Long-Term Incentive Plans
While a well-structured short-term plan can be quite effective in aligning a company’s and employee’s shared short-term interests, there’s usually a meaningful difference when it comes to a person’s longer-term goals, making long-term plans necessary as well. A simplistic approach structures long-term plans the same as short-term ones—but with longer assessment periods. Yet it’s only when incentives begin to take the form of equity do most employees truly begin to think—and act—like owners. And there’s a big increase in productivity and retention when someone transforms from a well-paid employee into a highly motivated owner. For this reason, many long-term plans take the form of equity-incentive programs.

By effectively using equity incentives, a private company can achieve four main goals in its talent strategy:
1. The alignment of employees’ interests as owners;
2. The preservation of a company’s current cash levels;
3. The creation of potentially large rewards for the risks inherent in the business; and
4. The hiring and retention of top employees.

The Importance of Context
Before we address the main types of equity incentives available to private companies, it is first necessary to speak about the context for granting them. Specifically, an equity-incentive program should not be developed without first answering three central questions:

1. What are the objectives of the program?
A private company must consider its objectives and how they might best be achieved through an equity-incentive program.

a. What are the main purposes of granting equity awards?
b. How egalitarian does the company wish to be in making equity grants?
c. Is the company worried about its cash position?
d. How tax-sensitive is the company?
e. Is the company focused on the financial accounting implications of its program?
f. Is the company concerned about potential control issues?

2. How is the business organized and capitalized?
The legal structure of the business will also influence the composition of its equity-incentive program. Certain types of equity awards don’t work (or don’t work well) if, for example, the entity is structured as a limited liability company or some other partnership for tax purposes. Therefore, a key question will be whether the business has been organized into a C corporation, an S corporation, an LLC or other type of legal entity. Indeed, the initial choice of entity is often based in part on its flexibility in creating an equity-incentive program.

Along with legal structure, the company’s capital structure must also be considered. Investors often impose covenants for equity grants, and complex capital structures can themselves lead to restrictions on certain types of grants.

3. What is the business’s exit strategy?
Understanding a company’s exit strategy is also important in constructing a plan. Companies that are planning to create liquidity through a sale or public offering can use structures that generally assume the liquidity will be available within a shorter period of time. These structures will usually be laden with restrictive covenants designed to facilitate such an exit.

In contrast, companies that rely on internal succession are more apt to rely on grants that produce current income for the employee and can easily be cashed out by the company, either upon vesting or when the employee retires or is terminated. These structures will also incorporate restrictive covenants, ones designed to ensure continuous control and ownership within a select group of owners.

A Comprehensive Selection
With a complete understanding of the context for granting equity incentives, we can identify the most appropriate structures for the company.

1. Equity grants
Perhaps most simplistically, a company may grant straight equity interests—usually stock or LLC interests—to its employees subject to a vesting schedule. This structure offers the immediate sharing of interests, with the recipients becoming equity holders upon grant as long as they remain at the company throughout the vesting period.

The company may require recipients of these “restricted” grants to purchase the equity at its fair market value as of the grant date. For tax purposes, the holders generally recognize ordinary compensation income at the time of vesting equal to the value at that time, less any purchase price paid. A tax election, however, is available to recognize any compensation income at the time of grant, thereby allowing future appreciation to be subject to capital gains treatment. In most cases, the company will get a tax deduction for any compensation income recognized by an employee.