We are all aware that corporate executives at publicly traded companies receive very large compensation packages. The current controversy involving McDonald’s, in which many employees earn less than $20,000 per year and the CEO earns approximately one thousand times that amount, is only one example of public perception of excessive or abusive executive pay.
Yet, many corporations (possibly including McDonald’s), have executive compensation programs that make sense for the employer and the shareholders as well as for the employee. As you’ve read in my earlier blogs, you know much of executive pay in publicly traded corporate America is directly related to company performance—if the value of the company increases due to good performance, the shareholders benefit and the company should “share the wealth” with the executives.
Two keys to a good executive compensation program
First, the corporation should only reward the executive if the corporation reaches pre-established, measurable performance targets. The board of directors should set goals for the executive which reflect shareholder desires—for example, a level of revenue or earnings, entering new geographic markets, selling unprofitable operations or bringing new products to market. This is known as ‘pay for performance’, and is a staple of public company executive pay programs.
Second, the executive’s reward for attaining the performance targets should be primarily, if not totally, paid in company shares or an instrument, the value of which is tied to company share value. This is important because it forces the executive to have more ‘skin in the game’—that is, the value of the reward drops if the share price drops, and increases if the share price increases. There are different forms of reward that have different tax consequences.
The issue that most critics raise with executive pay programs is the amount of the reward—typically the nature of the goals or the form of the reward does not cause much concern. Proponents of large rewards argue that if the reward is too small, the executive will take a position with another employer, and so the reward levels at similar companies are often used to establish the reward level. This tends to increase reward levels over time.
Does this work in a private company setting?
It does. The goals can be set in the same fashion—the only issue is whether the company wants to disclose financial information to the executives. A private company setting often leads to more collaboration in the establishment of the goals between the board and the executives.
There is an issue, however, regarding the form of the reward in a private company. As private company stock is not a liquid investment, some executives may not want to pay income tax on the value of the reward and then not be able to do anything with the underlying shares. There are various solutions to this issue, including phantom shares, stock appreciation rights and giving the executive the ability to sell a portion of his reward back to the employer.
A properly designed executive compensation program helps the employer (directs the executive towards appropriate short and long term goals, creates a reason for the executive to stay fully engaged) and the executive (knowing what needs to be done to receive the reward, and getting a reward which is valuable). We would be pleased to discuss issues related to the design of executive compensation programs. For more information on this topic, post a comment below or contact our Compensation & Benefits Advisory Services Group at 440-449-6800.
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