RSM Resources

Only boards of Fortune 500 companies used to worry about compensation committees and formal compensation programs. Today,however, leaders of small and midsized businesses are focusing on compensation to stay competitive in a tight market for increasingly mobile human capital. The much-publicized corporate governance meltdowns of the past several years, including the recent revelation of stock-option backdating at several prestigious U.S. corporations, also are spurring business leaders to act.

Even if your company is privately held, establishing an independent compensation committee and a formal compensation program can help make your company more competitive and align it with the best practices of corporate governance. Here’s an overview of how to do it right.

Competing with everyone

"My peers haven’t established a formal compensation program, so why should I?" you might ask. You might even feel that your commitment to competitive compensation is already implicit in your company’s stated mission to attract and retain top talent.

If you’re satisfied with your compensation program simply because it equals those of your peers, you may be putting your organization at a competitive disadvantage. Remember, you’re not just competing with your peers for top talent; you’re competing with everyone: publicly and privately held companies, not-for-profit organizations, and even the government.

You have to lose only one top candidate to the lucrative stock options offered by a Fortune 500 company to realize this. No matter how many times your company’s mission mentions a commitment to competitive compensation, it’s nothing but boilerplate if you lack a formal system specifically designed for your business and tied to measurable results.

The declaration of independence

Like the owners of many privately held corporations, you might serve on your own board. The problem with this leadership structure, of course, is that your board will lack independence — which your company needs as it grows. A formal, independent compensation committee can establish the kind of objectivity and transparency that characterizes the best practices of corporate governance.

When forming a compensation committee, "You want people who are basically external directors and who don’t have a conflict of interest in terms of their dealings with the company," says John Fossum, professor and associate dean of the Carlson School of Management at the University of Minnesota.

This means moving toward a boardroom populated almost entirely by independent directors. Not only can this provide your organization with the power of impartial analysis when creating a compensation program,it can insulate your organization from tax and legal liability.

Fossum cites the recent uncovering of stock-option irregularities at a national health insurer as a warning. In that case, "one of the members of the compensation committee was also handling investments for [theCEO]," he says. "That is a conflict of interest."

Compensation has to match objectives

Establishing an independent compensation committee is relatively easy compared with the challenge the committee itself will face: designing a program that attracts, retains and motivates employees. For one thing, these goals can stand at odds with one another. An aggressive cash-based compensation program might attract and retain talent, but it might fall short in motivating personnel once they come on board. Likewise, an aggressive performance-based program emphasizing incentive pay or even equity might fail to retain talent when business lags.

Your company’s compensation program will succeed only if it matches your long-term business goals. In an extreme example, a Silicon Valley start-up would damage its own chances of survival if it chose to emphasize cash-based compensation over equity-based compensation.

If a compensation program must support long-term business goals, it must also encourage shorter-term strategic initiatives that keep the company on track — everything from encouraging collaboration to eliminating an entitlement mindset to becoming more results-oriented.

With whom is your organization competing for talent? What should be the ratio of fixed to variable pay? If equity ownership is an option, who should be eligible, and what expectations go along with it? At what point should participants be vested? An independent compensation committee can assess the situation objectively, consult with third-party resources and establish a true comparative framework. It can also gauge liability, evaluate cash-flow ramifications and other accounting considerations, complete documentation, develop a communication strategy, and measure results.

Your toolbox is bigger than you think

When it comes to the specifics of the program, the compensation committee will have access to more tools than you might think are available.Private companies wanting to avoid the dilution of ownership and other constraints accompanying stock plans can consider other forms of variable compensation, including bonus plans, long-term incentive plans and phantom stock plans, which can compete very well with public companies’ equity-based plans.

With a phantom stock plan, you reward employees based on change in your company’s assessed value without actually giving them an ownership share. The key to this sort of plan is to "be careful that [you] have an appropriate valuation of the company at the time you make the reward," Fossum says.

For instance, you might give an executive 100 shares of phantom stock at$10 a share. At the scheduled time, if the valuation shows your company’s stock has risen by $30 [making it worth $40 under such a plan] a share, you reward the executive with $4,000. Your company would then qualify for a $4,000 tax deduction (and your executive would owe income tax on the $4,000). It’s always a good idea to review whether or not to cap your liability with a phantom stock plan.

Don’t go it alone

In establishing a compensation plan, your board should work with outside experts to ensure your organization isn’t inviting unnecessary tax or legal liabilities. Variable compensation, in particular, comes with a range of potential tax and accounting treatments, such as the timing of charges to earnings, and when and how to take tax deductions. On the payroll side, you’ll want expert help with withholding and W-2s. Your tax professional is a great place to start.

Survey Says:
Percentage saying excessive CEO pay occurs frequently

• 3 percent of CEOs
• 14 percent of compensation committee members

Source:Steven Hall & Partners survey of 88 CEOs and 71 compensation committee members from among the 1,000 largest U.S. companies

Fast Facts

• Compensation committee meetings increased 20 percent in the past year.
• 32 percent of companies require directors to meet a minimum share ownership guideline.
• Two-thirds of companies pay committee meeting fees, averaging $1,500 each.
• Total pay for compensation committee chairs increased 14 percent in 2005.
• Board remuneration is growing at a faster rate among smaller-revenue companies than among larger-revenue companies.

Source: Steven Hall & Partners survey of 850 of the 1,000 largest U.S. companies