Incentive plans for privately held businesses

Attracting, motivating and retaining key staff is a challenge for every business. Incentive plans can play a big part in achieving that aim, but many privately held companies shy away from using incentives, wary of experimenting with something as sensitive as pay.

But with care, a powerful and highly attractive incentive scheme can be designed for managers of privately held companies; one that focuses attention on sustained gains in the value of the business, while offering meaningful, competitive rewards for successful mangers.

In this series of articles, we’ll review some of the most common mistakes that privately held companies make in approaching the question of incentives, before looking at a sketch of what I have seen work well.

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But to start, it’s worthwhile looking at the basic framework of modern executive remuneration.

Modern remuneration practice

Traditional remuneration practice in Australia and New Zealand has seen the majority of rewards for managers paid in fixed remuneration, such as a salary. Then, if the business or manager has a particularly good year, he or she may qualify for a ‘bonus’.

Modern remuneration practice is different. At its heart is the concept of ‘at-risk pay’. Employees have a meaningful part of their pay at-risk, subject to loss if performance is disappointing, but capable of significant upside if performance exceeds expectations.

This is nothing new to anyone who has ever worked in sales. Most sales positions have an element of ‘at-risk’ pay, usually tied to sales performance (eg sales commission). If sales targets are met, the commission earned when added to base salary, combines for an attractive total remuneration package. But if sales are low, it makes for a tight year all round.

Owners like this kind of pay structure, because costs are more variable and good sales people like it, because they can usually earn significant amounts if they beat their sales targets.

Modern remuneration practice applies the same approach to managers. If targets are met, the at-risk component when added to base salary combines for a market competitive total remuneration package. But if performance is poor, the executive will be paid well below market. And of course, if performance is above expectations, rewards can be substantial.

Within that framework, remuneration for senior executives today comprises three parts: fixed remuneration, short term incentives and long term incentives.

The three parts of modern remuneration

3 parts of modern remuneraiton

Fixed remuneration is the employee’s salary and any additional perks, such as superannuation or a car allowance that do not vary with performance.

Rewards that are linked to performance measured over one year (or less) are called ‘Short-Term Incentives’ or STI, the most common example being an annual bonus paid to employees.

‘Long-Term Incentives’, or LTI, reward multi-year performance. LTI plans are most common in public companies and usually comprise equity based rewards such as shares or share options.

Equipped with an understanding of the structure of modern remuneration, we can now look at the most common mistakes made by privately held companies in the use of incentive plans.