Employee stock ownership plans (ESOPs) continue to attract attention as a succession and ownership model. But an often-overlooked element, one that's crucial to an ESOP's success, is incentive plan design. Thoughtfully structured incentive programs can attract and retain top talent, align employee behavior with business objectives, and position companies for long-term success.
In this episode of Markets Plus, Derek Garland, Managing Director and Head of BMO's Business Transition Advisory Group, speaks with Leah Turnbull, BMO’s Managing Director and National ESOP Practice Lead, and Matt Keene, Managing Director and Leader of the Executive Compensation Practice at Chartwell Financial Advisory. They discussed how designing the right incentive plan can drive business performance and enhance enterprise value in employee-owned companies.
Listen to the full episode:
Below are key highlights from the conversation.
Matt, can you walk us through how companies think about designing compensation programs, including the balance between base salary, short-term incentives, and long-term incentives?
Matt Keene: So, we often describe compensation as being a three-legged stool—those three legs of compensation being base pay, short-term incentives, and long-term incentives. And you really need each of those three legs to make the stool balance.
Of course, we all understand base pay. It provides certainty for paying the bills and for budgeting. And then we come to the short-term incentive—really an annual bonus, usually based on achievement of annual goals.
Finally, we have the third leg of the stool, the long-term incentive. I tend to think of that as anything that is earned or vested or paid over a period of more than one year. We used to see a lot of long-term, distant awards, but companies learned that people devalue that. We've seen a big move to bring compensation forward. So, I would say what we mostly see in those long-term incentive plans these days is really a midterm three-to-five-year vesting period.
Who ultimately decides what the right compensation structure looks like? And how do organizations determine which employees should participate?
Leah Turnbull: The board of directors sets compensation for the CEO, and the board will approve the aggregate grant amount for any incentive plans and give the CEO the discretion on how that aggregate amount is divided among the employees.
Even in public companies, bonuses are not announced until the board has approved the total pool, but obviously the board is not determining what each and every employee will receive. That's why governance is important when we're talking about incentive plans, especially for employee-owned businesses, to ensure there's not any self-dealing.
It would be great to hear how companies differentiate their approach between executives and rank-and-file employees.
Matt Keene: With the third leg of the compensation stool, the long-term incentives, we typically see that in employee-owned companies that are privately held. We typically see that reserved for the executive group and not going down to rank-and-file employees.
If you move down the organization, if I'm a rank-and-file employee, I can't really influence whole company results, but I can do the best I can in my own span of control, whatever my individual key performance indicators are. So, we tend to see bonus ratings vary from the top at the company level, then working down to divisional level VPs or regional presidents, and then down to the individual results reflected on my performance review.
Can you describe unique advantages that employee ownership can provide in attracting talent at all levels of the organization?
Leah Turnbull: The fact that all employees receive some level of equity-based benefit is huge and can be a very powerful recruiting and retention tool. I have many examples of successful ESOPs where employees quickly understand that the more money the company saves, the higher the stock price, the more money in my pocket.
That's why this is a really huge recruiting and retention tool, and we've seen employee-owned businesses across the nation run more profitably and more efficiently because employees really start to feel like owners, and they start to recognize how their actions impact the overall performance of the business.
Can you talk through when and how ESOPs distribute cash value to employees?
Leah Turnbull: An ESOP is a retirement plan. Employees will receive an allocation of shares every year. Hopefully, the value of those shares grows over time in line with the performance of the company, but they only receive cash for their shares upon death, disability, retirement, or when they leave the company.
I've seen examples where employees earning $50,000 a year retire with a seven-figure account balance. That is huge, but they won't have access to that until retirement. This is not a defined benefit plan. There isn't a guaranteed benefit that the employees will receive upon retirement like a pension. If the company does not perform, the value of that stock may not be as much. On the flip side, if the company exceeds expectations, the value of that account balance can be life changing.
What do you think are the most important takeaways from this discussion for our listeners?
Matt Keene: I think for ESOP companies, it's the same as any other company: good practical compensation governance, which starts with knowing where you stand. So, benchmark your compensation versus the market.
And I would say to have a competitive long-term incentive plan. You're competing with these larger private and sometimes public companies, and you have to be competitive and show [employees] something that brings them in until that ESOP really starts to kick in and they start to appreciate that for its own sake.
Leah Turnbull: My key question if I was on a board or part of the executive team is: why does this matter? We all know the studies that show how expensive turnover is for companies. And if you're not offering competitive, compelling incentive plans that drive the behavior that you want, it can be difficult for your business to hit the achievements that you've set.
I think from the board seat, the reason why they should care is that this is the way for them to drive behaviors that they want, grow the company in the direction that they have set the strategy for, and retain the key employees that are going to accomplish that strategic plan.