Long term incentives: Meaning, Criticisms & Real-World Uses

What Is Long-Term Incentives?

Long-term incentives (LTIs) are a form of compensation designed to motivate employees, particularly executives, to achieve sustained company performance over several years. This type of remuneration falls under the broader category of executive compensation within corporate finance. Unlike short-term incentives, which reward immediate results, LTIs align an individual's financial interests with the long-term strategic goals and shareholder value of the organization. They are typically tied to performance metrics that unfold over a period of three to five years or more.

History and Origin

The concept of incentivizing executives has evolved significantly. For a long time, executive compensation primarily consisted of salaries and bonuses tied to short-term financial targets. However, a notable shift occurred in the 1990s when corporate boards began to prioritize shareholder value, leading to a greater emphasis on linking executive compensation to the company's stock price¹⁷.

The use of long-term incentives, particularly stock options and deferred bonuses, became more common in the 1920s, although their prevalence declined during the Great Depression. By the mid-1950s, stock options started to make a more noticeable impact on median pay, with their share in total compensation fluctuating between 15% and 30% for executives receiving such awards from the mid-1950s to the mid-1980s¹⁶.

Significant regulatory attention on executive compensation grew in the 2000s. The Securities and Exchange Commission (SEC) has continually refined disclosure requirements to provide investors with greater transparency. For example, the SEC adopted amendments in 2006 to enhance disclosures related to executive and director compensation, aiming for a clearer picture of compensation earned by top executives¹⁴, ¹⁵. Further regulatory changes, such as the Pay versus Performance (PvP) disclosure requirements implemented in 2022, aim to help investors better understand the relationship between executive pay and company performance¹², ¹³.

Key Takeaways

Long-term incentives align executive interests with the company's sustained performance over multiple years.
Common forms of LTIs include stock options, restricted stock units, and performance shares.
The effectiveness of LTIs in motivating executives and aligning interests with shareholders is a subject of ongoing debate and research.
Regulatory bodies, like the SEC, require detailed disclosure of long-term incentive plans to enhance transparency for investors.
LTIs are often criticized for their complexity, the potential for excessive payouts, and a perceived disconnect between pay and actual performance.

Formula and Calculation

While there isn't a single universal formula for "long-term incentives" as a whole, the value of specific LTI components, such as stock options, can be determined using financial models like the Black-Scholes model. This model estimates the theoretical fair value of an option.

The Black-Scholes formula for a call option is:

C = S_0 N(d_1) - K e^{-rT} N(d_2)

Where:

(C) = Call option price
(S_0) = Current stock price
(K) = Option strike price
(T) = Time to expiration (in years)
(r) = Risk-free interest rate
(N(d_1)) and (N(d_2)) = Cumulative standard normal distribution probabilities
(e) = Euler's number (approximately 2.71828)

And (d_1) and (d_2) are calculated as:

d_1 = \frac{\ln(S_0/K) + (r + \sigma^2/2)T}{\sigma\sqrt{T}}

d_2 = d_1 - \sigma\sqrt{T}

Where:

(\ln) = Natural logarithm
(\sigma) = Volatility of the stock's returns

The fair value determined by this formula contributes to the overall reported value of executive compensation that includes options. Similarly, restricted stock units are typically valued based on the underlying stock price at the grant date, adjusted for any restrictions.

Interpreting Long-Term Incentives

Interpreting long-term incentives involves understanding their structure, the performance metrics tied to them, and their potential impact on both executive behavior and company outcomes. These incentives are designed to foster a long-term perspective in management decisions, encouraging investments and strategies that build sustainable value rather than focusing solely on short-term gains.

When evaluating LTIs, it is crucial to examine the specific targets set for performance shares or stock options. Are these targets challenging yet achievable? Do they align with the company's overall strategic planning? Investors often scrutinize LTI plans to ensure that executive pay is genuinely linked to the creation of shareholder wealth. A well-designed LTI plan should provide a strong incentive for executives to make decisions that benefit the company over an extended period.

Hypothetical Example

Consider "TechGrowth Inc.," a publicly traded technology company. To incentivize its CEO, Sarah Chen, to drive sustained growth, the board implements a long-term incentive plan. The plan grants Sarah 100,000 performance shares that will vest over three years, contingent on specific targets being met.

The vesting schedule and targets are as follows:

Year 1: 33,333 shares vest if the company achieves a 15% increase in revenue growth.
Year 2: An additional 33,333 shares vest if the company maintains 12% revenue growth and improves its net profit margin by 1 percentage point.
Year 3: The final 33,334 shares vest if the company's stock price outperforms the NASDAQ Composite Index by 10% over the three-year period.

At the grant date, TechGrowth Inc.'s stock price is $50 per share. If all targets are met, Sarah stands to gain a significant amount. However, if the company fails to meet these long-term objectives, the value of her incentive compensation could be substantially reduced or even zero, directly linking her payout to the company's sustained performance and strategic achievements.

Practical Applications

Long-term incentives are fundamental to corporate governance and compensation structures in various sectors. They are widely used in publicly traded companies to align the interests of executives and key employees with those of shareholders.

Executive Compensation Design: LTIs are a core component of most executive compensation packages, alongside base salary and annual bonuses. The specific mix of stock options, restricted stock, and performance awards is carefully tailored to motivate executives toward strategic objectives.
Employee Retention: Beyond executives, LTIs can be extended to other critical employees to foster loyalty and reduce employee turnover, as the value of the incentive often depends on continuous employment.
Mergers and Acquisitions: In mergers and acquisitions, LTI plans may be structured to incentivize management to achieve successful integration and synergy realization over a multi-year period post-acquisition.
Startup Growth: While typically associated with larger, established firms, startups might use forms of long-term equity incentives, such as stock options or phantom stock, to attract and retain talent in their early, high-growth phases, when cash compensation might be limited.
Regulatory Compliance: Public companies must disclose their long-term incentive plans in detail through proxy statements and other filings with the U.S. Securities and Exchange Commission (SEC). This regulatory oversight aims to ensure transparency and accountability in executive pay practices¹⁰, ¹¹.

Limitations and Criticisms

Despite their widespread adoption, long-term incentives face several limitations and criticisms. A primary concern is their complexity, which can make them difficult for executives to fully understand and for shareholders to evaluate effectively⁹. This complexity can also lead to a disconnect between perceived value by the executive and the actual economic cost to the company⁸.

Research suggests that LTIs are not always as efficient or effective in motivating executives as proponents might expect. One critique highlights that executives can be more risk-averse than traditional financial theory assumes, and they tend to heavily discount future rewards. This means that the value perceived by the executive for a long-term incentive might be less than its true economic value, potentially requiring larger payouts to achieve the desired motivational effect⁵, ⁶, ⁷. Furthermore, some studies indicate that a significant emphasis on high pay may wane in its motivational power after a certain threshold, contrasting with the assumption that financial rewards proportionally increase the will to succeed⁴.

Another common criticism is that the typical three-year duration of many LTIs may not be sufficient to genuinely focus executives on truly long-term company interests, potentially still encouraging a shorter-term focus³. There are also concerns that LTI plans can railroad executives toward specific targets, rather than promoting the complex behaviors needed to run a company effectively, and that payouts can occur regardless of the actual reasons for company success or failure, due to external factors². The misalignment between executive pay and performance continues to provoke discontent from shareholders, raising questions about the effectiveness of long-term incentives in addressing the agency problem ¹.

Long-Term Incentives vs. Short-Term Incentives

Long-term incentives (LTIs) and short-term incentives (STIs) are both crucial components of a comprehensive compensation structure, yet they serve distinct purposes. The primary difference lies in their time horizon and the behaviors they are designed to encourage.

Feature	Long-Term Incentives (LTIs)	Short-Term Incentives (STIs)
Time Horizon	Typically 3-5 years or more	Typically one year or less
Purpose	Drive sustainable growth, strategic objectives, and shareholder value creation	Reward immediate performance, operational goals, and annual targets
Common Forms	Stock options, restricted stock units (RSUs), performance shares, phantom stock	Cash bonuses, commissions, profit-sharing (annual)
Performance Metrics	Stock price appreciation, total shareholder return (TSR), multi-year revenue growth, strategic project completion	Quarterly or annual revenue, profit, individual performance, operational efficiency
Risk Exposure	Higher, tied to long-term market and company performance	Lower, tied to more immediate and controllable outcomes
Behavior Focus	Strategic thinking, long-range planning, capital allocation, innovation	Operational execution, sales achievement, cost control

While STIs provide immediate recognition and motivation for achieving annual goals, LTIs aim to foster a growth mindset and align executive decisions with the long-term health and prosperity of the company. Companies often use a combination of both to create a balanced incentive framework that addresses both immediate operational needs and enduring strategic ambitions. This blend is part of a larger compensation plan aimed at optimizing both individual and organizational performance.

FAQs

What are common types of long-term incentives?

Common types of long-term incentives include stock options, which give the holder the right to buy company stock at a predetermined price; restricted stock units (RSUs), which are grants of company shares that vest over time; and performance shares, where the number of shares awarded depends on achieving specific multi-year performance targets, such as total shareholder return (TSR) or earnings per share growth.

Why do companies offer long-term incentives?

Companies offer long-term incentives primarily to align the interests of executives and key employees with those of shareholders. By tying a significant portion of compensation to sustained company performance over several years, LTIs encourage strategic decision-making, promote employee retention, and motivate individuals to focus on building long-term value and achieving the company's strategic goals.

Are long-term incentives taxable?

Yes, long-term incentives are generally taxable, but the timing and nature of the taxation depend on the specific type of incentive and relevant tax laws. For example, income from stock options is typically taxed when the options are exercised (for non-qualified stock options) or when the shares are sold (for incentive stock options, under certain conditions). Restricted stock units are usually taxed when they vest, becoming unrestricted and transferable. It is advisable to consult a tax professional for specific guidance on your situation and for details on tax implications.

How do long-term incentives impact corporate governance?

Long-term incentives play a significant role in corporate governance by serving as a mechanism to align management's interests with those of shareholders. Effective LTI plans are designed to mitigate the agency problem, where a conflict of interest might arise between a company's management (agents) and its shareholders (principals). Transparent disclosure of these plans is mandated by regulatory bodies like the SEC to ensure accountability and allow shareholders to scrutinize how executive pay relates to company performance.