Executive Compensation – What Business-Owners Need to Know
By Peter Miterko
Many public and privately owned companies have experienced explosive growth and outsized profitability in the last decade. Owners of less successful companies wish they had the secret sauce to replicate their results.
At the same time, public company executive compensation is widely reported in the public press, and many business owners shake their heads in disbelief at the eye-popping size of executive pay. On the surface it looks like such a waste!
Executive compensation consultants know that in the overwhelming majority of cases, growth and profitability are firmly linked to the upside executives are entitled to enjoy when a business is successful. When the press reports outsize executive compensation, there is a high likelihood the business has experienced significant growth, increased profitability, and impressive share price increases.
The secret sauce for explosive growth and outsized profitability is the establishment of an executive pay structure and incentive plans which drive that growth and profitability.
Following are 10 things business owners ought to know about executive pay structure and incentive compensation:
- Annual incentive plans should deliver outsize awards for outsize performance. If a cap is used, it ought to be a high one. If cash flow is an issue, the incentive payment can be paid over 2-3 years.
- Long term incentive plans should be the centerpiece of executive compensation. These plans should pay an award for achievement of long-term goals over at least a three-year performance period. These plans serve to align the interests of the owner and the executive team more than any other element of compensation.
- Executives should own a stake in the business via actual equity. Executive ownership aligns the owners and executives even more than long term incentives and keeps everyone focused on growing the long-term value of the business. The best long-term incentive plans use actual company equity as currency for payment.
- Equity ownership should be actual equity and not phantom equity. With all due respect to my fellow members of the Bar who believe otherwise, actual equity has enormous psychological and tax advantages over phantom equity, and zero downside to the owner if the plan is properly constructed.
- Executives should have skin in the game by purchasing all or part of their equity stake, and it should not be easy for executive equity to be cashed out.
- Restrictive covenants (non-solicitation of customers, employees, non-competes (where applicable) and other covenants should be used to keep high performing executives. The generosity of the incentive plans and the executives’ status as shareholders should mean that executives will readily embrace these.
- Owners don’t need the highest current compensation. Owners should be focused on building the long-term value of the business and not so much on their current compensation. In some years managers below the executive level who are adding great value should be paid more than the top executives. In the last several years this had been true of merchant banks, investment banks, homebuilders, and a variety of other businesses.
- Beware how compensation is paid on a change in control. You, the business owner, want to make sure that if your exit strategy is a third-party sale, that your executive team does not exit when you do. (In that case, there many very well be no third-party sale!). There are a variety of techniques you can employ to ensure this does not happen.
- Multi-generational business pay lesson #1. If you are passing leadership in the business on to other family members make sure that the executives who are making high growth, profitability and increases in equity value happen are being paid first. Do not pay family members more. Do not let family members benefit from incentive plans where other executives are responsible for the results that drive the incentive payments. In today’s business environment, your business will be harmed significantly if family members are treated even a little bit better than non-family executives.
- Multi-generational business pay lesson #2. If a family member is making growth profitability, and share value increase happen, do not get sidetracked by family members not working in the business who are jealous of the executive’s pay. There is no quicker way to tank a family owned business than to engage in this type of activity. Make the dissenting family members an offer they can’t refuse and nip the dissention in the bud.
Feel free to reach out to us if you have any questions regarding executive compensation strategies for your clients or your business.
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