Four lessons private companies can learn from public companies about compensating their executives

Michael G. Riley, McDonald Hopkins

John M. Wirtshafter, McDonald Hopkins

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 protected] Reach Wirtshafter at (216) 348-5833 or [email protected]