Long Term Incentive Plans

I am interested in finding out how privately held companies with no market for their shares structure their long-term incentive plans. We have an annual appraisal prepared and use that data to calculate three-year growth rates, which become the basis for our incentives.

Top executives target at 80 percent of base, and most key contributors are in the 10 percent to 20 percent range as a target.

Paul Clancy (pclancy@divcom.com )

Response:

One way to structure such a plan in a privately held company where the owners will not issue equity is by using stock appreciation rights (SARs). A certain number of SARs are issued to the key people. A baseline period is selected, and you pick a way to value the company and the SARs. One possibility is to use a multiple, such as six times earnings, as the baseline company value. Then select an end period or interim periods and calculate the difference in company value over the periods. This difference is then paid out over a certain period of time. The SARs work something like stock options; they differ in that you can't actually buy the stock, and the income is taxed as ordinary income.

Tony DiGirolamo (tony@sweetstreet.com )

Response:

Our company (heavy industrial) uses a similar philosophy. We have a third party perform a simple valuation analysis on the enterprise, which is based on a three-year average of EBITDA, times a multiple, less debt, less a discount for liquidity. We use the value for charitable contributions of our stock or for valuing long-term incentives, such as SARs and phantom stock.

Anonymous

Response:

As a private company, our long-term compensation is based upon earnings multiples of public companies within a peer group. At the inception of each plan, we identify a public-company peer group. Since we know their market capitalization and earnings, we can derive an average multiple. For example, a company with a $5 billion market capitalization, with annual EBITDA of $625 million, produces a multiple of eight. The peer-group multiple becomes the basis of determining our current valuation and the target that we measure future performance against.

For example, suppose the peer-group multiple is eight, and our company’s base-year EBITDA is $50 million, producing a hypothetical enterprise value of $400 million. The compensation committee may want to provide a long-term incentive to grow the enterprise value 15 percent, compounded annually. The performance period is three years, with the payout over the three years following the end of the performance period.

The change in peer-group multiples can be used to modify the performance evaluation. For example, if the peer-group multiple declines to six during a performance period, the committee has the ability to lower the initial evaluation. EBITDA can be replaced with a more appropriate valuation technique for your particular niche or industry.

Anonymous

Response:

We allow key executives to elect to defer (at the beginning of the year) up to 100 percent of their annual incentive bonus into a nonqualified, unfunded deferred-compensation plan. The plan "earns interest" each year on the accumulated balances at the pre-tax return on the business’ beginning-of-the-year equity. (We are a Subchapter S corporation, so no taxes are assessed at the corporate level.) To avoid shareholder dilution, there is a cap on how much executives can accumulate in the plan. It is really simple and aligns shareholder and management interests. Upon retirement, separation, or death, we have various distribution options.

Anonymous