Competitive Pay for Private Companies
Given the controversy surrounding executive pay, private companies may be relieved that their compensation packages are protected from the glare of public disclosure. But private company pay packages also may be failing to attract the right sort of attention.
Executive compensation plans at private entities may be falling short for two reasons. First, they often fail to attract and retain top executive talent because their size and structure don't quite measure up to the incentive compensation packages at public companies. Second, private company compensation plans tend to motivate managers to concentrate too much on short-term challenges and too little on long-term success.
By offering managers more opportunities for long-term incentives (LTIs), private companies can fend off those public companies intent on poaching their best and brightest. LTIs can also help private organizations better align executive decision-making with long-term strategic objectives.
Shortsightedness and Other Risks
Public companies are well-acquainted with the benefits of properly designed and managed LTI plans; typically, more than 50% of an executive's pay package at large, publicly listed companies consists of LTIs, such as stock awards and stock option grants.
However, the majority of executive compensation plans among private companies includes only two elements: salary and an annual cash bonus. The bonus is awarded based on whether or not, or the degree to which, an executive meets annual performance goals. Limiting executive pay to only two elements poses several risks.
First, top prospects and current executives may be lured to organizations where compensation packages contain far more "upside" appeal. An annual cash bonus is often capped according to a predefined limit while equity-based incentives are determined by future stock performance.
Second, annual cash bonuses tend to focus attention squarely on short-term goals, even if those decisions and behaviors thwart the achievement of long-term strategic objectives.
Third, annual cash bonuses rarely cultivate a sense of ownership among recipients; even those who occupy the highest levels of executive management are more likely to behave as employees rather than owners, precisely because they are not owners. That difference can further ingrain a short-term perspective among private company managers who normally have enough trouble carving out time to focus on long-term objectives.
Defining Long-Term Success
To prevent those risks from taking root, private companies can introduce LTI vehicles to their executive compensation plans. To determine which LTI vehicles are best suited to their organization, the leadership team at a private company should answer three questions:
1. What are our most important compensation objectives? An LTI plan can strengthen long-term performance in two ways—by attracting and retaining executive talent and by focusing executive attention on long-term strategy. The temptation will be to assign equal priority to both objectives. If that's truly the case, fine. If not, identify which objective is more important; doing so will have significant implications on the design of the LTI plan.
2. How do we define long-term success? The question has two parts. First, identify length of time—three years, four years, five years?—during which success will be measured. Second, identify how success will be measured: Which performance indicators (e.g., revenue, profitability, market value) will determine whether the incentive is awarded?
3. Who and how much? Which management layers will be eligible to receive LTIs, and how much of their total compensation will consist of an LTI award?
Real Equity, Phantom Equity, or Cash?
Armed with those insights, private company leaders can determine which of the following LTI vehicles best support their compensation strategy. Three examples:
• Real Equity: Executives are granted shares or options in the company that vest over three years; the executives typically realize the value of those shares or options only after an initial public offering or a sale of the company.
• Phantom Equity: Executives are granted units (the value of which is tied to the company's value) that vest over three years; executives are paid (in cash) the value of the units after three years.
• Long-Term Cash: Executives receive a cash bonus tied to a three-year performance target, such as revenue.
Real equity involves giving executives an actual ownership stake in the business. That may be a tough call to make for family-owned businesses where equity is frequently viewed as the nest egg for future generations. However, real equity may be the most effective attraction and retention tool. Plus, it helps cultivate a sense of ownership among employee-shareholders, which can promote a better balance between short- and long-term decision-making.
As its name implies, phantom equity offers the allure of real equity without requiring private company ownership to share their stake and voting rights in the company. Real equity and phantom equity are both determined based on a valuation of the company; however, the valuation of phantom shares is easier and less expensive to determine and can be clearly defined for recipients. Phantom equity is essentially a long-term cash bonus tied to company valuation.
Long-term cash bonuses are generally tied to the organization's achievement of long-term strategic goals (e.g., the achievement of revenue, profitability, and/or market share increases) over a three- to five-year period.
Each of these LTIs has strengths and weaknesses. The trick is to weigh those pros and cons in light of a private company's attraction, retention, and strategic priorities.
Private companies will be more likely to bask in the glow of success if their compensation strategies employ appropriate long-term incentives to attract, retain, and focus the best and brightest executive talent.