Incentivizing Executive Compensation at Private Companies
When managed properly, private company executive compensation helps companies attract, keep, and motivate business leaders to achieve corporate objectives and generate financial returns. Many boards and recruiting teams at private companies struggle with the challenge, however, because they fail to consider the total compensation package or link it to desired corporate results.
According to executive recruiting software firm Thrive, opened executive searches grew by 18% in fourth quarter 2020 year-over-year with significant positive momentum swings in nearly all industries tracked. Although overall headcount is not expected to increase in 2021, demand for top performers is growing. To compete effectively for talent with public companies, executive recruiting teams are being challenged to develop more competitive compensation offers.
It is our experience that when executive pay aligns with corporate purpose, values, and strategies better performance is the result. A good private company executive compensation program begins with an organization’s strategic goals and business priorities. These objectives may have changed in the post-pandemic economy as some companies may have realigned their business purpose and strategies.
Although data about executive compensation at private firms is more difficult to obtain than pay at public companies, a WorldatWork biannual survey finds private firms are behaving more like their public company counterparts. In fact, spending on Short-Term Incentives (STIs) increased at private companies, reflecting 6.5% of operating profit compared to 6.0% in the prior survey. Moreover, an uptick in Long-Term Incentives (LTIs), from 54% to 62%, indicates private companies are taking a more holistic view to incentive management. An update to the survey is expected later this year.
With this data in mind, here are the pay variables and incentives to consider when preparing executive compensation plans:
Fixed Versus Variable Pay
Total compensation is made up of base salary (determined in advance and paid in cash), along with STIs and LTIs. Both types of incentives are variable or at risk and are typically contingent on achievement of organizational or individual goals.
The WorldatWork analysis shows that just under 65% of private company CEO compensation is variable. Reporting executives will have a somewhat higher percentage in fixed pay. When compared to public companies, small-cap companies pay approximately 70% of compensation in the form of variable payments.
Undoubtedly, as organizations reimagine the workplace in 2021 and determine how to adapt to future business needs, they are being challenged to keep up with the pace of change. For companies in transformation with ample resources to invest, greater emphasis should be placed on STIs to achieve short-term goals. Companies with less cash on hand and more focused on sustainability can incorporate LTIs.
According to the WorldatWork survey, Annual Incentive Plan (AIP) prevalence increased to 86%, which is up from two years earlier. Median target award levels are about 80% of salary for CEOs, although AIP opportunity often varies with industry, company size and appetite for risk. For positions reporting to the CEO, opportunity decreases by about half for each lower position level.
Most STI plans base payouts of performance against pre-established goals. Performance goals are generally derived from the organization’s budget. To a pronounced lesser extent, some companies prefer to base bonuses on after-the-fact assessment of performance.
Private companies typically use one to three performance measures, with profitability the most prevalent and revenue the second. In addition, we are finding a third measure related to Diversity, Equity, and Inclusion (DEI) being incorporated by approximately 25% of private organizations. DEI metrics will accelerate in coming years. The CEO is typically measured on corporate performance, while other executives are measured on both corporate and unit/division/personal performance.
Just over 6 out of 10 private companies have implemented LTI plans. That is up substantially over the past 12 years when only 35% reported having LTI programs in place.
Private companies offer three categories of long-term plans. Just over a third offer real equity programs, such as stock options, restricted stock units or restricted stock. Many owners are reluctant to part with real stock, however, as it dilutes their ownership. For companies that use real equity, total overhang is generally less than 10%.
Another option is phantom equity – used by 15% of organizations – including phantom stock and stock appreciation rights. The difficulty with these programs is the timing of reported results due to the lag in determining company values and the black box of valuations. The third alternative is cash-based performance awards used by 65% of organizations.
LTI eligibility is reserved for the CEO and other executives at the top level of the organization. Respondents related that median LTI incentive opportunity for CEOs is between 70% and 90%, falling about 30 percentage points for reporting positions.
Profitability measures are by far the most popular measure with performance plans, followed by a return-on-investment measure and revenue. Performance targets generally flow from budget or are an improvement over prior years. Cash payouts are primarily based on corporate results. Three years is the most common performance period, although it can vary from two to five years.
The robust economic recovery predicted by many experts will create fierce competition for executives who have proven they can perform under difficult circumstances. Organizations hoping to attract the best and the brightest must be ready with competitive compensation offers.
Copying another organization’s approach leads to suboptimal results. Make sure recruiting strategies and executive compensation packages are reality tested and aligned with corporate objectives.
Would you like to know more about private company executive pay practices or compensation planning for private companies? Please contact Neil Lappley at firstname.lastname@example.org or call 847-921-2812.
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