Executive Compensation: Strategies and Frameworks Program Playbook Activity 4

Playbook Activity 4.1: Comparing Executive Incentives

Stock options have created enormous wealth for executives in public organizations. Because of this, it should come as no surprise that private organizations find it challenging to attract, retain, and motivate top executive talent, mainly due to their limited ability to issue stock options.

Read about two privately held organizations to discover the options for executive compensation. After reading about the Delta Gamma and Beta Gamma organizations, you will answer several questions.

A nationally recognized family-owned wholesaler of kitchenware items decided to provide some form of equity-based compensation package for its executive team.

As the organization's fiscal health improved over the years, recognizing the contributions and loyalty of key executive team members became of paramount importance. In the long term, the owners wanted to ensure that the organization would be able to retain these executives while also having some way of sharing the organization's expected future growth and profitability with them.

Playbook Activity 4.1: Comparing Executive Incentives within Private Organizations

THE DELTA GAMMA ORGANIZATION: REWARDING WITH EQUITY

Deciding on whether to offer equity will depend greatly on a specific organization's circumstances.

However, organizations should not overlook other important considerations when looking at the pros and cons of providing an equity stake in the organization.

In a family-owned organization, for example, providing equity-based compensation raises a number of financial and emotional issues for the owners. Over the life of the organization, owners often make major personal and financial sacrifices to keep the organization afloat and growing, in many cases going so far as to pledge personal assets to obtain financing. They also have to deal with the inevitable long hours, extensive travel, stress, and other commitments of running an organization.

Therefore, it is not surprising that many owners are not completely comfortable "giving away" a piece of the organization, even to a deserving executive team. From a more practical perspective, equity ownership causes justifiable concerns about sharing detailed financial information with executives who are not part of the family or principal ownership. Even executives receiving an equity stake do not do so without qualms. First of all, equity ownership often requires executives to use their assets to purchase the equity. In fact, equity-based incentives may not appeal to many executives who think that they have enough "at risk" without adding equity ownership in a privately held organization with a small number of owners. Executives are also likely to be concerned about how the equity should be valued, the future risks of ownership, and the potential for "selling" their equity in the future, i.e., putting the stock back in the organization at a later date.

Because of these issues, executives are likely to name cash, and lots of it, as their preferred form of compensation. Unfortunately, smaller private organizations find that cash is usually tight, particularly if those organizations fall into the lower range of market capitalization (the common stock outstanding multiplied by the stock's market price) used to rank publicly held organizations. Small organizations usually manage cash flow tightly, especially if they are leveraged with high-yield debt. To work through these issues before offering equity-based compensation, executives and owners need to educate themselves about various equity-based and equity-like incentives and how they work. This way, both parties can develop a plan that suits all their needs.

The owners also felt that it was time the executives were rewarded for their contributions to the organization and their sacrifices in accepting modest compensation while the organization struggled back to profitability. Not only was the base pay for these executives relatively low, but their benefits package was not as generous as is typically found in larger, publicly owned organizations. For example, the organization provided no long-term capital accumulation or pension plan other than a 401(k) plan that did not provide an organization match.

It was clear to the owners that the existing compensation and benefit plans were inadequate to reward the executives at the desired level. However, with the organization still strapped for cash despite the turnaround, the owners were not interested in increasing base salary dramatically or implementing generous short-term cash incentive programs. Instead, the owners began considering how to provide the executives with some form of equity ownership tied to the organization's future financial performance. The only question remaining was whether the executives were amenable to such a compensation arrangement.

Fortunately, the executives believed that the organization's future growth prospects were good, and it might become an attractive acquisition target in the future. Even though the executives were pressuring the owners for more cash compensation, they were also interested in obtaining a percentage of ownership. The organization had recently gone through a valuation exercise to obtain additional financing, the results of which were shared with the executive team. Because the valuation was based on a third-party analysis, the executives were confident in the valuation methodology and the organization's estimated value.

Assured of the executives' interest in equity-based compensation, the owners decided to award each of the three executives an outright grant of restricted stock equivalent to 5 percent of the organization's equity per executive. The restriction provision required that the executives remain employed by the organization for five continuous years of service from the date of the grant.

Each executive also received options to purchase additional shares of stock based on the attainment of specific financial goals, with total equity ownership potential for each executive capped at 8 percent of organization equity. Once an executive reached that cap, he or she would receive any long-term incentive awards in cash.

The next step was to design the specifics of the plan. Overall, it would be based on a five-year strategic plan developed by the owners and the executives. The plan detailed specific goals for organization revenue, earnings before interest and taxes (EBIT), and profitability. Based on the plan, the sooner the organization achieved its EBIT targets, the sooner each executive was entitled to a percentage of the EBIT generated. The executives could then choose to receive payment in either cash or additional equivalent shares of organization stock based on the valuation at that time.

The organization also implemented a short-term incentive program whereby each executive would be rewarded for achieving specific goals geared toward improving operational efficiency, increasing gross sales and target market share, and improving gross margin through cost-saving steps. The short-term cash incentive award targets averaged 15 to 25 percent of their annual salary, depending on each executive's functional role. For example, the organization provided the head of giftware sales with the highest short-term cash incentive target in the hope of creating a sales incentive arrangement.

While the awards were determined on an annual fiscal-year basis, the actual payment schedule of the incentives, if any, correlated with the organization's cash flow dynamics. This approach helped prevent additional strain on short-term capital flows when the organization most needed cash.

Finally, to ensure adequate compensation in the short term, the organization reviewed each executive's base salary against current market data and provided a modest increase to make up for the shortfall identified.

THE BETA GAMMA ORGANIZATION: DEVELOPING EFFECTIVE EQUITY-LIKE COMPENSATION

Of course, not all privately held organizations decide to provide equity participation to non-owner executives. A jewelry-making organization was well established in its industry and relied heavily on the contribution of three key non-owner executives who were engaged in sales, manufacturing, and distribution. The three principal owners or "partners" in a subchapter S corporation structure viewed these executives as critical to the organization's continued growth and profitability. However, the three owners did not agree on how that should affect the executives' compensation arrangement.

The organization president, who is one of the owners, wanted to provide some form of equity-type participation for the three key executives. However, the other two owners opposed providing direct equity ownership for fear of diluting ownership.

To reach a compromise, all three owners agreed to a plan to provide each executive with a significant short-term cash award of 25 percent of their base salary if they reached specific operational milestones.

The executives would also receive cash payouts under an additional long-term incentive plan. Overall, this plan significantly departed from the organization's past practice. The new plan offered a significant increase in short-term cash compensation opportunities based on clear performance measures the executives could understand and act on. In the past, the organization offered modest short-term incentives based on the partners' discretion.

The organization also adopted a performance-based unit plan to satisfy the president's desire to tie some portion of executive compensation to long-term organization results. Deciding which measures to use to value the units was a relatively straightforward matter, as the partners and key executives had worked together to develop the organization's five-year plan. Each executive was familiar with the goals and challenges that the organization faced. Eventually, both the owners and the executives agreed that the key measure for the performance unit plan would be revenue growth.

Under the performance-unit plan, each executive was awarded performance units that would be valued over a cumulative three-year period. The targeted award was a cash payout equal to approximately 50 percent of base salary when the organization achieved each of the targeted revenue milestones. The value of the units could be as much as 100 percent of base salary if the revenue targets were exceeded.

The performance units were awarded each year for a successive three-year cycle. Because the cycles overlapped, unit valuation was the sum of one-third of each of the three-year unit values in the fourth and following years. The organization increased its short-term incentive targets during the first two years of the performance-unit plan because it would not make a payout until the third year.

By using cash in a performance-unit plan to simulate an equity-type plan, the owners could provide potentially significant rewards based on performance without diluting ownership in the organization.

For their part, the executives now had a compensation program with a long-term component that was tied directly to the organization's long-term growth prospects

Respond to the following questions based on the readings and your experience.

Name at least one similarity between the incentive compensation practices of the Delta Gamma Organization and the Beta Gamma Organization.

Name at least one difference between the incentive compensation practices of the Delta Gamma Organization and the Beta Gamma Organization.

Describe any similarities or differences between the incentive compensation practices of the Delta Gamma Organization and the Beta Gamma Organization and your organization or a publicly traded organization of your choice.

How do an organization's specific circumstances determine its compensation planning process?

Because of its circumstances, one organization opted to develop a full equity-based incentive program for its executive team. In contrast, the other organization came to a very different conclusion based on the same analysis. It chose not to offer equity to its executives but instead developed and offered a plan that mirrored an equity-based plan without diluting organization ownership. Which was the better option?

Conclusion

Deciding whether to provide executives with some form of equity-based compensation is one of the most important decisions a private organization can make. After all, the result has tremendous implications for the current owners and the executives. Equity-based plans can make sense given the right circumstances, the owners' willingness to share equity ownership, and the executives' desire to participate in equity ownership.

Even if an organization chooses not to provide equity, it still has an array of options available when looking for innovative ways to reward executives. In situations where equity-based incentive plans are not always the best executive compensation design solution, organizations can still develop effective cash-based plans that simulate equity ownership as a good substitute for stock.

In either case, privately held organizations must remember to provide as much opportunity for long-term compensation to the non-owner executive as their public counterparts.

Playbook Activity 4.2: Utilization of 10b5-1 Plans

Professor Alan Jagolinzer outlines some best practices when leveraging 10b(5)-1 plans. In this activity, reflect on how these plans affect executive compensation.

Respond to the prompts below:

Why is it important to publicly disclose 10b(5)-1 plans?

Why is there a "cooling off" period before executing a trade under a 10b(5)-1 plan?

Why is it important not to terminate a 10b(5)-1 plan?

Professor Jagonlizer mentions possible amendments to the 10b(5)-1 plan proposed by the Securities and Exchange Commission (SEC).

Refer to this SEC.gov press release SEC Proposes Amendments Regarding Rule 10b5-1 Insider Trading Plans and Related Disclosures How might such amendments affect these best practices?

Describe your experience with (or thoughts on) 10b(5)-1 plans and/or other internal constraints of executive compensation plans.

Playbook Activity 4.3: How Do External Regulations Affect Executive Compensation?

An external constraint, such as corporate or personal taxes, may affect how an executive makes decisions.

Professor Armstrong states, "Tax is a form of risk sharing with the government."

Consider the types of risk-taking the organization makes, the kinds of investments the organization makes, and how executives are compensated for bearing the risk.

Read the following article from The Wall Street Journal to find out how some senior executives respond to changes in tax law:

Elon Musk, Other Leaders Sell Stock at Historic Levels as Market Soars, Tax Changes Loom

What implications do personal income taxes have on how an organization's board or compensation committee designs a senior executive's incentive package?

Under what circumstances can an executive's personal income taxes influence their decision on when to sell stock or exercise their stock options?

Share an example from your organization, an organization of your choice, or one you found through research of corporate taxes, risk-taking, and the general effects of external compliance on executive compensation. Consider the types of risk-taking the organization makes, the kinds of investments the organization makes, and how executives are compensated for bearing the risk.

How can taxes and other regulations affect an executive's risk-taking based on the executive's incentive compensation package?

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