By giving key employees the chance to “buy low” you are investing in the future success of your company, and keeping a stable leadership group who will provide an even greater return over the long run.

As contractors continue to struggle with dwindling backlogs and diminishing margins, they are turning their attention to control. Line-item adjustments to budgetary items are simply not enough and despite valiant efforts to find an alternative, eventually most companies must address their compensation issues. 

Construction industry wages have historically failed to match the increase of the rate of inflation over the past 30 years. In fact, the construction industry’s failure to match inflationary levels snowballed to more than 25% erosion in the purchasing power of construction wages over the last 30 years.  

As little as two years ago, FMI’s phone was ringing off the hook with questions from clients like, “How do I keep my competitors from stealing my key people when they are offering 35% higher in base pay?” The aging workforce and subsequent labor gap had created an unparalleled level of demand for talent, which resulted in a quick spike in compensation wages. While some companies took safer routes, provided richer incentive plans and held “guaranteed money” (base pay) constant, most companies in the industry simply battled through fixed cost. In this case, the most aggressive companies were able to steal many people away from their competitors, and, because of the boom market, these companies grew quickly.  

When the general economy crashed and construction industry backlogs dried up, many companies were left with a stable of highly paid employees but with less revenue. Additionally, more and more bidders began to show up on each project, squeezing margins. Compensation concerns were caused by a reduction in overall revenue and job profitability, combined with a labor force with inflated wage rates. 

Many of the compensation-related articles you will read today discuss how to adjust the labor pool to fix one’s cost structure. Most commonly, they will list salary reductions, layoffs, employee furloughs and other tactics to reduce the cost implications to match revenue. While all of these are reasonable tactics to help weather the downturn, will they really help you retain your stars? How do we incentivize key people to stay with our firm and perform at a high level long-term?  

Using Long-term Incentives

Long-term incentives (LTIs) are easily described in two ways:

1. An incentive plan that is designed to fund a bonus that is based off of performance from a period greater than one year OR/AND
2. An incentive plan that funds a bonus that will not pay out in the specific period that it is earned due to a vesting schedule.

Ideally, the combination of these two definitions is a great way to get your employees to have a multi-year focus and to retain them long term, creating some golden handcuffs. Just as the stock market was at an historic low in April 2009, financial performance of contractors has also been at historic lows. If you had purchased a share of Apple, Inc. last March you would have likely paid 80-something dollars for the share. Now the same share of stock would be worth over $200. There is a huge financial opportunity in “buying low.” 

Similarly, giving your employees an opportunity to share in the upside of your company as it emerges from the downturn is an exciting proposition. With a multi-year plan in place, the payouts will begin sometime in the future when your balance sheet is a little stronger and your firm can afford the cash outlay. Additionally, a properly designed vesting schedule may delay the payouts further and balance the dispersement of cash over a multi-year period. 

Given this climate, contractors may ask themselves, “What if my company doesn’t perform over this time?” The answer is simple – if you design your incentive plan correctly, you will not have a financial obligation to pay if there is not correlating financial performance.  

The Facts

There are different types of incentive plans, each with their inherent advantages and disadvantages. Before deciding on a particular plan design, it is helpful to brainstorm around the following questions: 

• What is our long-term vision and what results and behaviors do we want to incentivize?
• What are our main objectives with this plan?
• Who are our key people?
• What makes a “key employee”?
• Do we want our award to have immediate value to the employee, or do we want it to be purely an incentive based on performance?
• What are the company’s financial objectives?
• Are there non-financial objectives that should affect our incentive payouts?
• To what extent should individual (versus team) performance matter?
• Do we want the award value to appreciate or depreciate with the value of the company, similar to stock?
• Do we want a vesting period and, if so, what type of vesting period is appropriate?
• How much of our future earnings would we be willing to give up to reward this group of employees, long term? (Some financial modeling is typically needed.)

There are obviously many more questions that can be discussed prior to or during the plan design phase, however this list can start the brainstorming process. 

There are many different plan types that can be structured to accomplish the motivational and retention of objectives, and they include performance unit plans, formula plans, equity-based incentive plans and stock option purchase plans. 

Performance Unit Plan (PUP)

These plans grant the participant “units” that are earned through the achievement of performance goals over a specified period, often three to five years. At the time of plan inception, the company establishes a fixed value for the unit that remains constant during the performance period. The variable is the number of awards earned during that period.  

A target financial goal is determined and is aligned with a corresponding number of units. If the financial target is met, the participants receive the target number of units. If the financial target is not met, a reduced number of units will be awarded, usually subject to a threshold. Accordingly, if the financial target is exceeded, a larger number of units will be awarded. Exhibit 1 illustrates the impact that year over year performance has on the number of PUPs that are awarded. 

Exhibit 1: Performance Unit Plan example

Year	Awarded in Year 1	Awarded in Year 2	Awarded in Year 3	Total
Performance Units Awarded	10 – Met financial objective	5 – slightly missed financial objective	30 – greatly exceeded financial objective	45
Value Per Unit	$2,000	$2,000	$2,000	$2,000
Total	$20,000	$10,000	$60,000	$90,000

Plan documentation should clearly define the level of performance necessary to achieve specific levels of PUPs.   

• Tax Treatment

The participant does not recognize any taxable income at the time the performance units are granted. Once the units are earned and vested, the participant is taxed at ordinary income rates and the company receives an equal deduction. 

• Advantages of PUPs

These plans provide an opportunity for long-term wealth accumulation based on narrower performance goals that the participants can directly influence, rather than on the broader measure of changes in stock price. On the other hand, senior employees, especially CEOs, may be fairly tasked with improvement in stock prices and be rewarded via that achievement. 

• Disadvantages of PUPs

Accurately projecting company performance with respect to financial goals over a number of years is difficult and, if not communicated properly, may be frustrating to employees. 

Formula Plans

These are similar to PUPs except the value of the unit is determined by the level of achievement with the number of units being fixed. Exhibit 2 demonstrates the difference between a PUP plan and the formula plan. In the case of the formula plan, the performance units that are available remain the same each year; it is the value of each unit that fluctuates depending on the success of achieving the goals that are set for the performance period.  

Exhibit 2: Formula Plan example

Year	Awarded in Year 1	Awarded in Year 2	Awarded in Year 3	Total
Performance Units	10	10	10	30
Value Per Unit	$2,000 – Met financial objective	$1,000 – Slightly missed financial objective	$6,000 – greatly exceeded financial objective	$3,000 (average value)
Total	$20,000	$10,000	$60,000	$90,000

  

• Tax Treatment

Same as PUPs. 

• Advantages and Disadvantages

Same as PUPs.

Equity-Based Incentive Plans

These plans all utilize company stock in some manner. There are three basic type plans. The first involves the purchase of stock, meaning that the employee makes an investment and becomes an owner. The second type of plan focuses on appreciation. These plans grant the employee the right to appreciation in the value of the stock. No investment is required and ownership is not transferred. These are often referred to as SARs (Stock Appreciation Rights) or Phantom Stock plans (because no actual stock changes hands). The third type is known as a full value plan. In addition to realizing the appreciation in value, at the time of payout the employee receives the full value of the underlying stock. Since full value plans effectively amount to a gift or bonus of stock and its appreciation, these are less frequently used than the first two types of equity-based incentive plans. 

While neither one of the examples in Exhibit 3 involves the gifting or purchase of actual stock, the values are tied directly to the price of the company stock. The SAR example demonstrates how the participant, upon exercise of the SAR, receives only the difference between the price of the stock at grant and the price at exercise. On the other hand, the participant in the Phantom stock plan would receive the full value at exercise.  

Exhibit 3: Stock Appreciation Rights example 

SAR

	Grant year		Exercise year
Year	Year 1	Year 2	Year 3
Value of Stock	$25.00	$40.00	$50.00
Number of rights	500
Total value of grant	$12,500.00	$20,000.00	$25,000.00
Value to employee	$0.00	$7,500.00	$12,500.00

Phantom Stock

	Grant year		Exercise year
Year	Year 1	Year 2	Year 3
Value of Stock	$25.00	$40.00	$50.00
Number of Phantom Shares	500
Total value of grant	$12,500.00	$20,000.00	$25,000.00
Value to employee	$12,500.00	$20,000.00	$25,000.00

Stock Option Purchase Plans

Stock option plans grant the participant the right to purchase a fixed number of shares at fixed price for a specified period. These plans offer valuable long-term incentives to employees to keep them motivated and focused on overall company performance. These plans are effective with young companies with plenty of growth potential. Exhibit 4 shows how the employee can purchase their options at year three. If the value of the stock had not eclipsed the price of each option then the options would have no value to the employee. 

Exhibit 4: Stock Option Purchase Plan example

	Grant Year		Exercise Year
Year	Year 1	Year 2	Year 3
Number of options	500		500
Price of per option	$10.00		$10.00
Total cost at exercise			$5,000.00
Actual stock value/share	$5.00	$10.00	$25.00
Total value of options			$12,500.00
Total value to employee			$7,500.00

 Incentive Stock Options (ISO)

ISOs are free of tax at the date of grant and the date of exercise if certain requirements are met. (The taxable event occurs at the time of subsequent sale of the stock after the option is exercised.) Among the most important requirements for tax-free treatment at the dates of grant and of exercise are:

• The maximum exercise period for an ISO cannot exceed 10 years, but if the employee eligible for the plan owns more than 10% of the company, that maximum cannot exceed five years.
• The exercise price of an ISO cannot be less than the fair market value of the stock at time of grant. If the employee owns more than 10% of the company, the exercise price cannot be less than 110% of the fair market value.
• The employee cannot sell shares within two years from the date the option is granted or within one year from when the option is exercised.
• The fair market value of the shares cannot exceed $100,000.

 

• Tax Treatment

Assuming the employee holds the stock consistent with requirements, he or she will incur a capital gains liability on the difference between the sale price and the exercise price. The recipient of the shares may be subject to the alternative minimum tax in the year the ISO is exercised. 

• Advantages

The employee chooses the time that a taxable event occurs as an ISO produces taxable income only when sold, so it provides an opportunity to defer income without taxation.   

• Disadvantages

From the company’s perspective, the primary disadvantage is that the company does not receive a tax deduction at exercise. For the employee the one-year holding requirement (one year after exercise; two years after grant) can be a disadvantage as the stock price may decline.  

Nonqualified Stock Options (NQSO)

The employee is subject to ordinary income tax at the time the option is exercised and the company receives a corresponding deduction. Once the employee owns the shares, future sales are taxed at capital gains rates. 

• Advantages

NQSOs have greater flexibility than ISOs as no statutory requirements have to be met and the company sets the option price. Companies can attach dividends providing payment to the employee before exercising the option. This allows cash buildup the employee can use when exercising the NQSO. 

• Disadvantages

The employee is taxed when the shares are exercised so there is no deferral of tax and the company is required to withhold a minimum amount of income tax from the gain when the option is exercised. This creates an additional burden on the employee who must find the money to exercise the option and pay the taxes. 

Restricted Stock Grants

The employee is granted shares that are subject to forfeiture unless certain conditions are met. Upon the lapse of restrictions, the employee is awarded the shares. Usually, the restrictions require completion of a period of years or attainment of a specified level of performance. 

Chief Executive Compensation Packages – What are the top contractors in our industry doing?

Data for the publicly held companies is taken from proxy reports that each company is required to file with the SEC. There is no issue with confidentiality since this information is available to the public. Data for the privately held companies is from FMI’s annual executive compensation survey that is commissioned by construction industry participants. As these companies are private and not required to disclose compensation levels or practices, we took precautions to assure that individual results would not be revealed. 

In 2006, the SEC redesigned the format that companies must use in disclosing their compensation information. As a result, the tables containing their data no longer match perfectly with our survey results (See Exhibits 5, 6 and 7). Another issue in surveying non-cash compensation among privately held companies is that these plans typically do not extend far down into the organization and tend to be limited to a smaller group of participants than plans among public companies. 

This analysis is limited to 2008 and many private companies, as well as some public firms, do not make long-term awards annually. This means that we could repeat these analyses a year from now and get considerably different results. The reader should be aware that the public companies tend to be heavily engineering oriented and have revenues much larger than those of most general contractors. 

Exhibit 5

Publicly Traded (13 Companies)
Component	Percentage of Total Compensation
Base Salary	20%
Cash Incentives	29%
Equity Incentives	40%
Other	11%
Privately Held (15 Companies)
Component	Percentage of Total Compensation
Base Salary	34%
Short-term Incentives	62%
Long-term Incentives	4%

Exhibit 6

CEO Total Compensation, Estimated Income
Public Companies
Total Revenue of 13 Companies	$96.4 B
Average Revenue per Company	$7.4 B
Total Income of 13 Companies	$2.9 B
Average Income per Company	$223.1 M
Total Compensation of 13 CEOs	$80.0 M
Average Total Compensation per CEO	$6.15M
Total Compensation/Revenue	0.08 %
Total Compensation/Income	2.76 %
Private Companies
Total Revenue of 15 Companies	$46.3 B
Average Revenue per Company	$3.1 B
Total Income of 15 Companies (est.)	$155 M
Average Income per Company (est.)	$10.3 M
Total Compensation of 15 CEOs	$24.7 M
Average Total Compensation per CEO	$1.65M
Total Compensation/Revenue	.005%

 Exhibit 7:Compensation Components – Publicly Traded Companies  

COMPANY	Salary	Non-Perf. Based Bonus	Restricted Stock	Nonqual. Deferred Comp	Stock Options	Non- Equity Incentives	Other
AECOM	X	X	X	X			X
CBI	X		X		X	X	X
EMCOR	X	X	X				X
Fluor	X		X	X	X		X
Foster-Wheeler	X		X	X	X	X
Granite	X		X			X	X
KBR	X		X	X		X	X
McDermott	X	X	X	X	X	X	X
Quanta	X		X			X	X
Shaw Group	X		X		X	X	X
Tetra Tech	X		X		X	X	X
URS	X		X	X		X	X

Column Header Definitions

Salary – Self-explanatory

Non-Performance Based Bonus – The SEC has added a column to the proxy format for non-performance bonuses. This column in not widely used, but does include bonus amounts that are discretionary or contractual.

Stock Options – Includes nonqualified and incentive stock options. Companies using these vehicles are required to report compensation expenses resulting from the awards.

Restricted Stock – Include restricted grants whose restrictions lapse when time or performance criteria have been met.

Non-equity incentive awards – These may include annual plans and annual payments made from a multi-year plan. They are formula based and not discretionary.

Nonqualified deferred compensation – The company only reports an amount if a change in the value to the executive is realized.

Other- Includes such items as perquisite allowances, insurance premiums, 401(k) match, personal security and protection expenses, and others. 

Summary

In an economic environment like we face today it is more important than ever to ensure that your top talent is on board for the eventual increase in activity. Long-term employee retention includes making sure that those key employees have a valuable multi-year incentive for helping pull the company through the tough times that then enables them to benefit from the momentum up.  

As illustrated in this article, there are many different types of LTI plans. They can be structured with varying levels of complexity and implemented at companies of all sizes. There is no better time than now to determine what LTI plan is best for your organization. Take the time to identify who the top individuals are that you want to participate in the plan. Fully develop and understand your long-term vision and how you would like to achieve it. Figure out how much of your future earnings you are willing to share. Then decide on what plan structure works best to accomplish your goals. Build the plan to protect the company in down times and reward your key people in the good times.  

A properly structured and communicated LTI plan will enable the leadership group to develop a clearer focus what is important and provide them with direct line-of-sight between company goals, their performance and eventual accumulation of wealth. By giving key employees the chance to “buy low” you are investing in the future success of your company, and keeping a stable leadership group who will provide an even greater return over the long run.