comes to designing the pay-out structure of an LTIP, there are endless possibilities. A balance must be struck between setting achievable performance targets and offering appropriate options that ensure staff are motivated and incentivised to contribute to shareholder value.
We take a quick look at three main types below:
Tenure – helps to retain staff, and shares the growth of the company.
Options to subscribe for 300,000 ordinary shares in the company’s share capital, vesting over three years. 100,000 options are granted on the first, second and third anniversaries of this agreement. The strike price: upon exercising these subscription rights, the options holder pays 6 pence per warrant share.
Shareholder return – aligns performance directly with shareholders’ preferences.
1,000,000 options to subscribe are granted if the company’s total shareholder return (TSR) exceeds the competitor TSR. TSR is calculated as the difference in the 10-day volume weighted average price of each company’s shares, at the beginning and end date of this agreement.
Target based – can be aligned to financial KPIs or business objectives
250,000 options to subscribe are granted if the company completes an environmental, social and governance (ESG) sustainability report (as part of its annual report) which indicates a minimum 10% improvement in all areas on the previous year.
Fair valuing share-based payments under IFRS2
Once an appropriate model (such as Black-Scholes, Binomial, or Monte Carlo) has been selected to fair value the scheme, the company must carefully consider the areas of judgement in the valuation.
Two of these are:
Time to maturity
Sometimes this is overlooked, just being viewed as the option expiry period (for example, ten years). But the company should consider the possibility of early exercise, bearing in mind these factors:
- The average length of time similar options have remained outstanding in the past.
- The price of the underlying shares. Experience may indicate that the employees tend to exercise options when the share price reaches a specified level above the exercise price.
- The employee’s level within the organisation. For example, experience might indicate that higher-level employees tend to exercise options later than lower-level employees.
- Expected volatility of the underlying shares. On average, employees tend to exercise options on highly volatile shares earlier than on shares with low volatility.
Share price volatility
When considering the share price volatility, the valuer should not only include daily movements from the inception of the company. They must also look at the following factors:
- Implied volatility from traded share options on the entity’s shares.
- The historical volatility of the share price over the most recent period that generally corresponds to the expected term of the option.
- The length of time an entity’s shares have been publicly traded. A newly listed entity might have a high historical volatility, compared with similar entities that have been listed longer.
- The tendency of volatility to revert to its mean (its long-term average level), and other factors indicating that expected future volatility might differ from past volatility.
If you would like to discuss any of the issues raised in this article, please contact James Savage