executive compensation in privately held companies: attracting, motivating and retaining top talent

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1 Executive Compensation in Privately Held Companies: Attracting, Motivating and Retaining Top Talent Hal Wallach December 1, 2016

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Page 1: Executive Compensation in Privately Held Companies: Attracting, Motivating and Retaining Top Talent

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Executive Compensation in Privately Held Companies: Attracting, Motivating and Retaining Top TalentHal WallachDecember 1, 2016

Page 2: Executive Compensation in Privately Held Companies: Attracting, Motivating and Retaining Top Talent

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Agenda

• Setting Pay Philosophy

• Pay for Performance

• Annual Incentives

• Long-Term Incentives

• Employment Contracts

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Setting Pay Philosophy

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Key Questions in Setting Compensation Strategy

What is the market for determining our

competitive positioning (e.g., industry, size,

location, for profit and non-profit)?

1How will we position

compensation levels against the defined market (e.g.,

market median, above/below market, fixed

versus variable pay)?

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What is the right mix between fixed and variable, short-term and long-term? How do compensation and

other elements of total rewards complement each

other?

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What is the right linkage between performance and

pay?

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Compensation Market Depends on Several Key Factors

• Industry

• Company size• Revenue (assets for financial organizations)• Rule of thumb: ½ to 2x

• Ownership structure (e.g., private vs. publicly held)

• Location

• Other factors can include: historical performance, economic conditions, business strategy, organizational reputation

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Positioning Pay Relative to the Market

• Default positioning typically at predetermined range above/below median of defined market

• Positioning above or below market often due to compelling business reason(s)• Above market: Company can yield high returns on

incrementally better talent, or company is relatively risky place for employees to work, or company pay mix emphasizes “at-risk” (e.g., annual / long-term incentive) pay

• Below market: Company can attract top talent due to non-monetary rewards

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Impact of Company Life Cycle on Pay

• Pay positioning (and mix) often influenced by business life cycle phase. Example:

Relative To MarketSalary / Bonus

Long-Term Incentives

Benefits / Perquisites

Business Life Cycle/Phase

Start-Up Below Above Below

Growth Near MarketAt or Above

Market Average

Maturity At Market At Market At Market

RenewalAt or Above

MarketAt or Above

MarketAt or Above

Market

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Pay for Performance

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Measuring Performance – Beyond Just Financial

StrategicLeading indicators

Tend to be qualitative

Basis for management decisions

Examples Customer satisfaction

New product sales

Cross-selling

Market share

OperationalLeading or lagging indicators

Quantifiably measured with enhanced line-of-sight

Examples Quality

Safety

Productivity

Cost reduction initiatives

Financial Lagging indicators

Quantifiable

Reflects results/progress to date

Captures economics of the business

ExamplesRevenue / sales

Profit (gross, operating, net, EBIT)

Margin (gross, operating, net)

Return on assets (gross, net)

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Picking the Right Measure(s)

• Most companies have one “key” measure (with others to support it); an effective key measure should:• Recognize the organization’s capabilities and people, and provide

senior management with a singular performance focus in support of the company's business strategy

• Reflect the external dynamics of the industry and the economics of the business

• Correlate with ownership value creation

• Be fairly easily determined from accounting numbers and the company's financial systems ‒ simple to calculate and communicate

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Determining the ‘Right’ Level of Performance

• Performance goals should be meaningful…and achievable

Meaningful Achievable

Aligned with Ownership Value Creation

Reasonable, given competitive market environment

Sufficient "stretch" required for upside rewards

Perceived by participants as attainable, especially at "threshold"

Calibration between performance required and pay expected Linked to realistic budgets

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Annual Incentives

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Objectives

• Provide variable, performance-based pay

• Provide competitive cash compensation opportunity

• Control fixed costs (salaries)

• Support/reinforce the business strategy, company culture and core values

• Clarify roles and responsibilities

• Motivate specific behavior and reward results

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Design Issues

• Incentives vs. bonuses

• Results vs. efforts

• Team vs. individual

• Influence vs. control

• Participation

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Common Funding Approach Using Single Performance Measure

Threshold (80%) Target (100%) Maximum (120%)0%

50%

100%

150%

200%

250%

Incentive Earned as a % of Target

Performance Results

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Common Funding Approach Using Two Performance Measures

Earnings Growth

Revenue Growth

Incentive Funded as a % of Target Pool

20% 100 120 140 160 180 200

17% 80 100 120 140 160 180

14% 60 80 100 120 140 160

11% 40 60 80 100 120 140

8% 20 40 60 80 100 120

<8% 0 20 40 60 80 100

<6% 6% 8% 10% 12% 14%

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Allocating Performance at Various Organizational Levels – Example Approach

CEO/COO 100% 100%

Other Tier 2 - Corporate 60% 20% 20% 100%

CFO 75% - 100% 0% - 25% 100%

Tier 3 - Corporate 50% 25% 25% 100%

Tier 4 - Corporate 25% 25% 50% 100%

Division President 25% - 50% 50% - 75% 100%

Tier 2 - Division 20% 40% 20% 20% 100%

Tier 3 - Division 34% 33% 33% 100%

Tier 4 -Division 25% 40% 35% 100%

% of award tied to Performance of

Position/Level Corporate Division Function Individual* Total

* Includes team and/or department measures

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Long-Term Incentives

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Objectives

• Similar to annual incentive plans

• Performance measured over a period greater than one year• Three to five years most common• More emphasis on achieving goals that support a company’s

long-term strategy• Stronger link to ownership value creation

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Market Practice

• Not surprisingly, long-term incentives (LTI) are less prevalent in private (non-publicly traded) companies• In a recent WorldatWork survey of privately held companies,

just over half of respondents indicated they had an LTI plan• This compares with over 95% for publicly held companies

• Lower prevalence often attributable to• Preference of ownership to avoid equity dilution, thus

requiring additional outlay of cash• Plan designs can sometimes be complex, making plan

administration and communication difficult

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Market Practice

• Majority of LTI Plans in privately held companies are cash-based

• Overwhelming majority of companies (79%) have only one plan (versus multiple plans in publicly held companies)

LTI Plan PrevalenceLong-Term Cash Plan 44%

Stock Option 30%Restricted Stock 22%Phantom Stock 14%Performance Units 11%

Stock Appreciation Rights (SAR) 9%Performance Shares 6%

Source: WorldatWork and Vivent Consulting – Incentive Pay Practices Survey: Privately Held Companies

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Plan Definitions

Plan Type Plan Description

Stock Option A contractual right granted by the company to purchase a specified number of shares of the company's stock at a specified price (the exercise price) for a specified period of time

Restricted Stock Grants of shares of the company's stock subject to restrictions on sale and risk of forfeiture until vested by continued employment

Performance SharesGrants of actual shares of stock with payment that is contingent on performance as measured against predetermined objectives over a multi-year period of time; same as performance units except that the value paid fluctuates with stock price changes as well as performance against objectives

Performance Units Grants of dollar-dominated unites with value that is contingent on performance against predetermined objectives over a multi-year period of time. Actual payouts may be in cash or stock

Long-Term Cash Plan Cash awards where payment is contingent on performance as measured against predetermined financial or strategic objectives over a multi-year period of time (typically 3 years)

Phantom StockA type of incentive grant in which the recipient is not issued actual shares of stock on the grant date but receives an account credited with certain numbers of hypothetical shares. The value of the account increases or decreases over time based on the appreciation for depreciation of the stock price and the crediting of phantom dividends. Payout may be settled in cash or stock

Stock Appreciation Right (SAR)

A contractual right that allows an individual to receive cash or stock of a value equal to the appreciation of the stock from grant date to the date the SAR is exercised

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Plan Design – Performance Measures

• According to published survey sources, common long- term incentive performance measures include:• Profitability

• Net Income, Earnings Before Interest & Taxes [Depreciation & Amortization] – (EBIT, EBITDA), Net Profits After Taxes

• Annual Sales/Revenue

• Return• Return on Assets or Equity (ROA, ROE)

• Economic Value Added (EVA)

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Plan Design - Vesting

• Vesting period definitions:• “Cliff”– 100% vested after a specified period of time

• “Installment” – portion vested each year after grant

• Typical vesting period is three to five years (cliff or installment)

• Vesting upon retirement:• To encourage a successful transition and continuity of the

organization, many organizations are setting vesting in the event of retirement at a date in the future (e.g., one year after retirement date) rather than automatic full vesting at retirement

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Plan Comparisons

• The tables on the following pages provide high-level details/comparison of the most common long-term incentive plans in use today

• Information provided includes• Plan description (including typical vesting/performance

periods)• Accounting treatment• Company and employee tax treatment• Pros and cons of each (e.g., dilution, cash requirements, link to

pay, etc.)

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Non-Qualified Stock Options

Employer Employee

Aligns shareholder and employee interests (value entirely based on increase in stock price)

Requires higher number of shares to provide the same value relative to other LTI vehicles

Easy for employees to understand and keep track of value

Broad stock market performance may impact stock price (up or down) beyond employees' efforts or contributions

Subsequent appreciation in stock price not charged to earnings

Future sale of stock considered capital gain (tax

basis is FMV upon exercise)

Once vested, provides employees flexibility to choose when to exercise options and recognize income

Pros Cons

Tax ConsequencesDefinition / Description

Typical Vesting or

Performance Period

Accounting to Company

Right to purchase (exercise) shares of a company's stock at a stated value for a defined period of time (typically 10 years). Exercise price is typically the fair market value (FMV) on date of grant

Accounting charge fixed at grant and expensed over vesting period

Deduction at time of exercise equal to FMV of shares upon exercise in excess of grant (exercise) price

Taxable income recognized upon exercise equal to FMV of shares

upon exercise in excess of grant (exercise) price3 - 5 years

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Restricted Stock

Employer Employee

Aligns shareholder and employee interests while promoting a more immediate sense of ownership

May provide value even if company stock price declines (or performs below the market)

Supports stronger retention than options since value is not tied wholly to increases in stock price

May incent less risk taking than options

If stock appreciates, company's tax deduction exceeds fixed accounting charge

Future sale of stock considered capital gain (tax basis is FMV upon vesting)

Fewer shares typically required to produce same level of pay as stock options

Definition / Description

Typical Vesting or

Performance Period

Accounting to Company

Tax Consequences

Pros Cons

Outright grant of shares with restrictions on when they can be sold or transferred

Accounting charge fixed at grant and expensed over vesting period

Deduction equal to FMV of stock upon vesting

Taxable income recognized equal to FMV of shares upon vesting

3 - 5 years

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Performance Shares

Employer Employee

Deduction equal to FMV of shares when earned

Taxable income recognized equal to FMV of shares when earned

Strong link of pay-to-performance. Value tied to both achieving multi-year performance goals as well as stock price

May provide value even if company stock price declines

Fewer shares typically required to produce same level of pay as stock options

Requires effort to select appropriate performance measures and levels over multi-year periods

Popular plan among shareholders and proxy advisors

Pros Cons

Grant of shares which only vest (are earned) upon attainment of pre-defined performance goals over a multi-year period

3 years

Future sale of stock considered capital gain (tax

basis is FMV upon vesting)

Variable accounting

(quarterly profit & loss

fluctuations based on

performance against goals)

Definition / Description

Typical Vesting or

Performance Period

Accounting to Company

Tax Consequences

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Cash-Based

Employer Employee

Deduction when amounts earned/paid

Taxable income recognized when award earned/paid

No stock dilution since awards paid in cash

No (or smaller) link between shareholder and employee interests since performance goals not typically linked directly to stock price performance

Promotes employee focus on company strategy and performance beyond one year (vs. annual incentives)

Requires effort to select appropriate performance measures and levels over multi-year periods

Cash payments required

Definition / Description

Typical Vesting or

Performance Period

Accounting to Company

Tax Consequences

Pros Cons

Opportunity to earn a cash

award based upon

attainment of pre-defined

performance goals

measured over multi-year

period

3 years

Variable accounting (quarterly profit & loss fluctuations based on performance against goals)

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Employment Contracts

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Employment Contracts - Objectives

• Companies generally enter into employment contracts only with their most senior executives. Provisions commonly found in employment contracts include:• Term of contract and provisions for renewal• Specific duties and responsibilities• Compensation• Benefits/perquisites• Upfront/signing awards• Termination (e.g., severance benefits and outplacement

assistance)• Special change-in-control provisions• Non-compete, non-solicitation and confidentiality provisions• Dispute resolution

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Employment Contracts - Objectives

• Contracts have become more prevalent, with nearly half of all major companies reporting having contracts with one or more executives• CEO and a few direct reports most likely to have contracts

• Anecdotally, common reason given for having contracts is to "formalize" employment relationship• New hires asking for contracts

• Most important element of most contracts involves setting forth termination provisions• Most common amount for executives is one year of salary• Severance generally based on salary only• Full or partial COBRA subsidy is common• Common to offer outplacement services

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Questions?

Hal WallachDirector

Executive Compensation Consulting CBIZ Human Capital Services

[email protected]

CBIZ Human Capital Services is a business and financial advisory firm providing a vast array of services, including compensation consulting. Our professionals perform compensation valuations on a regular basis and

are qualified to provide such.

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Hal leads CBIZ Human Capital Services’ Executive

Compensation Consulting practice.

With more than 25 years of experience, he helps

management teams and boards of directors create and

institute executive compensation programs that attract and

retain top leadership, adhere to regulatory requirements,

and drive maximum return on compensation investment.

He previously served as an adjunct professor at Washington

University in their Executive MBA program where he led

classes on executive compensation.