What it means
An LTIP sits above salary and annual bonus in the pay structure. Where a bonus rewards this year's results, an LTIP typically measures a three-year performance period and then holds the reward for a further period before it can be sold.
Businesses use them because short-term incentives can encourage short-term thinking. A sales director paid only on this year's revenue has little reason to worry about contracts signed today that will be unprofitable in year three, and stretching the measurement window changes that calculation.
The mechanics usually start with a target award expressed as a percentage of salary. Performance against agreed measures then produces a multiplier, often somewhere between zero and two, which scales the award up or down.
Common measures include earnings per share growth, total shareholder return against a peer group, return on capital employed and, increasingly, non-financial goals such as safety or emissions. Accounting treatment matters to the finance team.
Share-based awards are charged to the income statement over the vesting period based on their fair value at grant, so an LTIP creates a real, if non-cash, cost. Cash-settled plans are remeasured each reporting date, which can make the charge move around as the share price does.
The usual variants are performance share plans, restricted stock units and share options, and many companies run more than one at the same time. Clawback and malus provisions, which let the board reduce or reclaim an award after misconduct or a restatement, are now standard in listed companies.
In practice
Real-world examples
Example 1
A listed engineering group grants its top 40 managers performance shares measured on three-year total shareholder return against a group of 15 peers. Vesting is on a sliding scale, with nothing paid below median performance and the full award only at upper quartile.
Example 2
A private equity backed logistics business runs a cash LTIP instead of shares because its owners do not want to dilute their holding. Managers accrue a pot that pays out only if the business is sold above an agreed valuation within five years.
Example 3
A family-owned food manufacturer introduces a simple three-year plan for its five senior managers after losing two of them to competitors. The award is based on cumulative operating profit and is forfeited if the manager resigns before the third anniversary.
Think of it
Think of a Long-Term Incentive Plan like planting an orchard. Instead of picking the unripe fruit on day one, you agree to tend the trees for five years, and then you get to keep a generous share of the harvest.
Formula
Calculation
Target Award = Salary x Target Award Percentage
LTIP Award Value = Target Award x Performance Multiplier
Shares Granted = Award Value / Share Price At Grant
Consider an operations director on a salary of $240,000 with a target award of 50% of salary. Target award = $240,000 x 50% = $120,000.
Over the three-year performance period the company beats its earnings target and finishes in the upper half of its peer group, so the remuneration committee applies a multiplier of 1.25. Award value = $120,000 x 1.25 = $150,000. At a grant share price of $25, that is $150,000 / $25 = 6,000 shares.
The accounting charge is spread over the three-year vesting period, so roughly $150,000 / 3 = $50,000 a year runs through the income statement. If the share price at vesting is $32, the director receives shares worth 6,000 x $32 = $192,000 before tax, which is $42,000 more than the grant-date value purely because the share price rose.Case study
Seen in the real world
Harbourline Instruments is a fictional maker of laboratory equipment, used here as an illustrative example rather than a real company. After a period in which managers pushed hard for annual bonus targets by discounting heavily in the final quarter of each year, the board replaced half the bonus opportunity with a three-year plan.
The new plan set a target award of 40% of salary for each of eight senior managers whose combined salaries were $1,600,000, giving a total target award of $1,600,000 x 40% = $640,000. Performance was measured on cumulative operating cash flow rather than revenue, precisely to discourage the year-end discounting.
Three years later, cash flow came in slightly above target and the committee applied a multiplier of 1.1, producing a total award of $640,000 x 1.1 = $704,000 in shares. In this illustrative account the more useful outcome was behavioural: quarter-end discounting fell away because managers were being measured on cash collected over three years rather than orders booked in December.
Watch out
Common mistakes
- Assuming an LTIP award is guaranteed pay, when the whole point is that it can pay nothing at all if the performance conditions are missed.
- Treating the accounting charge as optional because no cash leaves the business, when share-based payment charges reduce reported operating profit every year of the vesting period.
- Setting performance measures that management can influence in the short run, such as reported revenue, which reintroduces exactly the behaviour the plan was meant to discourage.
Questions
People also ask
How long is a typical performance period?
Three years is the market norm for listed companies, often followed by a further two-year holding period before shares can be sold.
Can a private company run an LTIP?
Yes, either through shares with an agreed valuation mechanism or through a cash plan linked to profit, cash flow or an eventual sale price.
What happens if someone leaves partway through?
Most plans treat resignations as forfeiture, while retirement, redundancy and ill health usually give a pro-rated award that still depends on the final performance outcome.