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A Guide to an Employee Retention Strategy

ESOP

A Guide to an Employee Retention Strategy

By , October 28, 2015
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Strategies to attract, retain and motivate key employees, often the most valuable asset of any business can represent a formidable sustainable competitive advantage that is available to all businesses committed to best practice performance measurement and employee compensation.

An effective performance measurement and compensation system is essential in creating an entrepreneurial culture and an engaged workforce committed to creating long-term value in any business.
The employee compensation practices of publicly listed companies are of great interest to employees, investors, business media, consultants and academic researchers alike. They are also influential in shaping public expectations and by extension, the policies and practices of private companies. This article draws on analysis of disclosed employee plan features of some 40-50 ASX300 companies plus anecdotal information from direct exposure in this area to provide some insights on employee compensation practices to privately owned businesses.

Added significance of such policies and practices to privately owned businesses is the impact of strong governance in this area has to a privately owned business looking to exit. Publicly listed trade buyers offer the prospect of paying the highest price to owners of privately owned business. Companies whose practices, including employee renumeration practices, which align with those of their potential buyers are more attractive and, by extension, more valuable to incumbent owners. A well-thought strategy towards employee retention can represent a formidable sustainable competitive advantage that is available to all businesses committed to best practice performance measurement and employee compensation.

1. Remuneration Structure and Mix

The first thing to observe is the structure of a remuneration package for employees whose duties and key decisions are expected to have a long-term impact on a company. In this respect, long-term for employee remuneration purposes is three or more years. For these employees, their total package comprises the following components:

  • Base Pay
  • Short-term Incentive (STI)
  • Long-term Incentive (LTI)

This structure generally covers the CEO and direct reports. It typically extends to some or all of the next management tier, while some companies make selective awards to high potentials and high performers below the top management tier.

While the base pay is a fixed annual cash amount, the STI and LTI components are entirely discretionary, dependent on agreed performance.

The mix varies widely by company size, industry and company specific strategic considerations. However, for companies in the bottom tier of the ASX300, a typical mix might comprise of the following components:

CEOBase50-55%STI 25-30%LTI 20-30%
CEO direct reportsBase 60-65%STI 20-25%LTI 15-25%
Other participantsBase 75-80%STI 15-20%LTI 5-15%

Smaller companies tend to have a more conservative mix, with less reliance on LTI.

Apart from the CEO often having a different remuneration mix to their direct reports, other elements of incentive pay, such as performance hurdles and the vesting period are usually the same for all senior team members.

More recently, there has been a trend to merge executive STI and LTI plans into a single plan and a single annual award. While not prevalent, it has appeal because of its simplicity. The challenge of a more simple structure in the listed environment however, is to strike a reasonable balance between sometimes incongruous goals or differing stakeholder interests.

For private companies where the managers are often owners this incongruence is less of an issue. In such cases, an unbounded incentive compensation payout formula below has appeal.

2015_corporate_governance_insights_formula01

In this instance, incentive compensation is a function of the amount of the employee’s compensation that is at risk or subject to business performance (that is the combined STI and LTI components) and the business’ actual performance for the period relative to a target level of performance. Caps and floors can also be applied (typically an 80/120 bounded structure) that means that a bonus is generally paid at some threshold level of performance and is capped above some level. In practice, this basic system might be the same for all employees but differ in terms of the level of employee base pay and the percentage of that base pay that is at risk or subject to incentive compensation.

2. Basic Incentive Design

In formulating suitable LTI performance measures, the aim is usually to complement, rather than to duplicate the main STI measures. STI generally focuses on the drivers or lead indicators of shareholder value, while LTI emphasises the value actually delivered.

The vast majority of listed companies (at least 90%) deliver executive STI in cash and LTI in the form of equity.

STI is typically based on performance in a single accounting period whereas LTI is subject to performance or vesting usually of 3 or more years. In some cases, vesting of LTI is staggered, that is partial vesting at say 3 years followed by residual vesting at 4 or 5 years.

In formulating suitable LTI performance measures, the aim is usually to complement, rather than to duplicate the main STI measures. STI generally focuses on the drivers or lead indicators of shareholder value, while LTI emphasises the value actually delivered.

For LTI, the dominant performance focus is on prospective performance throughout the vesting period subsequent to the award. It is generally based on company-wide performance and often includes a relative performance measure. For this reason, a measure such as relative total shareholder return (TSR) is most predominate.

TSR returns of a listed company over a given period are the actual dividend yield and capital gains to the company’s shareholders over that period.

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TSR is a comprehensive measure reflecting all activities or decisions by a management team, be they acquisitions, operation improvements, product innovations, market or volume gains and capital structure changes. Because TSR is based on market prices, it is virtually impossible to game.

Relative TSR is simply TSR that has been indexed to the market or a peer group. It is designed to filter out the external noise and industrywide factors that affect market returns of a particular company.

Because TSR is based on market-wide stock returns it is not applicable to private companies.

The Boston Consulting Group (BCG) however introduced an internal TSR measure known as total business return (TBR) that extends TSR to private companies.

TBR compares the sum of the estimated future value of the business (the capital gains) and the free cash flows (dividend yield) to the current investment or business valuation. This is a direct internal analogue to TSR.

2015_corporate_governance_insights_formula03

Calculated by looking backwards (comparing the current value to the initial value), TBR can be used for compensation purposes. A relative TBR measure can be calculated to replicate relative TSR, by comparing TBR to the business’ cost of capital.

3. Performance Measures

Research sourced from Hewitt Associates Pty Ltd found that the prevalence of various performance measures is as set out in the table below. Note that the percentages sum to more than 100% as some listed companies apply multiple measures.

TSR, including Relative TSR86%
EPS35%
ROCE13%
Cash Flow7%
Other profit measures5%
Revenue3%
Other8%

Among ‘other’ measures, value based measures (other than TSR or share price) have been used such as Market Value Add and Economic Profit. Economic Profit, Residual Profit or combinations of profit and weighted Average Cost of Capital (WACC) are more commonly found in STI plans and increasingly so post the GFC.

At this juncture it is pertinent to review the efficacy of the types of performance measures and their relative utility as triggers for incentive pay. In this regard I have classified the various types of measures into 3 groups: accounting based, economic profit based and market based measures.

3.1. Accounting Based Measures

Popular accounting-based measures of performance include operating profit, net income, earnings per share, return on investment and return on assets.

The main advantages of these measures are their relative simplicity and ease of calculation. Employees at most levels of a business are familiar with these measures and understand them easily. They are routinely calculated for financial reporting purposes and do not require any special adjustments.

The disadvantages of accounting-based measures, however, outweigh their advantages.

Accounting based measures are appropriate measures of performance only when they correspond closely to shareholder or business value maximisation, and this is usually not the case. Value depends on long-term economic cash flows. Accounting measures are one-period, backward looking and focus on accounting earnings or similar statistics. As a result, when compensation is based on accounting measures, there is a tendency for managers to shorten their time horizon and concentrate on projects with short-term value, ignoring investments with long-term payoffs.

Another disadvantage is that they do not reflect the cost of invested capital. A project can show accounting profit without creating any true economic value. Business value is increased by investing in projects with good growth, where the return exceeds the cost of capital. Finally, accounting-based measures are easily manipulated, limiting their effectiveness as objective measures of management performance.

3.2. Economic Profit Based Measures

Economic profit measures such as residual income and economic value added adjusts accounting profits for the opportunity cost of invested capital. Either absolute or incremental economic profit measures could be used as the basis for compensation.

Economic profits, although superior to accounting based measures, are still one period historical measures. As such they tend to be well suited as triggers for STI reward but not LTI.

This has been borne out in practice, with the increasing use of such measures in STI compensation in publicly listed companies, particularly since the GFC. This period has coincided with a large recapitalisation of company balance sheets which over time brought about increased accounting profits on the back of new capital raisings and larger balance sheets. Paying for performance off accounting profit without considering a charge for capital was tantamount to awarding a free kick to relevant executives without acknowledging the expected returns of the key stakeholders.

Economic profit measures per se are not generally suited to LTI performance measures as prima facie they do not measure prospective or future economic value. This requires a forward-looking measure which is the preserve of market based measures or in the case of private companies, market based valuation measures such as BCG’s TBR.

3.3. Market Based Measures

Market based measures use market prices in some form to measure and assess performance.

Market based measures are multi-period, forward looking measures of economic value. In a single measure, they capture cash flow, growth, risk, return and capital. Because of their forward looking and economic nature they are well suited to measuring and assessing LTI performance.

For listed companies, relative TSR is most prominent. Others measures include CFROI, SVA, EVA and Jensen’s Alpha. For private companies, the TSR equivalent is TBR which can be indexed against a business’ cost of capital to replicate relative TSR.

Relative TSR, and TBR in the case of private businesses, are an appropriate measure to assess corporate level or senior management LTI performance. These measures are directly correlated with shareholder wealth maximisation, are not biased by company size and can be easily indexed to the market, peer group or their own expected return. More importantly, these measures are easy to calculate and widely accepted by the investment community.

4. Methods of Payment

Once the level of incentive pay has been determined, there is still the issue as to whether it should be paid in cash or equity.

Earlier I highlighted that for the vast majority of listed companies, STI is typically paid in cash while LTI is paid in equity.

Equity-based compensation programs are widely supported in practice and in principle by publicly listed companies. Experience shows that the composition of compensation packages will vary across the levels of management, with higher levels receiving more equity and the lower levels receiving more cash.

While remunerating employees of listed companies with equity is relatively simple given the publicly listed nature of their shares, the process is less straight forward for privately owned businesses.

To highlight this issue, Employee Ownership Australia and New Zealand’s (EOA) Expert Panel’s Research Report, July 2014 found:

While broad-based employee ownership is relatively widespread in the listed company sector in Australia, the report estimated that only 3% of private and unlisted companies have “all-employee” share ownership schemes compared to 23% in the United States. http://www.employeeownership.com.au/blog

5. ESOPs: Peak Performance Trust

Equity remuneration for employees of a privately owned businesses is achieved through specialised structures or employee share ownership plans (ESOPs).

One of the most innovative vehicles through which to provide employee share ownership in a privately owned business is a customised Peak Performance Trust (PPT).A PPT has been developed and is only available through Succession Plus.

One of the most innovative vehicles through which to provide employee share ownership in a privately owned business is a customised Peak Performance Trust (PPT). A PPT has been developed and is only available through Succession Plus.

With a PPT, the employer creates an investment trust into which it makes contributions on behalf of, and for the benefit of, specified employees. It makes a commitment to investing a predetermined amount of money into the trust on a regular basis, contingent upon participating employees achieving predetermined performance outcomes. As performance increases, so too does the percentage share that employees can benefit from. If performance is not increased, then no further allocation of funds is made to the PPT.

A recent product ruling confirms favourable tax treatment of the PPT structure:

  • Contributions to the PPT are tax deductible to the employer.
  • The receipt of these contributions is not taxable income to the trust.
  • The contributions are not taxable income to employees.
  • No FBT is payable on the contributions to the PPT.
  • No Super Guarantee Contributions will be applied to the contributions.
  • Part IVA of the ITAA 1936 is not invoked.

The rulings also confirm that the tax treatment does not change where for instance:

  • Only one employee “joins” the PPT, or
  • The PPT becomes a majority shareholder in the employer.

While ESOPs are effective in providing a vehicle for delivering the equity component of employee compensation in a privately owned business, ESOPs are also known to bestow significant other advantages to both employees and business owners.

Savings vehicle. A major attraction ESOPs have for employees is that they accumulate savings and acquire and hold shares. Most plans have a long term focus 3 – 7 years.

Participation. Employee ownership gives employees a sense of community, allows employee engagement and involvement, as part owners they feel part of the decision making process.

Performance Enhancement. ESOPs provide a strong incentive for performance from employees – their financial well-being (at least a part of it) is closely matched to that of the major business owner/s. The better the business performs, the more profitable it is and the better off are employees. Getting employees to think and act like business owners can make a substantial difference.

Succession planning. When the owner (or owners) want to retire (or change their business direction) and need to sell. In these instances an ESOP can be an effective employee buy-out instrument.

Buyer Attractiveness. ESOPs substantially reduce one of the key risks for buyers – that is that your employees will exit when you do. ESOPs are effective in retaining key employees long after the founding owners have exited.

Perhaps, the final word about the effectiveness of ESOPs is best encapsulated by Sir Stuart Hampson, former Chair of the John Lewis Partnership:

“Employee ownership is a different way of thinking about business. It targets long-term sustainability by recognising that employee/owners are more committed to developing innovative products and processes. The result is competitive advantage and lasting success – in good times and bad.”

6. Closing Thoughts

A business’ compensation policy is a critical component of its internal control system and a source of sustainable competitive advantage. A basic tenant espoused by public listed companies is that what a business measures and rewards gets done. If a business is to be run to maximise shareholder value, the compensation program must measure employee activities that contribute toward this goal and reward them.

Good governance on employee compensation that is modelled on public company experience suggests:

  • Employee compensation for senior employees in most businesses consists of both a fixed and a variable component.
  • The variable portion might comprise both an STI and LTI component which are generally tied to measures of business performance that are connected to the business’ primary goal of maximising shareholder value.
  • The level of incentive pay is usually linked to a comparison of actual versus target or planned performance.
  • Measures of economic profit are suited when measuring and tying performance to STI and marked based measures for LTI.
  • A market based measure for privately owned businesses that replicates TSR for publicly listed companies is TBR.
  • STI is typically paid in cash and LTI in equity.
  • Paying with equity offers a number of advantages for both owners and employees including the potential to motivate employees to behave like owners because they now share in the benefits of the wealth they help create.
  • A PPT is an ESOP developed by Succession Plus that offers significant tax advantages. It is used in privately owned businesses to remunerate employees with business equity.
michaelvincent

Michael Vincent

Partner, Succession Plus | Succession Plus

Michael Vincent is a Chartered Accountant and strategic business advisor with a wealth of experience as an external business consultant and senior executive of corporate Australia. As one who has worked both sides of the corporate divide, Michael understands the challenges facing business owners. He also understands the unique role an adviser can play in navigating business owners through the process of identifying, protecting, planning, building and realising business value.
Succession Plus Partner - Victoria & Tasmania