Executive Compensation Strategies for Private Companies:

Transcription

1 Executive Compensation Strategies for Private Companies: developing the right program to attract, retain and motivate top executive talent * *connectedthinking

2 Private Company Services PricewaterhouseCoopers Private Company Services practice is an integrated team of audit, tax, and advisory professionals who focus on the unique needs of private companies and their owners. Within the practice, dedicated professionals concentrate on the needs of manufacturing, retail, wholesale and distribution, construction, food and beverage, and private equity portfolio companies, as well as on the needs of law firms and other service organizations. Our Private Company Services professionals are committed to delivering cost-effective, practical solutions and responsive services with the quality clients expect from PricewaterhouseCoopers. For more information about PricewaterhouseCoopers Private Company Services practice, visit Human Resource Services PricewaterhouseCoopers Human Resource Services practice is a global network of 6,000 human resource practitioners in 153 countries focused on managing the financial, regulatory and operational challenges associated with human resources. Our professionals work with companies in the areas of benefits, retirement, compensation, financial planning, international assignment, and process management in order to align their people strategy with their business strategy. Special thanks go to Bruce Clouser, Michael Lennartz, and Kimberly Schweitzer of PricewaterhouseCoopers Human Resource Services practice for their invaluable contributions to this white paper.

3 Introduction Owners of private companies face the issue over and over again. They face it when they have been unsuccessful in hiring a top executive who just couldn t pass up stock options from a public company. They face it when they lose a valued executive who was lured away by options and other public company benefits. Indeed, for private company owners, attracting and retaining top talent to help run their companies is a continuing challenge. And, it s not an easy issue to resolve. Developing an effective private company executive pay program often involves working through conflicting principles and goals, attempting to achieve a delicate balance between attracting and retaining key talent, motivating management to achieve business objectives, and managing concerns regarding minority ownership, cash flow, accounting, administration and regulatory issues. But, developing an effective compensation program is attainable, and of critical importance in a marketplace that is increasingly competitive. Compensation Strategy The attraction, retention and motivation of talented management personnel are the primary objectives of a successful compensation strategy. Unfortunately, these goals are sometimes conflicting. Compensation approaches that are highly motivational (in other words, that are deeply aligned with company performance), may provide little in the way of retention. On the other hand, approaches designed for strong retention (usually, premium pay levels relative to the competitive market) may not provide sufficient incentives to drive business results and result in substantial costs to a company s owners. In addressing this conflict, one of the key human capital questions that privately held companies must address is: To what extent does our executive pay program need to be competitive with our private and public company competitors? How will that impact our ability to attract and retain top executive talent? The answers to these questions are rarely obvious and depend on many subjective assessments, including: What are the differences in responsibility between private and public company executives? What are the relative risks of working for a public company vis-à-vis a private one? What are the differences in the benefit/perquisite programs? How do non-pecuniary benefits (e.g., culture, work-life balance) differ? Once the compensation program sufficiently addresses a company s attraction and retention needs in the competitive labor market, the company must ask: How closely is the pay program aligned with the business strategy? Does it motivate management to do the right things? While highly competitive pay levels may enhance a company s ability to attract and retain talent, it may have little effect on managerial behavior once executives are through the door. When establishing a pay strategy, it is essential to understand the longterm business strategy and align the pay program so that management is sufficiently motivated to achieve strategic objectives. For example, it would generally be inadvisable for a technology start-up to rely on a low leverage pay philosophy (high salary/low incentives), or to focus on free cash flow at the expense of revenue growth in its incentive programs. In addition, pay opportunities must be properly calibrated to performance such that incremental performance results in an appropriate level of incremental pay. **************** The key is to understand the role of pay in (1) attracting and retaining appropriate executive talent and (2) motivating executive talent to achieve strategic objectives. In this respect, public and private enterprises are really not different. As discussed in the next section, what is different is the set of compensation tools that are typically used by public and private companies. developing the right program to attract, retain and motivate top executive talent 1

4 Why Not Stock? The generally unfettered ability of public companies to use equity compensation has, over the last decade, constituted a competitive advantage in the labor market. The use of stock-based plans in private companies is much less common than in public companies for a number of reasons. Private company owners generally want to avoid both the dilution of ownership and the additional complexities that flow from minority ownership. Minority shareholders typically have the right to vote, review financial records and attend shareholder meetings. In addition, the relationship between the company and the executive can become strained which can make liquidating the equity position of a minority shareholder more complicated. Although this issue can be addressed with restrictive buy-back agreements, many private companies simply prefer to avoid the issue altogether. According to the Securities Exchange Act of 1934, companies with more than $10 million in assets whose securities are held by more than 500 owners must file annual and other periodic reports. For large private companies that have fairly widespread ownership, or wish to use equity compensation broadly throughout the organization, the annual and periodic reporting requirements would need to be carefully monitored. In addition, businesses classified under the tax law as S corporations would need to carefully manage ownership to 75 or fewer shareholders and monitor transfers of shares to trusts to maintain their S-status. There are also valuation considerations that can be somewhat challenging for private companies and often require the use of an outside valuation firm. Assuming that a private company s business strategy is to perpetuate the business (i.e., no sale or public offering is being contemplated), then the company will need to cash-in any long-term incentive regardless of whether or not real equity is used as the compensation device. Unlike public companies, private companies generally do not achieve any cash flow advantage using real equity plans versus phantom or long-term cash plans. The company will need to carefully manage the cash obligations flowing from the plan regardless of whether a real equity, phantom equity or long-term cash plan is used. Financial accounting principles have also been thought to have contributed to the preference of public companies for real equity plans and, in particular, stock options, as their long-term incentive device of choice. In part, this was due to the fact that stock options generally resulted in no accounting expense on the income statement. Because private companies frequently focus on managing the business to budgeted cash flow, as opposed to net income, the accounting issue is generally not a sufficiently compelling reason to use real equity. (Note: for private companies that need to achieve a certain level of net income for specific reasons, such as compliance with debt covenants, the accounting expense is an important consideration). With the proposed changes to US Generally Accepted Accounting Principles (GAAP) for share-based compensation (as of the date of this publication), the use of equity will likely go through a transformation as companies assess the impact of such rules. All companies, whether public or private, will be required to record an expense for employee share-based compensation. A nonpublic company would make a policy decision about whether to account for its share options and similar instruments based on their (1) fair value using an option pricing model (which is the preferred method) or (2) intrinsic value on each reporting date, through the date they are exercised or otherwise settled. For awards that can be settled in equity only, the fair value approach would result in fixed accounting expense as determined on the grant date, while the intrinsic value approach would result in variable, or mark-to-market, expense on each reporting date. For any award that an employee can compel the company to settle in a form other than equity (such as cash or some other asset), the award will be considered a liability instrument with mark-to-market accounting based on either fair value or intrinsic value, per the company s policy decision. 2 developing the right program to attract, retain and motivate top executive talent

5 Because of the constraints (both real and perceived) that privately held companies face in using real equity, the remuneration tools available to them are somewhat more limited than for public companies. Private companies can approach this challenge in several ways. Some private companies emphasize short-term cash devices over long-term compensation programs. Still, many other private companies use long-term incentive compensation approaches (e.g., phantom equity and long-term cash programs) to achieve their human capital objectives. Alternative Long-Term Incentive Vehicles In both public and private enterprises, the principal objective of long-term incentive compensation is to motivate executives to create long-term, sustainable value for shareholders. This is achieved through pay plans that carefully align the interests of executives and owners. As previously discussed, public companies have attempted to achieve this alignment through equity based compensation, especially stock options. While private companies generally have fewer choices in terms of long-term incentive vehicles, these choices often have superior alignment qualities versus stock options, which are subject to the vagaries of the stock market. Phantom equity plans and cash-based plans that are based on discounted cash flow valuations, or other such formulae, may represent a more consistent approach to value measurement year over year. In addition to the basic alignment question, privately held companies should carefully consider the following issues in developing long-term incentive plans: Eligibility status. Impact on employee attraction and retention. Allocation of value creation between owners and managers. Cash flow constraints. Accounting impact, to the extent debt covenants are impacted by accounting measures. Tax impact on company and executives. Typical long-term incentive alternatives for private companies are explained on the following pages. These alternatives apply primarily to U.S. executives of private companies and may need to be modified for application outside of the U.S. developing the right program to attract, retain and motivate top executive talent 3

6 Phantom Stock Appreciation Rights (PSAR) Description PSAR plans generally mimic Stock Appreciation Rights (SAR) plans in that participants benefit from an increase in the value of the company. Unlike SARs, however, the underlying vehicle used to determine the payout is not the company s stock. Under a PSAR plan, employees are awarded rights to earn a compensation amount equal to the appreciation in the value of a phantom share over a specified time period usually three to five years. The phantom shares are generally valued using a formula-based methodology, such as a multiple of Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) or book value. At the end of the performance period, the increase in PSAR value is typically paid in cash. Rationale PSAR plans are commonly used by privately held businesses, and are typically adopted when the use of actual stock is not possible or is undesirable. The incentive effects of PSARs are similar to stock options/sars. Accounting Treatment A variable charge to earnings will be made each year from grant to payout. Tax Treatment There is no taxable event at grant or vesting. Awards generally become taxable to the executive as ordinary income when payments have been actually received or made available. The company receives a corresponding deduction in the year in which the executive incurs taxation. The company must report income on the employee s W-2 and must withhold income and employment taxes for the employee. Considerations for Privately Held Companies Unlike stock options/sars, it is not necessary for phantom shares to have any linkage to the company s actual stock. Ultimately, the value of a phantom share will be a function of two things: 1. Enterprise value, which can be determined by a third-party valuation or by a formula (typically based on discounted cash flow or multiples of such key financial measures as earnings, revenues or book value). 2. The number of phantom shares reserved for the plan, representing a participatory interest in future appreciation in enterprise value (e.g., one million phantom shares representing a 15% participatory interest). Alternatively, phantom shares underlying PSARs may be designed to mirror the value of actual stock. Pros Strong incentive to increase enterprise value. No dilution to share ownership percentages if PSARs are settled in cash. Relative to other long-term incentive arrangements, employee generally has more flexibility over the timing of taxation. Company receives a tax deduction for income recognized by the executive. No cash outlay required for participant to exercise. Cons Variable expense charged to earnings. Uncapped liability from the company s perspective, although the PSAR can be designed with a capped value. Payout subject to ordinary income tax rates at the employee level. 4 developing the right program to attract, retain and motivate top executive talent

7 Phantom Stock Description Full value phantom plans are the phantom equivalent of restricted share plans in which executives receive actual shares subject to a vesting schedule. The executive is entitled to receive the full value of the phantom share upon vesting (or at the end of a predetermined period), including any appreciation that may have occurred from the date the shares were awarded. The value of the shares is typically paid in cash. Rationale Companies typically adopt phantom stock plans when the use of actual stock is not possible or is undesirable. Phantom plans can be designed with dividend equivalent features. Full value phantom shares function as an effective retention device when subject to appropriate vesting requirements. Accounting Treatment A variable charge to earnings will be made each year from grant to payout. Dividend equivalents, if applicable, will also be charged to earnings. Tax Treatment There is no taxable event at grant. Awards (including dividend equivalents, if applicable) generally become taxable to the executive as ordinary income when payments have been actually received or made available. The company receives a corresponding deduction in the year in which the executive incurs taxation. The company must report income on the employee s W-2 and must withhold income and employment taxes for the employee. Considerations for Privately Held Companies Same as for PSARs described earlier. Pros Effective retention device. No dilution to share ownership percentages if phantom shares are settled in cash. Company receives a tax deduction for income recognized by the executive. Dividend equivalents, if applicable, provide cash compensation to participants prior to vesting and, consequently, create the perception of real equity. No cash outlay required by participant. Cons Variable expense charged to earnings. Dividend equivalents, if applicable, charged to earnings. Uncapped liability from the company s perspective, although the phantom stock can be designed with a capped value. Payout subject to ordinary income tax rates at the employee level. developing the right program to attract, retain and motivate top executive talent 5

8 Cash Long-Term Incentive Plan (LTIP) Description Cash LTIPs may have many similarities to short-term incentive plans, or what are commonly referred to as bonus plans or annual incentive plans. The executive is entitled to receive a cash payout at the end of a predetermined performance period. The performance period is generally a specified period of time, usually three to five years. The performance periods often overlap (e.g., a new three-year plan commences each year) and the performance is generally assessed at the end of each performance period. The amount of the payout is based on achieving predetermined, specified performance goals. LTIPs typically employ financial performance metrics such as return on capital, growth in operating income, etc. Rationale Companies typically adopt a long-term incentive plan when the use of actual stock is not possible or is undesirable, and/or they would like to reward management for multiyear operating performance. If the LTIP plan is designed to offer significant upside potential, it may create a strong retention effect given the overlapping performance periods. Accounting Treatment A variable charge to earnings will be made on actual performance relative to target, with true-ups conducted throughout the performance period. Tax Treatment Awards generally become taxable to the executive as ordinary income when payments have been actually received or made available. The company receives a corresponding deduction in the year in which the executive incurs taxation. The company must report income on the employee s W-2 and must withhold income and employment taxes for the employee. Considerations for Privately Held Companies Ultimately, the value of a LTIP will be directly tied to the company s ability to set appropriate goals to motivate executives to achieve specific operational objectives to increase shareholder value, while at the same time, providing enough upside potential to create a strong retention vehicle. For tax planning purposes, executives can be provided the opportunity to defer payouts, thereby deferring taxation to a later time. This also would result in deferral of the company s tax deduction. Pros Rewards executives for increasing operational results. Company receives a tax deduction for income recognized by the executive. Generally creates a strong retention effect. Cash payments are aligned with the company s ability to pay. Cons Does not always compete effectively with public companies that provide equity compensation, which has unlimited upside. Entire benefit to the executive will be taxed as ordinary income. Variable expense charged to earnings. Can be difficult to establish a performance matrix that is both achievable and challenging. 6 developing the right program to attract, retain and motivate top executive talent

9 Developing the Right Executive Compensation Program In order for private companies to develop an appropriate executive compensation program to meet their human capital objectives, the following steps should be considered: Step 1 Develop a well thought-out executive compensation strategy that addresses, at a minimum, the following items: Alignment between total rewards and business strategy. Competitive positioning of executive pay relative to appropriate labor market. Appropriate mix of pay and weighting (e.g., 45% base salary, 30% short-term incentive opportunity, and 25% long-term incentive opportunity). Eligibility status. Appropriate time horizon for pay delivery (performance period). Validation of stakeholder perspectives, including shareholders and executives. Consideration of changes in accounting and other regulatory rules. Step 2 Develop an appropriate executive compensation program designed to support the compensation strategy, which includes: Assessment of various compensation vehicles to support an executive compensation strategy that will deliver the appropriate competitive value to executives and return to shareholders (including both short-term and long-term compensation vehicles). Determination of program components including: Specific pay mix for various executive levels, Performance period and vesting criteria, Appropriate performance metrics, Leverage calibration, and Other design considerations. Step 3 Assess the potential impact of a planned executive compensation program, including: Financial-based considerations (e.g., cash flow and accounting at various performance levels). Tax impact to the executive and company. Allocation of value creation and return to shareholders. Step 4 Focus on implementation and ongoing considerations with respect to the following: Execution of plan documentation. Development of an appropriate communication strategy. Development of administration process to support the program. Assessment of results on an ongoing basis, making modifications as necessary regarding the impact on human capital and cost. **************** Interestingly enough, it is often the execution of the compensation program, including communication and roll-out, which will ultimately determine the success of the program. Even the best designed programs can fail without an effective communication strategy that clearly links performance expectations to business strategy and compensation opportunity. developing the right program to attract, retain and motivate top executive talent 7

10 Conclusion Privately held companies face unique challenges when competing with public and other private companies to attract and retain executive talent. The compensation tools available to compete for executive talent are somewhat more limited for private companies in that they do not typically use stock options and other forms of equity compensation. However, with a well thought-out compensation program, these challenges can be overcome through the creative use of other types of long-term incentive arrangements. Please Note: Under the American Jobs Creation Act of 2004, long-term incentive plans, including phantom stock appreciation right programs and other phantom equity programs, may be deferred compensation plans subject to Section 409A of the Internal Revenue Code. Section 409A restricts when amounts may be paid from such plans and includes other requirements that may be relevant. Any plan must be structured in light of Section 409A to avoid premature taxation and penalties. 8 developing the right program to attract, retain and motivate top executive talent

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