Performance-based long-term incentives (LTIs) have become the most dominant form of LTI. In most of these plans, performance goals are set to be attained in a fixed period of time, typically three years. But does it have to be this way, especially in the case of major, one-time initiatives?
There are certain situations where companies should consider replacing traditional, time-based vesting with vesting based on the attainment of key milestones, such as the successful completion of a business startup, entry into a new category, completion of a major re-organization or a specific transaction.
The benefits of milestone-based LTIs include:
- Managing uncertain timing. Tying the vesting of incentives to the attainment of key milestones rather than somewhat arbitrary time periods avoids situations where goals are met a few weeks or even months late. Generally, missing by a short amount of time is not consequential and management should not be severely penalized, especially if the delay was caused by factors beyond participants' control. These factors could include weather, late delivery by a supplier or slow government-approval process. It is the results that matter, not when they are attained (within reason). Currently, many companies rely on discretion, which can be a slippery slope because the rules governing when and how discretion is used are generally not stated or clear.
- Using stretch goals. Focusing on the result, while removing inflexible time constraints, allows the board and management to set more ambitious goals, such as in the case of a business transformation. It can also provide more freedom to adapt the method for achieving success, enable the executive team to reallocate resources and respond to changing environments, as appropriate. Conversely, tying the goal to a fixed period of time may encourage short cuts that have long-term consequences, such as design defects, or cause unnecessary risk taking to accelerate goal attainment.
- Rewarding true outcomes. Milestone-based approaches can focus on the accomplishment of the desired outcome as opposed to poorly defined intermediate progress points. Thus, management can be rewarded for successful completion, which can be more carefully defined. Also, this avoids situations where intermediate progress points are achieved, but the endeavor ultimately fails.
The drawbacks of milestone-based plans include:
- Competitive positioning, cost and transitioning. Milestone-based awards are typically used as one-time awards. If the milestone-based awards are used on top of regular awards, then competitive positioning and overall cost will increase. If they substitute for all or part of regular awards, then transitioning back and forth between the awards can cause confusion and logistical complexity.
- Accounting. Given the flexible nature of the achievement period, both the estimated level of payout and the time over which the cost of the award is recognized can change. This may increase pressure on earnings and the potential outcomes should be thoroughly modeled before being used.
- Administration. Using a longer, and variable, performance period can increase the complexity of plan administration. For example, it is more difficult to project annual share usage for stock-based plans. Also, if milestones are achieved in the middle of a quarter before audited results are available, it will be necessary to delay vesting until quarter end. Finally, if milestones are achieved during a blackout period, then either vesting could be delayed or taxes could be addressed through share-based withholding.
The major design considerations include:
- Clear and objective milestones. To be successful, milestones must be clear and objective. Too much subjectivity in defining success can damage the program's effectiveness.
- Time limits for completion. While milestone-based programs can take the pressure off time, it does not mean timing should be entirely open-ended. Instead, reasonable maximum limits, such as five to six years, should be established based on the nature of the milestone(s).
- Premiums/cutbacks. Payouts do not have to be fixed amounts. For example, if executives are expected to achieve a milestone in four years and it happens in two, executives can be rewarded by an above-target payout, such as 150% of target.
When designing a milestone-based LTI program, it is sometimes helpful to include a post-vesting, at-risk period to ensure milestones are truly achieved. This can be done through a post-vesting holding period or clawback period where awards can be adjusted downward if success was prematurely judged.
How Do Companies use Milestone Programs?
Even though milestone-based LTI programs are not prevalent, they can be successful, especially when future revenues/profits are tied to specific events. For example, we used such a milestone-based plan for a mining company. Vesting was tied to the successful completion of a multibillion dollar mine-development project. Success was based on meeting a detailed set of specifications, including budget goals. There were outer time limits for completion and payouts were increased when the project was completed sooner and when costs came in under budget. If the cost and time parameters were missed, payouts declined. Half the award was deferred a year and was cut back if there were operational problems during that period.
Milestone plans can be flexible and effective tools to motivate and reward executives, and yet they are often overlooked. Companies are always going to face situations where the desired outcome is clear, but the time to achieve success is unknown. In these situations, companies should consider using a milestone-based LTI program. In some cases, it is more about achieving successful outcomes than it is a matter of time.
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