Structuring Long-Term Incentive Plans for Privately Held Companies September 12, 2013
Speakers Denver Compensation & Benefits, LLC John Schultz, Managing Director Brennan Rittenhouse, Manager 2
Agenda Overview of Long-Term Incentive Plans Plan Structures Real Equity or Synthetic Equity Examples
4 Overview of Long-Term Incentive ( LTI ) Plans
a. Purpose Overview of LTI i. The long-term benefit of an effective LTI plan can be invaluable to the long-term success of a company ii. A well designed LTI plan aligns employee interests with those of the company s owners iii. Long-term incentives can drive employee performance, company growth, and provide a buffer against short-term drivers iv. It can also be used to help retain high performers 5
Overview of LTI (cont d.) b. Prevalence i. Approximately 75% of public companies have LTI plans ii. LTI plans are less prevalent among private companies; but are quickly catching up i. According to a 2012 World at Work survey of over 300 private companies, 61% of iii. the responding companies had some kind of LTI plan Reasons for the disparity: 1. Lack of sophistication/resources 2. Reluctance to dilute ownership 3. Minority shareholder concerns 4. Complexity 6
Overview of LTI (cont d.) c. Award sizes i. Awards are typically granted based on a percentage of ii. base salary Watson Wyatt Survey (under 1,000 full-time employees) 1. Company officers 102.5% 2. Other management 51.4% 7
Overview of LTI (cont d.) d. Correlation to short-term incentive ( STI ) plan i. Sometimes companies will coordinate their annual short-term ii. iii. iv. incentives with their LTI plans Annual performance metrics and aggregate target payouts can be established The individual incentive awards are allocated between LTI and STI (e.g., 75% LTI and 25% STI) LTI awards will have a multi-year vesting and/or performance schedules (e.g., 3 years, earnings growth, etc.) 8
9 Plan Structures
Plan Structures (cont d.) a. Public company practices i. Equity (as opposed to cash) plans 1. Favorable accounting treatment 2. Simple 3. Understood 10
Plan Structures (cont d.) a. Public company practices ii. Equity award form 1. Options a. The right to buy a number of shares at a price fixed at grant for a specified term b. Companies use an option-pricing model to calculate the value of awards as of the date of grant and expense that amount 11
Plan Structures (cont d.) a. Public company practices ii. Equity award form (cont d.) 2. Restricted Stock a. Provide employees with shares of company stock at little or no cost, subject to a risk of forfeiture ( vesting ) 3. Restricted Stock Units a. Employees do not actually receive shares until the restrictions lapse 12
Plan Structures (cont d.) a. Public company practices ii. Equity award form (cont d.) 4. Performance measures a. Time vesting b. Performance either grant or vesting i. Company performance ii. Business unit performance iii. Individual performance 13
Plan Structures (cont d.) a. Public company practices iii. Options vs. full-value awards 1. Historically options were preferred because of the favorable accounting treatment 2. A big shift to restricted stock with FAS 123R 2005 a. Companies now expense options 14
Plan Structures (cont d.) a. Public company practices iii. Options vs. full-value awards (cont d.) 3. Full-value awards concerns a. Will realize value regardless of performance b. Pay for pulse i. Because most restricted stock vests on the passage of time, employees receive benefit for simply continuing employment 15
Plan Structures (cont d.) a. Public company practices iii. Options vs. full-value awards (cont d.) 4. Option concerns a. Market conditions beyond employee control can result in awards being worthless b. Awards too far underwater lose retention effect 16
Plan Structures (cont d.) b. Private company practices i. Equity-based plans 1. Advantages of equity-based plan a. More closely mirror public company structure b. People understand the plans c. Takes care of alignment issues d. Consolidates all factors into 1 measurement: VALUE 17
Plan Structures (cont d.) b. Private company practices i. Equity-based plans (cont d.) 2. Private company issues a. Valuation challenges i. Difficult/expensive to value ii. Internal Revenue Code section 409A complexity iii. Skepticism of valuation models 18
Plan Structures (cont d.) b. Private Company Practices i. Equity-based plans (cont d.) 2. Private company issues (cont d.) b. Lack of Liquidity i. Makes it difficult for participants to realize value ii. Can lead to phantom income problems iii. Impacts perceived value iv. Cash flow issues c. Minority shareholder concerns 19
Plan Structures (cont d.) b. Private Company Practices ii. Cash-based plan 1. Using STI structure (including targets) and stretching terms 2. Adding vesting terms 3. Less favorable accounting 4. Can be difficult to set metrics that work over extended periods 5. Can be complex and difficult to understand/communicate 20
21 Real Equity or Synthetic Equity
Real Equity or Synthetic Equity a. Actual equity grant 2 basic forms i. Options ii. Restricted Stock/RSU 1. Both result in the transfer of actual equity 22
Real Equity or Synthetic Equity (cont d.) b. Phantom grants stock /SAR i. Acts like real equity, but only cash transferred 1. Phantom stock grants the right to receive cash based on the future value of the company's stock 2. SARs are the right to receive cash based on the appreciation in the value of the stock 23
Real Equity or Synthetic Equity (cont d.) b. Phantom grants stock /SAR (cont d.) ii. Closest to true equity plan 1. Avoids minority shareholder issues 2. Company provides the liquidity 3. Still has valuation issues a. Typically addressed via formula approach 24
Real Equity or Synthetic Equity (cont d.) c. Hypothetical unit grants i. Grant unit based on operations or profitability of company ii. Create a bucket where value correlates to company performance 1. Example: Contribute a percentage of profits, and use the present value of cash flows over a particular period for valuation (e.g., seven or ten years) iii. iv. Grant interest in the bucket (hypothetical company) 1. As profits of the company increase, so does the value of the bucket 2. Drives employee behavior similar to equity grant Eventual payout is in cash, based on the value of the units at the time of the payout 25
26 Examples
Example 1 Three-tiered approach ABC Co. i. Facts 1. $500 million oil and gas company 2. 300 employees 3. Private 4. Very little financial statement sensitivity 5. Short term focus; 3-5 year exit strategy 27
Three-tiered approach ABC Co. ii. Example 1 (cont d.) Plan design 1. The Participants (which include all employees) are granted phantom stock, stock appreciation rights, and shares via an ESOP, all of which vest over a four-year period 2. The target size of the award is based on the individual s position, responsibilities, compensation level, performance, historical contribution, and market practices 3. The target makeup of the award is the first 10% of base salary is made as an ESOP contribution, then equally between phantom stock and SARs up to 20% of base salary, then the remainder in SARs 28
Example 1 (cont d.) Three-tiered approach ABC Co. ii. Plan design (cont d.) 4. ESOP provides tax efficiencies, while developing a long-term ownership culture 5. Payouts a) ESOP is paid out in accordance with qualified retirement plan rules b) SARs have a 10 year exercise period c) Phantom stock is paid out upon vesting 6. Annual valuation is performed each year, which is used for all the LTI vehicles 7. Annual grants drive employee behavior and increase retention 29
Example 2 Hypothetical unit grant DEF Co. i. Facts 1. Privately held mining company 2. While pay is not generally below market, the lack of a LTI program makes it difficult to attract talent within the industry (where longterm incentive awards have become prevalent at all levels ). 3. Some financial statement sensitivity (particularly regarding cash flow) 4. Want to create an LTI plan that provides employees an opportunity to gain value while limiting potential cash flow drain at payout. 30
Hypothetical unit grant DEF Co. ii. Example 2 (cont d.) Plan design 1. Private company creates an LTI plan that grants units that track the value of the Company based on annual Reserve Valuation Reports 2. Employees granted annual awards as a percent of base salary 3. Awards vest 100% after three years (i.e., three-year cliff) 4. Awards to be paid out in cash on the fifth anniversary of grant (i.e., limited deferral mechanism to maintain incentive and retention value after vesting) 5. Discretionary dividend equivalents to be reinvested as additional units until the underlying awards on which granted vest. Dividend equivalents paid out in cash upon vesting. 31
Example 2 (cont d.) Hypothetical unit grant DEF Co. ii. Plan design (cont d.) 6. Attempt to keep it simple so employees appreciate plan A. Well developed education up front B. Annual statement to communicate value 32
Example 3 Hypothetical units and appreciation right grants QRS Co. i. Facts 1. Privately held home-health care company, CEO owns entire company 2. Pay to top executives has been historically below market, but expansion of executive team is necessary to build out new product lines 3. Owner does not want executives to receive cash out from plan unless and until he realizes certain level of gain from a transaction(s) 4. Want to create a phantom share and stock appreciation rights plan that provides historically underpaid executives with incentive value compensating for prior year underpayments and well as ability to earn value based on future growth of the company for all executives going forward. 33
Example 3 (cont d.) Hypothetical units and appreciation right grants QRS Co. ii. Plan design 1. Company creates an LTI plan that grants units and appreciation rights that track the value of the Company based on market multiple of EBITDA 2. Distributions from the plan occur upon: a participant s Separation From Service with the Company; the occurrence of a Change in Control; and/or, following the occurrence of a Change in Control, at the time an additional portion of an outstanding award becomes vested. 34
Example 3 (cont d.) Hypothetical units and appreciation right grants QRS Co. iii. Employee grants 1. Historically underpaid executives receive a one-time grant of phantom units to represent historic compensation shortfall 2. All executives granted annual award of appreciation rights, determined as a percent of base salary (using a 3x multiple for determining the number of SARs awarded) 3. Awards vest 20% on grant, and 20% on each fifth anniversary of grant 4. Remaining unvested awards vest, if at all, only following a Change in Control. 35
Example 3 (cont d.) Hypothetical units and appreciation right grants QRS Co. iii. Employee grants (cont d.) 5. Measures built into Plan to reassure executives that incentive value will be protected A. Anti-dilution provisions B. Modified Change in Control definition to account for potential spin-offs of business units 36
Example 4 STI Conversion XYZ Co. i. Facts 1. $10 million revenue billboard advertising company 2. 20 employees 3. Private equity owned 4. High growth phase; limited cash available for incentive compensation 5. Potential 5-7 year exit strategy, but far from guaranteed 37
STI Conversion XYZ Co. ii. Example 4 (cont d.) Plan design 1. The Participants (which include all employees) convert 50% of their STI award into LTI Units, which track company value based on a multiple of EBITDA 2. As an extra incentive for converting current cash into potential future payouts, the participants are also guaranteed a guaranteed 18% return on their converted cash 3. The target size of the award is based solely on current STI structure 4. Distributions from the plan occur upon: A. Separation From Service B. Change in Control C. Recapitalization of the company 5. This conversion both provides employees with a long-term focus, while reducing the current needs of the company 38
Example 4 (cont d.) STI Conversion XYZ Co. iii. Employee grants 1. In the event of a CIC or recapitalization, company value is based on a multiple of 10x EBITDA 2. In the event of a separation from service, the participant has a put right, but the units are valued at 7x EBITDA 3. Because current cash is converted into units, no vesting schedule is used 39
Questions? John Schultz Johnschultz@Denverbenefits.com 303-779-2080 Brennan Rittenhouse Brennanrittenhouse@Denverbenefits.com 303-779-2082 Denver Compensation & Benefits, LLC 7600 East Orchard Road, Suite 230 S Greenwood Village, CO 80111
Please note that, though we believe this presentation provides accurate information, its accuracy is not guaranteed. Also, this presentation does not provide legal, accounting or tax advice. Finally, this presentation cannot be used to avoid any tax penalty.