Well-drafted executive compensation programs aren’t just used to recruit and retain top-level leadership to your company. Public and private companies can tailor executive pay packages to encourage executives to achieve certain goals.
“We can put strings on short-term and long-term benefits to drive executive behavior, and that’s one of the things that’s really coming to the forefront now,” says Ted R. Ginsburg, CPA, JD, a principal with Skoda Minotti.
Smart Business spoke with Ginsburg about leveraging executive compensation.
What are the key components of an executive compensation program?
In general, an executive compensation program consists of four key parts. These are base pay, annual bonus, long-term incentives and perquisites, which could include car allowances, country club memberships, executive physical programs, security services and use of the company airplane. Because of recent economic events and more scrutiny by shareholders, perks are not such a big part of the package anymore; employers are providing higher base pay and instructing executives to acquire the perks on their own.
An optional component is a sign-on and/or retention bonus. A sign-on bonus is appropriate when trying to hire an executive from another company who would lose a bonus if he or she left. The retention bonus — a promise to stay through a certain date or event in order to receive a bonus — is used when you have incurred hard times and worry the executive is going to leave.
How does executive compensation differ in a public and private company?
There are some significant differences, and oftentimes, private companies are at an inherent disadvantage. A public company normally provides a long-term incentive using either a stock option or restricted stock. A stock option allows executives to purchase shares at a stated price while he or she remains employed; a restricted stock program gives executives a share of stock outright after meeting certain targets. Stock doesn’t drain cash flow, often doesn’t immediately reduce earnings and can have favorable tax treatment for the company and the recipient. In a publicly traded company setting, the recipient can usually turn around and resell the shares on the open market immediately. The total pay package of chief executives of major public Cleveland corporations may comprise 60 to 70 percent in company shares.
Many executives in private companies don’t want to receive stock unless they already own a substantial company stake. Executives would need to pay income tax on the stock and can’t sell part of the shares to cover the amount. Also, executives usually must sell the stock back when they leave in exchange for a cash payment made over time. Furthermore, private company owners might not share financial information with executives so the value of the ownership interest is unclear.
What can a private company offer someone from a public company instead of stock options?
Some private companies award only base pay and an annual bonus, but attracting a senior-level executive from a public company is difficult without a long-term incentive program. There are programs that provide a cash payment based on company performance and the current company value over a number of years, making executives feel as if money has been put aside for their future. Two types of long-term incentive programs are:
- Phantom stock — an owner gives executives a check representing the full value of a number of shares of stock when they leave.
- Stock appreciation rights — an owner gives executives a check when they leave, which equals the number of rights given to them multiplied by the difference between the value of the stock when it was awarded and when they leave. Mimicking a stock option, it rewards executives for increasing the value of the company.
These programs often have a vesting schedule stating an executive leaving before a certain time does not receive the entire benefit.
Another methodology is a change of control payment, where an owner planning to sell or transfer the business gives the executive a check based on the sale price or value of the company at the time ownership is transferred.
Some larger private companies with the necessary liquidity also use long-term cash incentive programs. Over a period of time, if revenue is up or costs are down, cash is put aside for when the executive leaves.
Why do long-term incentive programs help an employer?
These programs act as retention devices. They focus employees on long-term performance rather than maximizing annual bonuses and they don’t drain cash immediately as they are deferred payment obligations.
Long-term incentive programs are familiar to public company executives. If a private business owner offers to pay to replace the value of stock options lost because the executive left for a private company, the recruited public executive might ask what he or she is going to get for subsequent years.
Finally, they allow for a trial period, giving the option of cutting him or her loose early.
Why are employers moving away from discretionary annual bonuses?
With discretionary bonuses, private company executives walk away without knowing what they did to earn it and how to repeat it. Many businesses now give bonuses based on company performance.
Well-drafted programs have easily measured goals that drive behavior and set annual priorities. Long-term, multiyear program goals relate to financial performance and other forward-thinking items, such as establishing a new geographic market or bringing a certain number of products to market. If the goals aren’t met but executives put in the effort, ownership can always give discretionary bonuses. This type of program helps employers manage the executive’s expectations and creates transparent working conditions.
Ted R. Ginsburg, CPA, JD, is a principal with Skoda Minotti. Reach him at (440) 449-6800 or email@example.com.
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