Designing incentive compensation for key non-family executives
You need a long-term incentive plan that both attracts non-family executives and eases family members’ concerns. Here’s what you need to know.
Many family businesses will reach a point where non-family executives are needed to manage the company and take it to the next level. There are myriad challenges to overcome in attracting outside talent to a family firm. Some executives are concerned about the uncertainty of family dynamics. Others are discouraged by what they see as the slim chance of a lucrative exit.
One of the biggest hurdles for family businesses is the need to develop an attractive long-term incentive (LTI) plan that recognizes enterprise value created over time and is competitive with plans offered by public companies and private equity–owned businesses. There are several ways to offset the inability to offer publicly traded stock or stock options.
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About a decade ago, we saw private companies shift dramatically toward LTI plans. According to a 2012 World at Work survey of private companies’ incentive pay practices, 61% of the respondents used LTI plans in 2011, compared with 35% in 2007. The 2017 edition of the survey found that the prevalence of these plans has settled in at about 55%.
Around 2009, I began receiving requests from clients at private and family companies to design new LTI plans as part of the overarching executive compensation plans. The clients noted that it was becoming more difficult to pull talented executives out of public or private equity–owned companies. Why would these talented individuals join a business where all the enterprise value they helped create would go to someone else, while all they would get was a base salary and possibly a nice bonus each year? Executives wanted a piece of the action.
After almost a decade of tinkering, we have identified the most prominent plan designs and a typical path that a plan follows as it evolves. Let’s start with the alternative plans.
General plan types
Equity instruments. These are actual shares that represent real equity and put executives in the same position as family shareholders. While there are advantages to this type of arrangement, many family business owners are reluctant to grant shares to non-family members. These shares might be afforded voting and other rights under state and federal securities laws.
One upside to his type of arrangement is that executives are aligned with shareholders when it comes to building enterprise value. If the valuation of the company increases, so does the wealth of the family owners and the executives alike. Further, if dividends are paid on the shares, the executives receive the same proportional cash payment as the other shareholders.
Issuing actual shares to executives raises at least two areas of concern for family shareholders. First, the tax structure of the business can be affected. For example, S corporations cannot have two classes of stock, so if the family does not want new voting shareholders, granting real equity to executives is a non-starter. Second, if the executives want liquidity, the company could end up with a large cash liability. Long-term planning is required if liquidity is offered during an executive’s employment.
In almost all cases, a valuation of the business is necessary to understand and communicate the value of the shares on the date they are granted, and to assess the value accruing to the executive over time. The valuation is typically conducted annually and can be costly.
In my experience, few family firms issue actual equity to non-family executives. The drawbacks outweigh the positive aspects, and the positives can often be replicated by using other LTI plan designs.
Phantom equity. Phantom equity, or equity-like instruments, seek to mimic the value of equity without actually issuing shares in the company. Plans can mirror stock options (called stock appreciation rights, or SARs) or shares of stock (called restricted stock units, or RSUs). This approach has the added benefit of providing flexibility in the way phantom equity is valued.
These plans track the value that would accrue if actual shares were granted. Rather than having the stock valued each year, a formula for the stock price is set at the beginning of the plan so it can be easily calculated at any time. For example, stock values are often viewed as a multiple of earnings. So if an industry valuation multiple is 5x earnings, we would apply that multiple to the earnings of the business in order to determine the grant value and subsequent value of the phantom shares.
SARs and RSUs act similarly to actual shares in terms of the value delivered to executives. The payout value is given in cash, typically on a schedule set up at the time of the grant. For example, if $100,000 is the ending value of a grant, there might be an agreement stating that it will be distributed in two payments (for example, 50% at the third anniversary of the grant and 50% at the fourth anniversary). The performance period of the grant is usually three years, corresponding to the first 50% payout. Often some of the cash payment is delayed in order to add retention power for another year while a follow-on grant gains value and to spread out the cash cost. Of course, because of the cash payout feature, this type of grant represents a cash liability for the company, which can be a drawback.
Pool and allocation. Private companies, including many family businesses, often will strive for a simpler way to provide long-term incentive value to executives. When communicating the plan to a broad spectrum of family shareholders, it is prudent to provide a model that is easy to understand and shows the highest and lowest payouts available to the executives.
One way to achieve this simplicity is through pool and allocation designs. This type of plan merely sets aside a fixed percentage of earnings or revenue (the “pool”) to be paid to executives at a pre-defined rate (the “allocation”). A very simple calculation is used to determine the total value being reallocated from the shareholders to the executives: percentage of earnings x earnings. For example, if 2% of earnings is being set aside and earnings are $50 million, the split is $49 million for shareholders and $1 million for executives. The $1 million is divided among executives based on a predetermined percentage of the pool.
When a family shareholder asks how much of their potential dividend is being paid to the executives, an easy answer is available. It is also a benefit that the answer is in aggregate (e.g., $1 million is being taken from earnings to pay to executives), which is really what the shareholder is looking for. There is no need to get into how much each executive is paid.
Plan design alternatives
Elements of these plans can be altered to tailor the plan to an individual business or compensation philosophy. Once the best plan type for the company is determined, specific design features can be incorporated to provide incentive value to executives and leverage in the payment or protection for the family shareholders. Let’s take a look at a few of these features.
Performance orientation. The better the performance of the executives and the company, the more the executives feel they should be rewarded. This is typical in any company, whether public, private with institutional backing or family-owned. The plans above can be tweaked to provide the kind of upside typically seen in public companies.
Instead of merely granting equity or phantom equity or carving out a percentage of earnings, the number of shares or percentage of earning can be adjusted based on the performance of the company during a set time frame. When equity or phantom equity is granted, the number of shares that will be paid out can be based on how well the company performs. For example, consider an executive who is granted 100 shares. If revenue growth is above 10% over a three-year period, the executive is paid out 150 shares. If revenue growth is below 5%, no shares are paid out. If growth is between 5% and 10%, 75 to 100 shares are paid out based on the level of growth.
The metric by which the number of shares paid out is determined can be tailored to the company’s specific business and strategy. We have seen metrics based on revenue, earnings, return on capital, free cash flow and many others.
This concept can also be applied to pool and allocation plans by adjusting the percentage of earnings that are set aside based on the company’s financial performance.
Leverage. Incentive plans are generally more effective when executives see the benefit of outperforming expectations. In incentive designs, that means providing more than 100% payout if actual performance (however that is defined) exceeds target performance. Upside ranges can be anywhere from 150% to 300% of target. For example, if target performance was 5% earnings growth and the number of target shares was 100, at 7% growth the payout would be 150 shares. In the case of 10% growth, the payout might be 200 shares.
Of course, if family shareholders provide upside, executives should also be willing to accept downside risk. In our example, if growth were only 3%, 50 shares would be paid out. If growth were below 3%, no shares would be paid out.
This can also be applied to pool and allocation plans through different mechanisms.
In any case, providing more leverage should be accompanied by layers of more difficult performance metrics.
Protection for family shareholders. We have seen many well-intended plan designs fail to be approved because family shareholders do not feel they have protection against payments or granted share values that eat into shareholder value too much. There is a fairly simple fix for this: payment or value caps. These can take the form of maximum payouts or caps on the number of shares that an executive can liquidate.
In the pool and allocation design, the maximum payout is controlled by the percentage of earnings being set aside.
Typical progression of plans in family businesses
We have been involved in developing long-term compensation plans for many family businesses. In our experience, finding the right plan can take some time. The more mature a company is, the easier it is to use an equity-like plan because methods of forecasting financial performance and planning for larger cash liabilities are more developed. On the other hand, less mature companies tend to migrate toward pool and allocation plans because they are simple and provide built-in limits on the amount of value transfer to executives.
In almost all cases, plans evolve over a number of years. In one case, a client started with a performance-based pseudo-equity plan. Three years later the company moved to a hybrid pseudo-equity/pool and allocation plan. Since then, the client has adopted a more complex version of a pool and allocation plan with no equity component. Much of the change occurred because family shareholders had difficulty understanding how to measure the possible value transfer from the family to the executives.
Things to consider
First, gauge shareholders’ level of sophistication. This will guide you to a starting point with regard to the complexity of the plan you design.
Second, benchmark the compensation of the executives working in your company and those you would like to attract. When you add a component of compensation, it must be viewed through the lens of total direct compensation and should be reasonable in amount and design.
Third, look at more than one design. When you compare two compensation plans side by side, you understand more about both.
Fourth, model the possible outcomes. Spend the painstaking time to build a model of the plan so you can be confident that there will not be an unanticipated outcome.
Finally: Communicate, communicate, communicate. Build enough time into the design schedule to sit with each family shareholder multiple times and walk through the plan design and plan modeling. If a shareholder has a vague feeling that they are missing something, the plan will very likely fail, as there will be consistent questions and misunderstandings. Also, create communication materials for both the executives and the family shareholders that illustrate simply the performance and the associated payouts.
Theodore Sharp is a senior client partner for Korn Ferry Hay Group, based in the firm’s Boston office (www.kornferry.com). He is a member of the Executive Pay and Governance team.