Long term incentives

Many firms end up tying short term bonuses to both organizational and individual performance. Perhaps the simplest method is the split award plan. This basically makes the manager eligible for two bonuses, one based on his or her individual effort and one based on the organization’s overall performance. Thus, a manager might be eligible for an individual performances bonus of up to $10,000 but receive only $2,000 at the end of the year, based on his or her individual performance evaluation. But the person might also receive a second bonus of $3,000 based on the firm’s profits for the year.

One drawback to this approach is that it may give marginal performers too much — for instance someone could get a company based bonus, even if his or her own performance is mediocre. One way to avoid this is to use the multiplier method. In other words, make the bonus a product of both individual and corporate performance. As illustrated multiply the target bonus by 1.00 or .80 or zero (if the firm’s performance is excellent, and the person’s performance is excellent good fair or poor). Here a manager whose own performance is poor does not even receive the company bonus.

Employers us long term incentives to inject a long term perspective into their executives’ decisions. With only short term criteria to shoot for, a manager could conceivably boost profitability by reducing plant maintenance for instance; this tactic might catch up with the company two or three years later. Long term incentives are also golden handcuffs – they motivate executives to stay what the company, by letting them accumulate capital (usually options to buy many stick) that they can only cash in after a certain number of years. Popular long term incentives include cash, stock, stock options, stock appreciation rights and phantom stock.

Stock options

The right to purchase a stated number of shares of a company stock at today’s price at some time in the future.

A stock option is the right to purchase a specific number of shares of company stock at a specific price during a specific period of time. The executive thus hopes to profit by exercising his or her option to buy the shares in the future but at toady’s price. The assumption is that the price of the stock will go up. Unfortunately this depends partly on considerations outside the manger’s control such as general economic and market conditions. When the market or Internet stock plummeted several years ago, many managers saw their options go underwater. Many of these firms then had to scramble to sweeten their manager incentive plans. One study compared performance of 229 new economy firms offering broad based tock options to that of their non stock option counterparts. Those offering the stock options had higher share holder returns than did those not offering the options.

The chronic problem with stock options is that firms have traditionally used them to reward managers for even lackluster performance. There is therefore a trend toward using options tied more explicitly to specific goals. For example, with indexed options the option’s exercise price fluctuates with the performance of, say a market index. Then, if the company’s stock does no better than the index, the manager’s options are worthless, With premium priced options, the exercise price is higher than the stock’s closing price on the date of the grant so the executive can’t profit from the options until stock has made significant gains.

Long term Incentives for Overseas

Developing long term incentives for a firm’s overseas employees presents some tricky problems, particularly with regard to taxation. For example it’s not unusual for an executive to be taxed $40,000 o $140,000 of stock option income if he or she is based in the United States. However, if that person receives the same stock option income while stationed overseas he or she may be subject to both the $40,000 US tax and a foreign income tax (depending on the country) of $90,000 or more. The employer therefore either ha t forego the stock options incentive value, or pay the extra taxes itself, In any case firms cannot assume that they can simply export their executives incentive programs Instead, they must consider various factors including tax treatment, the regulatory environment and foreign exchange controls.

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