Incentive Based Compensation – Pay for Performance

Demystifying Valuation, Economic Damages + Forensic Accounting

Pay for performance can mean different things to different people.  Should the pay reflect past performance or should it reward for future performance?  Is the compensation meant to be for short-term purposes or long-term purposes?  This is a hotly contested issue and should be resolved based on the employee’s job function and the goals of the company.

Short-term goals like increasing the company’s stock price can merit bonuses based on achieving the goal.  This will ensure the employee will work towards the goal that will benefit the company as well. This strategy represents compensation for past performance in which the employee receives money immediately.  However, this can lead to problems like employee retention or manipulating the system to achieve the short-term goals at the detriment of the company over the long-term.

An alternative strategy to immediate bonuses is to establish a “bonus bank”.  This bonus bank requires the bonus to be fully vested before the employee can withdraw it or they can only draw up to a certain percentage or amount each year. This type of strategy will allow bonus payments and help retention while preventing manipulation of the bonus system.

Compensation for long-term goals can be reflected in pay raises or promotions.  This type of system will reward the employee not only for past performance but also in the future.    This is often the most common strategy that employers use because it is less risky than offering bonuses and attracts the same type of employees.  Pay raises and promotions will reward employees for loyalty and continuity of service and will help to reduce training and other turnover costs.

Equity based compensation is another common method of long-term compensation. This is usually done in tandem with pay raises and/or promotions and most often given to executives as a form of performance compensation.  The five basic types of equity compensation are:  stock options, restricted stock, stock appreciation rights, phantom stock, and employee stock purchase plans.

Stock options will give employees the option to buy a certain number of shares at a specific fixed price.  This long-term compensation method can be structured several different ways but allows the employee to exercise the options once they are vested.  This will help encourage investing in the company and provide future compensation should the company continue to perform well.

Restricted stock will give employees the right to acquire or receive shares once certain goals or years of service have been met.   Employees can receive the stock at fair market value, a discount, or at no cost once the performance goal has been met.  This differs from stock options because restricted stock can provide dividends, voting rights or other benefits based on the employer’s decision.

Stock appreciation rights will give the employee a cash or stock payment based on the increase in value of a company’s stock over a certain period of time.  This right is a bonus based on the increase in the stock price not the stock price itself.

Phantom stock will give a cash bonus based on the value of a certain number of shares almost as if you owned the shares.  The bonus is paid based on the value of the shares at a certain point in time as opposed to only the increase over time.  Phantom stock plans often are based on meeting certain performance goals.

Employee stock purchase plans encourage employees to purchase company shares at a discount.  This option is most often offered to all employees because the discount incentivizes them to invest in the company.  The other equity compensation plans can require a greater amount of control within the company that is only available to the people in higher positions.

To reinforce the point stated earlier, compensation should be based on the employee’s position within the company and the goals of the company.  Doing otherwise could lead to a misallocation of company resources.

By Henry & Horne