Incentive Compensation and Employee Ownership

6th ed. (2006). 230 pp. (6" x 9"), softcover; $25 for NCEO members; $35 for nonmembers

This book takes a broad look at how companies can use incentives, ranging from stock plans to cash bonuses to gainsharing, to motivate and reward employees in growing companies. Using both technical discussions and case studies, it explores incentives both as self-sufficient tools and as complements to retirement-oriented plans such as ESOPs. The sixth edition has been revised to clarify the technical material and bring it up to date, to fine-tune the chapter on cash incentives, and to add a new case study and remove an old one.

Preface
PART ONE: ESSAYS
Measuring, Improving, and Rewarding Performance
Beyond Bribery: Communicating Short-Term Group Incentives
Incentive Compensation and the Great Game of Business
A Primer on Sharing Equity with Employees
Restricted Stock Plans
Simulating Employee Ownership with a Rolling Bonus Program
Replacing Stock Options with Performance Shares
Designing Shorter-Term Cash Incentive Programs: Getting the Basics Right
Gainsharing and the Scanlon Plan

PART TWO: CASE STUDIES
Incentive Programs in a Professional Services Firm
Using the Scanlon Plan at an ESOP Company
A Two-Tier Equity Incentive Program at Apex Systems
Growing Toward a Total Rewards Portfolio at Intuit
Employee Ownership with an Internal Market at TEOCO

Excerpts

From Chapter 2, "Beyond Bribery: Communicating Short-Term Group Incentives in Employee Ownership Companies"

Employee ownership's greatest strength--a shared interest in long-term performance--is also its greatest weakness. For younger employees and people who are not familiar with the benefits of equity ownership, the rewards can seem nonexistent. Equity ownership has drawbacks as an incentive. First, the rewards are not timely, and second, the connection to daily work is difficult to see. This is particularly true where the value of the equity is realized at retirement, such as in an employee stock ownership plan (ESOP). In ESOP companies, incentives are frequently implemented to make ownership more "real." If you reward people for current performance results, so the thinking goes, they will be more aware of how the business is doing and pay attention to performance.

Among the strongest advocates of short-term incentives are companies that describe themselves as "open-book" firms. These companies point to their bonus programs as linchpins of their successful approach. Open-book advocate Jack Stack, president of Springfield ReManufacturing Corporation, summed it up this way: "What a bonus program does is communicate goals in the most effective way possible-by putting a bounty on them."

From Chapter 4, "A Primer on Sharing Equity with Employees"

Millions of employees become owners in their companies through employee stock purchase plans (ESPPs). Many if not most of these plans are organized under Section 423 of the Internal Revenue Code and thus are often called “Section 423” plans. Other ESPPs are "nonqualified" plans, meaning they do not have to meet the special rules of Section 423 and do not get any of the special tax treatment.

Under Section 423, companies must allow all employees to participate, but they can exclude those with less than two years’ tenure, part-time employees, and highly compensated employees. All employees must have the same rights and privileges under the plan, although companies can allow purchase limits to vary with relative compensation (most do not do this, however). Plans can limit how much employees can buy, and the law limits it to $25,000 per year.

Section 423 plans operate by allowing employees to have deductions taken out of their pay on an after-tax basis. These deductions accumulate over an “offering period.” At a specified time or times employees can choose to use these accumulated deductions to purchase shares or they can get the money back. Plans can offer discounts of up to 15% on the price of the stock. Most plans allow this discount to be taken based on either the price at the beginning or end of the offering period (the so-called “look-back feature”). The offering period can last up to five years if the price employees pay for their stock is based on the share price at the end of the period or 27 months if it can be determined at an earlier point.

Plan design can vary in a number of ways. For instance, a company might allow employees a 15% discount on the price at the end of the offering period, but no discount if they buy shares based on the price at the beginning of the period. Some companies offer employees interim opportunities to buy shares during the offering period. Others provide smaller discounts. Offering periods also vary in length. NCEO studies, however, show that the large majority of plans have a look-back feature and provide 15% discounts off the share price at the beginning or end of the offering period. Most of the plans have a 12-month offering period, with six months the next most common.

From Chapter 6, "Simulating Employee Ownership with a Rolling Bonus Program"

By varying the phantom stock idea somewhat, we can create a system that should function smoothly. It would work much like a stock appreciation rights plan (SAR), except that, unlike most SARs, it is specifically designed to make an annual payout, it is based on equity performance over a short period of time, and it is not tied to providing employees cash to make an actual purchase of shares. The idea is to mimic what would happen if employees were given stock options. With a stock option, an employee has the right to buy a certain number of shares at a price fixed today for some number of years into the future. When the option is exercised and the shares are sold, the employee ends up with the spread between the grant price and exercise price. If the option were granted at $10 in 1998 and exercised and sold at $18 in 2003, the employee would get $8 net for each share. In the best-designed option plans, employees get new options each year, thus giving them an ongoing interest in the company. While some old options will be exercised at various times, employees will always have new ones to give them an interest in the company's future.

From Chapter 8, "Designing Shorter-Term Cash Incentive Programs: Getting the Basics Right"

Management compensation plans were the source of today’s performance-based cash compensation models, just as they were the origin of equity-based compensation plans. Generally, the higher a worker is in the management hierarchy, the more performance measures lean toward ultimate objectives; the lower in the hierarchy, the more focus on critical or interim objectives (figure 8-2). From a financial perspective, the question is where we “draw the line” on the income statement. Senior management is responsible for total return on capital and is directly involved in managing both return and capital. A sales manager may have responsibility only for revenue, perhaps gross margin.

When we extend this to all workers, we have the proliferation of buzzwords (figure 8-3) we’ve been subjected to over the years. Some have emerged recently while others date back to the early part of the 20th century. These result from attempts to resolve the issues of performance measures and organization levels in developing performance-based reward programs. Organizations considering performance-based cash compensation should not be intimidated by this plethora of terms. My clients’ experiences show that a solid business-based process can lead through this maze of labels, and the final product—an effective performance-based pay program—can be named at the end. The key is understanding critical design decisions and the central issues of each.

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