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 firstname.lastname@example.org.
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One of the more interesting times of the year to be an executive compensation attorney -— proxy season -— is about to begin. That is when publicly traded companies issue their annual proxies containing a substantial amount of information regarding how they compensate their executives.
“This information not only contains a comprehensive analysis of the issues and factors that are taken into consideration in designing and implementing the compensation strategy, it contains detailed descriptions of the amounts paid to such executives,” says John M. Wirtshafter, a member with McDonald Hopkins. “In addition to simply being interesting reading, private companies can learn a lot from how public companies compensate their key employees.”
Smart Business spoke with Wirtshafter and Michael G. Riley with McDonald Hopkins about four lessons private companies can learn from public companies about executive compensation.
1. You don’t need to go it alone. Typically, public companies use independent compensation committees and outside consultants and attorneys to design, implement and administer the compensation programs for executives of the company. We are not suggesting that private companies should all create compensation committees on their board of directors or independent groups to review and set their compensation. However, most private companies could benefit from impartial advice and counsel. It is easy to lose perspective when you are so closely involved. It makes sense to periodically step back and make sure that your compensation programs are appropriate and strategic. After all, we can all use a sounding board from time to time.
2. Know where you stand. Publicly traded companies have access to all sorts of public information about the compensation paid to executives of their competitors. So do their investors and executives. They rely on this information to ensure they are paying a market rate of compensation and in order to attract, motivate and retain their executives. The same information is equally important to privately held companies. While the information available from proxies may not be all that applicable for most smaller and middle market privately held companies, there are a number of resources that could provide helpful information. If nothing else, it is important that you understand how your total compensation packages compare to others. Otherwise, your best executives may have better opportunities elsewhere and take them.
3. Get on the ‘pay for performance’ bandwagon. Perhaps the most-used terminology in executive compensation in the publicly traded world is ‘pay for performance.’ It has been the mantra of compensation specialists for years. Shareholders of public companies demand that the compensation strategies for executives align the executive’s interests with their interests. This is usually best accomplished by a combination of short-term and long-term bonus and incentive plans that are tied to the actual economic performance of the company. For executives to really succeed in such programs, they need to build long-term shareholder value. For instance, practically every Fortune 500 company awards substantial amounts of stock options and/or restricted stock to their executives. As the value of the benefit is directly tied to the performance of the company’s stock, this closely aligns the executives’ interests with the shareholders’ interests. Many privately held companies also share stock options and restricted stock with their executives. Companies that are unwilling to use actual stock can provide a similar benefit through phantom stock or other long-term strategies that are based upon the net worth of the company. For limited liability companies or partnerships that do not have stock, there are other methods, such as profits interests, limited partnership interests and restricted units that can potentially be used to accomplish a similar incentive. Each method has its own distinct tax, accounting and cash-flow issues. Furthermore, as there is not a market for the stock, these programs must be designed so that the tax and cash obligations of the company and the executive are considered. It is important to fully understand your objectives and alternatives before settling on a strategy. This is clearly a case where one size does not fit all.
4. Ensure your compensation programs align risk with the reward. Perhaps the most recent concern relating to pay for performance in executive compensation is to ensure that the compensation programs are designed, both qualitatively and quantitatively, to align pay with actual performance of the company. Investors often object when large compensation payments go to executives when the company’s stock is failing. It is also critical that pay plans not encourage executives to expose the company to unacceptable risks in the pursuit of performance targets.
One way publicly traded companies protect themselves from this risk is through the use of ‘claw-backs.’ Claw-backs are where the company is entitled to a refund of the bonus or stock gains received by an executive if the company’s financial statements upon which the bonus or profits were based are later restated or if the executive breaches an employment agreement covenant or a company policy. These provisions penalize bad behavior, ensure that the executive does not receive an undeserved windfall, and protect the company from unnecessary risk.
Other ways to address these concerns include using performance-based metrics for vesting rather than simply basing vesting on the passage of time; requiring severance or certain payments to be approved by the board of directors; ensuring bonus criteria are strategic; and implementing programs based, in part, on the company’s performance relative to the performance of its competitors. These same issues are important for privately held companies.
John M. Wirtshafter and Michael G. Riley are members with McDonald Hopkins LLC. Reach Riley at (216) 348-5454 or email@example.com. Reach Wirtshafter at (216) 348-5833 or firstname.lastname@example.org.
A competitive compensation package is essential to attracting and retaining high-performing executives. In addition to base salary, such a package ties performance to bonus and incentive awards as well as supplemental retirement packages, and includes provisions for severance pay.
Understanding the principles of compensation packages is critical when competing for top-level talent, says John Klevorn, a partner with The Stolar Partnership.
“From the company standpoint, hiring the right executive is incredibly important for the lifeblood of an organization,” says Klevorn. “You want to make sure that you have the right leader in place.”
Smart Business spoke with Klevorn about executive compensation, how to benchmark benefits and how recent reform has impacted executive compensation policies.
Where should a company start when negotiating executive compensation?
Executives come with hefty demands in terms of salary, benefits and other perks. Before you initiate a talent search or begin compensation negotiations, it’s important to establish a benchmark so that when you do begin to negotiate, you have a point of reference. Next, determine the level of proficiency and performance you’re seeking. With this information and the compensation benchmarks, it will be easier to search the marketplace, look at databases and understand the market value for the position.
There will be ranges with regard to market value so you will want to land somewhere inside those market value ranges. In some instances, a company will want the right person to grow into the job, so it might pay at a lower salary level within that range. In other cases, a company might want a star, and that star may only commit if he or she receives compensation at the high end of the market range.
How should a company benchmark benefits?
Make sure you’re compensating your executive fairly relative to the market. At the same time, make sure compensation is not so far askew internally that the incoming executive’s compensation compared to the next level below is out of whack. You don’t want to create such disparities within the company to cause employees to say, ‘Not fair, not fair.’
There is also an external aspect. Take financial services, for example. If you look at the compensation of CEOs of major financial institutions, you’re going to see symmetry. Company X does not want to pay its executive three times the amount that Company Y across the street is paying.
There is no collusion, but they do look at external matrices and metrics to remain competitive. Executive benefit companies monitor this information and keep their eyes on the latest figures.
You also want to make sure that the package you’re offering is not so diverse compared to other companies that the shareholders become concerned that the value of the company is being diminished.
What types of compensation programs are most effective at attracting and retaining executives?
First, the base salary has to be competitive. Second, executives want to know about bonuses. Are bonuses performance based? What standards will apply? Will bonuses increase over time? Stock options are also a key consideration.
Also, executives are often interested in longer-term plans. For example, add-on 401(k) plans allow those at the top to contribute more into the plan than other employees. Additionally, supplemental executive retirement plans (SERP) are designed to provide enhanced benefits to corporate executives and some are insured through life insurance programs and policies.
Are there laws to be considered when setting an executive’s salary?
You have to follow the standard array of laws. You can’t discriminate on the basis of race, age or gender. You can’t retaliate. Tax rules tell you that any compensation must be consistent with the ordinary and necessary business needs of the company. For example, if you manufacture widgets and employ 15 people, it would be difficult to justify paying your CEO $5 million per year because it would not be deemed ordinary or necessary by the IRS. Also, you need to make sure you’re not diluting the value of the shareholders’ interests, as they have a say in making sure their rights are protected.
Other than these basic rules, however, executive compensation is fairly unregulated.
How has the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 affected executive compensation policies?
Dodd-Frank imposes new executive compensation rules and appropriate governing requirements on publicly held companies in the United States. The government is taking the stance that, for the protection of companies, employees and shareholders, it is necessary to monitor executive compensation.
Executives have negotiated multimillion-dollar compensation deals both during their tenure and after they leave their companies. Dodd-Frank is designed to provide better disclosure regarding these. There are now nonbinding shareholder votes at least every six years with respect to regular compensation and golden parachute arrangements.
Because the votes are nonbinding, there has been discussion about the possible impact. If shareholders overwhelmingly state that they do not believe the compensation paid to their CEO is the correct amount, boards of directors will be inclined to listen. The Dodd-Frank Act also includes rules that deal with the independence of compensation committees and their ability to hire legal counsel and consultants. The independence clauses are a result of what happened with Enron, Tyco and others. Nobody was independent; they were all part of the company, and their subjectivity was high and their objectivity low. The result: no one was able to blow the whistle.
The Dodd-Frank Act was designed to provide better information about what’s going on inside companies.
John Klevorn is a partner with The Stolar Partnership. Reach him at (314) 641-5179 or email@example.com.