Public v. Private Companies: Approaches to Competitive Pay

Working for a public company has always had its allure:  There is a lot of opportunity to grow professionally; career ladders are well established, top-of-the-line benefits combined with great retirement and even post-retirement benefits.  Of significant importance is the potential to earn highly competitive pay, where part of the compensation package may consist of real equity (readily available in public companies).  Many of these ideas are true, to one degree or another.  However, as many individuals unfortunately find out, some can be illusionary – like a pot of gold at the end of the rainbow.
 
It was common for publicly traded companies to offer a comprehensive array of pay and benefits to compete for the talent needed to fuel the spectacular growth that occurred in the 70’s through the mid 90’s.  The success of many to these companies provided the financial ability to virtually guarantee lifetime employment.  Most publicly traded companies would pay competitively, but not overly generously, while providing good benefits that even extended to the post-retirement period.
 

Piece of the Action

As we have seen, times have changed, as have the types and extend of benefits that are now provided. 


One of the compensation elements that became increasingly popular, and very prolific for management from the mid-80s on, was the introduction and increasing use of equity programs.   This generally took the form of stock options in a publicly traded employer.  Until the bubble burst in 2000-2001, the use of stock as a compensation vehicle grew exponentially for executives and management, and also extended through the ranks of all employees.


Using stock as supplement salary served many purposes at that time:  Companies could easily authorize additional stock; it was considered a cheap form of compensation; it could create incentives and therefore retain key employees; and awards in the form of options provided a perception of above-average compensation, particularly when cash flow was a concern. There has always been a strong belief that an individual with some ownership interest in the company will act more like an entrepreneur and have common goals with the other shareholders.  Even though it has not been proven after reviewing the results of many research studies on the subject, it appears that this is somewhat of an “urban legend” – the idea is still widely accepted and often used as the rationale for adopting many such programs.


Nonetheless, many of the benefits ascribed to equity and long-term pay programs have been realized.  As would be expected, stock-based companies appear to have an unfair advantage, being able to lure talent by offering a long-term compensation element with the potential of making executives very wealthy over their careers.  As the supply of qualified applicants became scarcer due to demand, companies raised the ante by continuing to provide more and more stock and long-term incentives.

From 1985 through 2000, not only did the value of the total compensation package increase dramatically, but the mix of compensation elements for CEOs of the Fortune 200 companies changed dramatically as well.  In 1985, compensation was made up approximately 50 percent base salary, 25 percent of short-term incentives (STI) and bonuses, and 25 percent of long-term incentives (LTI).  By 2005, the compensation mix became 25 percent salary, 25 percent STI and 50 percent LTI.  This major shift in these elements was considered by many to have stacked the deck unfairly in favor of public companies over their privately owned counterparts.
 

Privately Held Firms

Privately held firms do not have a marketable stock and there is limited, if any interest by the owners in having employees or outsiders invest in their companies.  As a result, the design of compensation programs among this group has focused more on base salary, and to an increasing degree, annual incentive compensation for the non-owner executives.  Owners and family members who work for the company very often perceive their long-term incentives as their equity stake in the company, whether real or perceived for the future.


However, when the need arises to recruit key management members from outside the organization, privately held firms are challenged by their inability to provide a long-term incentive component within the total compensation package.  This challenge limits the labor pool of individuals who are willing to forego this significant element of compensation.  Those who may be agree to salary and short-term bonuses are often provided with rich base salaries that can cause consternation among working family members.


From our experience working with privately-owned companies, most owners are reluctant to give up stock in their firms - even to their most critical management team members and even if it would more positively position the company and make it much more competitive in the marketplace for talent.  Owners usually don’t want “partners” and don’t want to share control with others, if they don’t have to.  But, in order to level the playing field when it comes to attracting, hiring and retaining highly qualified managers, private organizations need to adopt some form of long-term incentives.  This additional element of the compensation package will allow then to compete for those executives, particularly those current working for publicly traded counterparts - and to hold on to those that they have.
 
To do this, a growing number of private companies are adopting a variety of phantom stock, shadow equity, and similar cash-based incentives.  These plans provide the missing element to the compensation package for non-owner executives, and in turn provides the company with the means to focus executives’ attention on the long-term success of the organization.
 

Alternative Long-term Incentives

There are a least three major questions that must be addressed when evaluating alternative long-term incentives:

• How do you measure and value the performance used for determining awards?
  
• In what form will the award be paid?
  
• What are the tax and accounting implications to both the company and the executives? 
  

 
Each of these issues has a number of alternatives that can be used; however, each has its own implications.
 

Measuring Performance

One method is to actually value the company.  Typically, this is an expensive procedure that requires outside valuation experts and may have some undesired effects.  Another measurement can be to use “book value” or a simple formula such as a multiple of earnings or revenue, or some combination of these measures.  Lastly, rather than valuing the company, the measurement may be based strictly on the change in performance from year to year to year.  Any of these methodologies will provide the answer to the first of the questions.
 

 
Tax and accounting issues:  If real stock is used, it is possible to structure the award to take advantage of lower capital gains tax rates.  This is not available with cash, which limits the taxability to ordinary income treatment.  This trade off has a greater impact on the recipient than on the company. 
 
Besides preserving the equity position of the owner(s) through a cash payment in a long-term incentive plan, there is considerably more freedom in the design of the compensation plan since SEC and similar regulatory issues are avoided.  The cash-based plans must comply with applicable deferred compensation regulations; but for the most part these are far easier to comply with, and still allow sufficient design flexibility.


The bottom line is that the long-term compensation component is an important part of any executive compensation package.  And there are enough alternatives that privately owned companies can and should include this pay in their toolbox of compensation components.  The use of long-term incentive programs within privately held firms serves to level the playing field with publicly traded companies.
 
 
We welcome the opportunity to discuss this article and specific issues that the readers may have.  Please contact Paul Dorf by email at prd@compensationresources.com, or call 877-934-0505.