RSM Resources

By Bob Lindeman and Jim Kauss
September 2007

These are very interesting times we are experiencing, especially in the area of corporate business. When accounting for stock options and board of director governance make the front pages, times are certainly changing. The substantial interest in and scrutiny of executive compensation will probably remain in the spotlight for regulators, investors, boards of directors, executives and the press for quite some time. The future success of any company depends upon the performance of its key executives, and a sound executive compensation program is essential for properly recruiting, motivating and retaining a high-quality executive team. Organizations seeking to develop such a program must now navigate through all of the regulatory, reporting and design constraints which characterize the current environment, which is as difficult as it is critical.

Institutional investors in public companies wish to utilize variable compensation opportunities to align the interests of company executives with their financial goals. Similarly, private business owners seek to establish executive compensation programs, especially long-term incentive and non-qualified deferred compensation plans, for the executives charged with the success of their businesses. There has consequently been a significant increase in the amount of attention focused on executive compensation within privately-held companies. It is through various long-term incentive programs that companies can establish a proper linkage between enterprise success and the opportunity for executives to earn a significant payout in the future.

The primary vehicle for rewarding executives in publicly-held companies is stock, either through stock options or restricted stock. However, stock is not always available in privately-held companies. Nonetheless, privately-held companies still need a sound long-term compensation program to attract and retain high-quality executives and key managers.

The following discusses some of the reasons for this emphasis in long-term compensation as well as some pitfalls in the design and implementation of these plans and how to avoid them.

Types of Long-Term Compensation
There are two different types of long-term compensation plans: long-term incentive and non-qualified deferred compensation plans:

• Long-term incentives provide executives with long-term financial opportunities that are based on performance; primarily corporate performance. Stock options and restricted stock are primarily used by public companies, and stock appreciation rights and phantom stock are often used for privately-held companies.
• Non-qualified deferred compensation plans provide executives with long-term financial opportunities that are not based on performance. Supplemental retirement plans are examples of non-qualified deferred compensation plans.

Need for Long-Term Compensation
Many executives in public companies have earned significant amounts of compensation through long-term programs, sometimes due to, or other times in spite of, corporate performance. Accordingly, long-term incentive arrangements have been subject to substantial scrutiny and in some cases have been reduced accordingly. However, this comes at a time when there is actually an increased need for long-term compensation in public and private companies alike, for some of the reasons discussed below:

Demographic Trends: Baby boomers will be retiring starting in 2007 and that trend will continue for the next 18 years. It is projected that 26.6 million US workers will be age 55 or older in 2010, and many baby boomers are concerned about the ability of Social Security to fund their retirement. It is a fact that the ratio of workers to retirees will shift radically in the next twenty years. As such, various economic and financial planners estimate Social Security payments to retirees will be reduced to remain solvent. The boomers realize they only have a few more years to save; as such, some are making their employers aware of their shortfall or in some cases leaving their jobs to find employers with better retirement or long-term incentive packages.

Retirement Plan Shortfalls: Even if managers/executives contributed to their 401K at maximum levels, it may not be sufficient to fund their retirement if their employers did not provide pension plans or non-qualified plans as well. Very few privately-held companies (less than 3%) offer defined benefit pension plans compared to 17% of all employers. 401K plans did not become available until the 1980s when the early baby boomers were already reaching the age of 40-45. There is a big difference in the amount a person can save over 35-40 years versus 20-25 years because of the power of compounding. For these reasons, many managers and executives have not or will not be able to replace 70% or more of their pre-retirement income if they plan to retire at age 62 (the national average age for retirement per the 2000 Bureau of Labor Statistics). The 70% retirement ratio is the general rule of thumb that financial planners use as an estimate for the income retirees will need to maintain the lifestyle equivalent to that prior to retirement.

Ability to Attract: Many privately-held companies realize that the talent they need either comes from publicly-held companies or larger privately-held companies that most likely already have long-term incentive or non-qualified plans. To attract this talent, the privately-held company must implement one of these plans or increase the position’s base salary or annual incentives significantly to compensate for the lack of a long-term plan of some kind.

Ability to Retain Key Talent: The war for talent has always been considerable, but will increase exponentially as baby boomers retire. Also, talented people are no longer staying at only one or two companies throughout their career. There are three compelling reasons for shorter tenure:

• Companies are less loyal to their employees as evidenced by layoffs and downsizing
• The reduction in defined pension plans or generous retirement programs to retain employees
• The stigma of job hopping has disappeared as people move every five years or so

Long-term incentive and non-qualified deferred compensation plans can help retain an organization’s key people by:

• Offering something other privately-held companies may not offer
• Making the walk-away cost significant enough to make them think twice before leaving for other opportunities

Economic Times: Since 2003, the economy has grown quite nicely with GDP increasing 3-5% per year in the last three years. In addition, the overall stock values of both privately- and publicly-held companies have notably increased in value over this same period of time.

The Wilshire 5000 index which is the summary of the total publicly-held market has averaged returns in the mid teens in the last three years. For privately-held companies, there is no index for valuation although the private equity firms have experienced increased profitability and revenue which drive their valuation upward similar to the publicly-held sector. Long-term compensation programs usually gain renewed interest during growth periods.

Private Equity Firm Impact: In the last five years, private equity firms have aggressively focused on privately-held companies for acquiring a partial or full interest. There are some estimates that private equity firms will own over 50% or more of the privately-held companies within the next 10 to 15 years.

Private equity firms almost always provide current or new management with generous long-term incentives focused on value creation to attract, motivate and retain top talent. This is quickly beginning to change and influence compensation packages of privately-held companies.

Ownership/Management Succession: As baby boomers continue to age, ownership/management succession is becoming more important. Many owners need key management talent to run their companies as they position themselves for any one of the following succession alternatives:

• Transition the business to the next generation of family (Family Business Model)
• Owners plan to shift to part-time or full-time retirement, yet remain owners (Owner Investment Model)
• Owners partially or totally cash out with an ESOP (Employee Stock Ownership Plans)
• Ownership sells partially or totally to management through a management buyout or internal transfer of ownership
• Ownership sells partially or totally to a private equity firm or strategic buyer

In all of these cases, the need to retain key talent prior to and after a transaction or transition can be greatly enhanced with either a long-term incentive plan or a non-qualified plan. Without such plans in place, privately-held companies bear the risk of losing key people or not being able to attract them in the first place, possibly harming the value of their company and derailing their succession plans.

Board of Director Cross-Pollination
Many individuals serving as outside directors on private company boards may have also served, or serve on the board of a public company. These directors therefore are likely to be familiar with and favor the use of long-term incentives to align the agendas of investors and executives.

All of the above stated factors are contributing to the growth in the use of long-term incentive plans or non-qualified plans.

Plan Selection
Assessing the need for a long-term incentive plan within an overall executive compensation program is a critical first step. The next step is to select the most appropriate plan or long-term incentive vehicle. The key to choosing the most appropriate plan is to first establish some plan objectives and parameters. For example:

• Is stock available?
• Should the plan be performance-based?
• If performance-based, what criteria should be used to measure value?
• What is the appropriate timeframe?
• Are there any tax issues that should be considered?
• What are the cost considerations?
• What do potential plan participants perceive as valuable?
• Are there significant individual differences among your executive team which would prohibit a single approach?

The answers to these questions will help form the basis for selecting the most appropriate long-term compensation plan for the company and executives.

There are several key considerations in the selection of the most appropriate plan and in its design. The different types of performance based plans and non-performance based plans are:

Performance Based
Stock Plans

• Qualified Stock Options
• Non-qualified Stock Options
• Incentive Stock Options
• Restricted Stock

Non-Stock Plans

• Stock Appreciation Rights
• Phantom Stock
• Performance Unit Plan

Non-Performance Based

• Supplemental Executive Retirement Plans (SERP)
• Deferred compensation plans

An in-depth discussion of the pros and cons of each of these plans is not the subject of this article. Rather, the remainder of this article focuses on the important steps of selection, design and implementation of these plans.

Selection, Design and Implementation
The decision to implement a long-term compensation plan can have a positive impact on the future success of the company. However, if the wrong type of plan is selected, or if it is not implemented properly, it can have a disastrous impact on the company and the morale of its executives.

Nine common pitfalls in the selection, design and implementation of long-term compensation plans are discussed below:

1. No Compensation Strategy Review - Not determining how a long-term compensation plan fits with the company’s overall compensation strategy. The company needs to look at how the total compensation package stacks up in terms of base salary, annual incentive, qualified retirement plans and long-term compensation plans. Critical factors to consider are:

• How does the plan relate to our overall business strategy and culture?
• How does the plan relate to ownership objectives?
• What is the appropriate compensation mix?
• How does it compare to the competition?
• How does it compare to the general market?
• How variable is the plan based on performance?
• How does each component compare to the market?
• Who should be eligible to participate in the program?

One of the objectives of any compensation program is to maximize the value of your compensation dollars. Determining the appropriate compensation strategy and selecting and designing a plan consistent with that strategy will help maximize the return on the required financial investment.

2. No Plan Selection Criteria - Ownership not clarifying and defining what they really want to achieve with a long-term plan for the employer and the participants. These requirements should be matched with what each type of plan offers to ensure the selected plan meets their needs.