Calibrating an Appropriate LTI Opportunity for Not-for-Profit Orgs

Not-for-profit (NFP) organizations often want to integrate the leverage of long-term incentives (LTIs) into their executive compensation strategy. However, this decision often comes at a price. Because LTIs are commonly provided in cash at NFPs, it’s costly to try to match LTI values that are being provided through publicly traded equity vehicles. As such, appropriately sourced private-company LTI values may serve as a better benchmark for cash-based vehicles for most (but not all) NFPs.

Should NFPs Consider For-Profit Comp Levels?

A common misconception is that NFPs should benchmark only against nonprofit compensation levels. This ignores the reality that many roles have transferable skills, and NPFs seek to bring in fresh perspectives from outside the sector. As a result, they compete for executive talent in the same labor markets as private-sector employers; larger NFPs are especially likely to recruit leaders from comparably sized organizations where a significant portion of pay is delivered through incentives.

Most U.S.-based NFPs can’t grant actual equity because they must remain mindful of private inurement and intermediate sanctions considerations (under the Internal Revenue Code). This likely makes cash LTIs the only option. Even if NFPs don’t need to fully meet for-profit pay levels, given the benefits and intrinsic rewards many nonprofits can offer, they often need to be at least directionally competitive. The trick is finding the balance between cost and competitiveness.

Cash Is More Expensive to Deliver Than Stock

While values delivered to incumbents may be similar, the economics of the vehicles are very different.

Cash LTIs are straightforward:

The organization pays exactly what participants earn.
There is no shareholder dilution.
Accounting expense generally equals the expected payout.
Governance is simpler because no equity valuation is required.

For example, if an NFP grants a target LTI opportunity of $100,000 and pays at target, the cost to the organization is approximately $100,000 (plus payroll taxes and administration expenses).

LTIs delivered in equity are a non-cash cost to the organization. The annual shareholder dilution is acceptable because the ultimate value of the equity delivered to the participant also is tied to the organization’s overall value, resulting in aligned participant and shareholder interests.

Unfortunately, even cash-based programs that are tied to enterprise value generate additional costs:

Annual valuations often are required, and it may be important to conduct these independently versus internally.
Governance and board oversight are more complex.
Accounting values can fluctuate significantly.
High-growth outcomes can create unexpectedly large payouts that may still need to be delivered in cash, while stock prices theoretically can increase infinitely.

Besides the administrative costs and governance challenges, cash-based programs tied to enterprise value also can raise concerns regarding private inurement and Internal Revenue Code Section 4958 exposure if payouts become exceptionally large. Consequently, many NFPs find that performance-based cash LTIs provide the comparable motivational value of equity while avoiding many of the legal and administrative complexities.

For most nonprofits, private-company LTI data provides an excellent reference point for establishing values for long-term performance leverage while recognizing the organization’s corporate structure and talent demands.

Why NFPs Should Consider Private-Company LTI Opportunities

In addition to the cost considerations of adding LTIs to the executive pay program (even if they are mitigated through the performance achievements), WTW’s Long-Term Incentive Plan Design survey revealed that — all else being equal — equity-based LTI opportunities are higher than their cash-based counterparts.

So, do cash-based LTIs need to fully replace the value that’s delivered by stock-based programs? In some cases, perhaps — such as when an organization is in an industry that heavily depends on equity-based LTIs as part of its pay package (e.g., research institutes that compete with defense contractors or biopharma companies). But for most nonprofits, private-company LTI data provides an excellent reference point for establishing values for long-term performance leverage while recognizing the organization’s corporate structure and talent demands.

Private-company benchmarks provide a useful comparison because they:

Reflect organizations that face many of the same structural realities as nonprofits (limited liquidity, concentrated executive participation, an emphasis on long-term value creation);
Are generally of similar size to large NFPs ($1 billion or more in annual revenue/budget), which also is an important consideration given the impact of revenue size on executive pay levels; and,
Have a common objective (retention, sustained performance and accountability for multi-year outcomes, rather than shareholder alignment).

The magnitude of private-company LTIs tends to fall between two extremes:

Public companies that provide LTIs in much larger quantities due to readily available access to liquid equity; and,
Private companies that don’t provide LTIs at all.

Private-company LTI data, therefore, represents a sensible middle ground, recognizing the market for talent is, in part, public companies, but at LTI levels that are sized to the cash affordability constraints among non-public companies.

Moving Forward: A Practical Approach

For many NFPs, an effective approach may be to:

Consider whether adding LTIs would be in line with the compensation philosophy and support achievement of the organization’s strategy.
- Relatedly, consider if the optics of providing LTIs is acceptable, once the prevalence of LTIs among the organization’s traditional comparators/peers is understood.
Compile private-company LTI market data for the included positions while also considering the total remuneration provided relative to the comparator and/or talent markets as part of the ongoing competitive assessments.
Design the programs to best fit the organization’s needs and circumstances.
- Some organizations may find the added complexity of performance units or phantom-equity-like vehicles worthwhile.
Identify performance metrics that focus on strategic, financial and transformation areas that require sustained, long-term effort.
As with all incentive plans, be mindful of governance and the role of discretion.

What Do You Need to Offer?

NFPs shouldn’t lament the inability to grant stock. Rather, they should consider, “What level of LTI opportunity is necessary to recruit, retain and motivate our executive talent?”

For some, the answer will be to benchmark opportunities to publicly traded companies because their talent and business competitors also are publicly traded. However, for most NFPs, benchmarking opportunities to private-company practices likely is a more appropriate alternative.

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