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LONG-TERM INCENTIVES

Axiomatic Consulting | Graphic BlockOver the last few months, several exasperated clients have expressed difficulty determining new grants for their Long-Term Incentive Schemes (“LTI”) and/or are questioning the effectiveness of the current LTI given the financial uncertainties relating to Covid-19 and post pandemic financial landscape.

Without being inane and stating the obvious, LTI is a vital component of your Employee Value Proposition (“EVP”) and influences the company’s ability to attract and retain talented individuals, introduce a high-performance culture and ensuring the attainment of the company’s strategy- ultimately resulting in increased profitability.

Perhaps The Time Has Come To Comletely Re-Engineer your LTI

Let’s examine a few truths about current LTI schemes extracted from behavioral psychology:

  • The most important observation from behavior psychology is that executives are prone to hyperbolic discounting. Assume I was to receive $100 in 3 years. The present value (the value today) should simply be the future value discounted by the risk-free rate applicable in that country – as a global average this would probably be around 5% per annum. $100 would then be worth $86.38 today – a discount of 14%. Executives however discount the $100 by almost 50%.
  • Executives are risk adverse and prefer a smaller guaranteed amount to a possible bonus of higher value.
  • Inclusivity Recognition Need – in various surveys, only 50% of executives state that an LTI is an effective incentive but 66% stated that they valued the opportunity to participate in such a scheme.
  • LTI’s have always been proposed as the ideal vehicle to address Agency Theory which states that by bridging the divide between the executive and company, this will ensure that both are working towards a common goal and the implication is that both will strive to increase the long-term value of the company.

However, various studies have shown that there is LITTLE correlation between LTI schemes which are designed on the Agency Theory methodology and/or incorporate the agency philosophy, and the share price. If shareholders do not receive the benefit of a higher share price, why have an LTI, in its current format, at all?

Axiomatic Consultants Possible alternative incentive designProfessor Alexander Pepper in his article, “The Case against Long-Term Incentive Plans” which was published in the Harvard Business Review, October 2016 issue states:

”My research suggests, somewhat perversely, that companies would be better off paying larger salaries and using annual cash bonuses to incentivize desired actions and behaviors. Additionally, they should require leaders to invest those bonuses in company stock (or should pay the bonuses in the form of restricted stock) until a certain share of leaders’ net worth, or some multiple of their annual salary, is invested”

 

According to Pepper, if executives continue to hold substantial equity, their interests will be aligned with those of shareholders and achieve the Agency Theory. What alternative LTI design would achieve this aim and simultaneously address the lessons learnt from behavioral psychology?

We would contend that the following incentive scheme design could be an option:

Axiomatic Consultants Point #1 Graphic

Short-Term Incentive (“STI”) scheme

  • 50% of the pay-out would be subject to a short deferral period
  • The remaining 50% would be paid into the LTI scheme
  • The employer would match, or match a higher multiple, of the employee’s payment to the LTI.
Axiomatic Consultants Point #2 Graphic

LTI scheme

  • No other LTI scheme would be introduced other than the vehicle to house the deferred pay-outs from the STI
  • The employee would receive growth in the share price (or other measurement criteria in the case of a phantom share scheme, particularly for unlisted entities) on both the employer and employee amounts, in the LTI, from the outset
  • Vesting and exercise of the LTI is only permissible 1 to 3 years after the executive’s last day of employment
  • Additional conditions could be introduced to allow the executive to partially exercise if a minimum holding requirement is exceeded.
The advantage of this incentive design includes inter alia:
  • The design ensures that all decisions taken by the executive are based on long term value creation
  • Negates the temptation to implement short term initiatives which may boost the share price in the short term, but which may not be a driver of long-term value creation
  • Aligns the design of incentives with the principles of Agency Theory
  • Reduces the occurrence of hyperbolic discounting given that the value is not some intangible possible future amount but rather the quantum is known
  • One of the issues which may be raised by executives (and especially CEO’s) is that the actions of a new CEO may lead to a decline in the share price:
    • This methodology will ensure that adroit succession planning is done. The outgoing CEO will know that the actions of the new CEO may affect the value of his LTI and thus the new incumbent will be subject to a stringent and robust selection process; and
    • So often a new CEO is appointed and writes down the value of assets. The suggested methodology will ensure that a “clean balance sheet” is left for the incoming CEO; and
    • Clawback provisions seldom work.  The computation of a clawback is fraught with difficulty and will often involve significant legal costs. This methodology has an in-built clawback and allows the market to determine the value of the clawback and further, aligns the clawback amount with the interests of shareholders.
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