Maybe money can’t buy happiness, but it can buy the services of talented executives and help keep them happy. For that to work, however, compensation not only has to be dispensed in the right quantities but according to the right formulas.
Many family businesses are increasingly aware that “they have to be more competitive in the market vis à vis other companies in order to attract the right kind of people,” notes Bruce Benesh, a partner in charge of the compensation practice at Arthur Andersen in Atlanta. As a result, Benesh says, they’re narrowing the traditional compensation gap between private and publicly held companies. But family companies are still struggling with what has become the currency of choice for attracting and keeping talented executives—stock options—because they are reluctant to give away ownership.
Benesh says innovations in finance and desktop computers have made smaller companies much more competitive with larger ones in terms of access to capital and technology. The real challenge for family held businesses “is finding and affording the kind of people they need,” says Benesh. “The key is to think more creatively about how to design compensation packages.”
Many of these companies have a long way to go, according to a survey released recently by Arthur Andersen and the M Financial Group, a consortium of financial advisers in Portland, Oregon. They received 209 responses from private firms with a median of 250 employees. The median salaries for CEOs, COOs, and CFOs were $200,000, $140,000, and $100,000 respectively. By contrast, an analysis of data from similarly sized public companies revealed medians of $263,000, $173,800, and $136,900 for the CEO, COO, and CFO. The differences in annual incentive compensation were even larger: While the private companies paid $35,000, $40,000, and $12,000 respectively, the public companies paid $105,000, $54,800, and $23,000.
Despite the gap, the report noted, “Private companies are beginning to realize the value of linking top executive compensation to the long-term objectives of the company.” It found that 37 percent of the private companies in the survey provided some form of long-term incentive plan, and 24 of the 209 firms included stock options. Another 24 percent were considering some form of long-term incentive.
At the higher reaches of management, compensation is not about weekly paychecks, but custom-tailored “packages.” A Watson Wyatt survey of 1,406 U.S. companies found that “other compensation” for CEOs totaled 4.3 times base salary, for CFOs 2.4 times base pay.
What’s in these packages? An example comes from Kevin Hanrahan, vice chairman of Crist Partners, an executive recruiting firm. He recently recruited Bill Chiasson, the CFO of Kraft Foods, to be CFO of family owned Levi Strauss. In order to lure Chiasson, Hanrahan says, Levi Strauss began by being “very competitive” on the base salary he would have made at Kraft. “Then they offered an annualized bonus that was very competitive versus Kraft. They also offered a long-term cash compensation package that was very attractive, and, in lieu of stock options, made him eligible for some senior management bonus programs that were tied to the profitability of the company.” Chiasson also received a significant signing bonus and aid in moving from Chicago to California. This was coupled with the promise of an opportunity to move into positions beyond finance. “Levi is reputed to be an outstanding company to work for,” Hanrahan adds, “so that made it an attractive opportunity.”
To be sure, Levi Strauss has deeper pockets than most family firms, but Hanrahan says the same principles apply: To hire and keep executive talent, companies need to put together the right package. Besides salary, the two key elements are incentive compensation and supplemental benefits. The former offers rewards for good results, while the latter provides additional compensation beyond the paycheck itself. If properly designed, both serve as golden handcuffs to keep talented people with the company.
Alternatives to stock
Incentive compensation has become a business buzzword, with companies of all sorts seeking ways to “align the interests” of employees and owners. However, bonuses tied to annual increases in revenues or profits are in disfavor because they induce a short-term, just-make-our-numbers approach. And profit-sharing plans aren’t effective at private companies which may not want to maximize reported profits.
In corporate America today, stock options have become the most popular incentive for encouraging the pursuit of long-term growth. A Towers Perrin study found that options packages comprised 28 percent of executive compensation at major U.S. companies. Startup and fast-growing companies that can’t yet afford large salaries often rely on stock options to compete for talent. This U.S. model has spread to other countries as well.
This trend has been bad news for private family companies, which either don’t have stock or don’t want it going outside the family. How can they make executives feel like owners without actually making them owners?
For many family companies, the two main answers are phantom stock and stock appreciation rights (SAR). With phantom stock, the company gives an executive units that correspond in value to the company’s shares at that point in time. The units receive dividends and their value changes in tandem with the company’s shares. They are ultimately cashed in. With stock appreciation rights, the holder simply gets a cash bonus equal to the appreciation in the value of the company stock over a specific period of time.
Jim McMahon, president of the Analytical Consulting Companies in Phoenix, explains, “Phantom stock typically pays off at a fixed point in the future, while the SAR has a life that is more typical of a stock option plan—it’s usually for a 10-year period, with some vesting provision, and the executive may have several years to make a decision to exercise.”
But if a stock isn’t publicly traded, how can it be valued? “A common method would be to use the book value of assets or the net worth of the company,” McMahon says. But he adds, “In certain corporate settings, where the company is not long-established or not asset-based, the owners may have to find some other means of valuing the company in order to establish credibility with the prospective participants in the plan.” Many companies hire a business valuation service to appraise the company. “They may say it’s worth X based on a multiple of revenues or profits, or what companies like this one have sold for in the past,” McMahon says. “There are five or six valuation methods and they will recommend the one that is most credible.”
McMahon, whose firm advises companies on compensation, has set up more than a dozen phantom stock or SAR programs this year, and says the number of such plans is growing rapidly. His clients have included a $5-million sign manufacturer in Arkansas, a $7-million engineering company in Montana, a $60-million newspaper chain, and a $300-million construction company in Kentucky. “And I just got a call from an insurance broker with four employees.”
About 11 percent of firms in the Arthur Andersen survey with long-term incentive plans had either phantom stock or a SAR. Andersen’s Benesh says these plans can work for any company, “as long as they don’t see themselves going public in the near term.”
Sauder Woodworking Co., a family business in Archbold, Ohio, is one of those launching a stock appreciation rights plan. “I thought of stock options more in terms of the Fortune 500,” says Kevin J. Sauder, executive vice president. But the company’s philosophy is to pay all employees at market levels; so to compete with stock options, Sauder has set up an SAR program, effective Jan. 1, 1999. He notes that the company already values its stock annually for estate planning purposes, and the SAR plan may lead to quarterly valuations.
For some managers, phantom stock or SARs may be more desirable than stock options, says McMahon, because the executive doesn’t have to lay out cash for a purchase, as he would have to do with options. But these plans can be costly to the company. Stock options usually involve dispensing treasury stock, which doesn’t cost the company anything, and the appreciation is derived from selling the stock into the market. Privately held companies with phantom stock and SARs are, in contrast, paying out cash, and the bigger the run-up in share price, the more the benefit costs the company.
Of course, as the Arthur Andersen survey shows, some family companies offer actual stock options. If it’s a big company and a small options program, the impact on ownership would hardly be noticeable. But the employee receives little ongoing benefit. Ben Betty, CEO of Betty Manufacturing Co. in Hendersonville, Tennessee, notes, “In a closely held company like ours, we don’t want to pay any dividends—they just get taxed twice. So if executives took money and bought stock, they wouldn’t get any income from it. It would only be useful for cashing out when they retired, and you can do the same with an ESOP, which has a lot better tax consequences.” Betty Manufacturing has 130 employees and annual sales of $12 million.
Meanwhile, some companies offer managers restricted stock. The shares are real, but they come with provisions on how and to whom the executive can sell them, and these limits can blunt their appeal. There are also second thoughts about the whole concept of options during stock-market setbacks, such as the August 1998 plunge in prices. When that happens, stock options lose their magic.
Some companies believe properly structured long-term bonuses are sufficient. Instead of options, Betty Manufacturing has a bonus plan that rewards senior managers if the company hits certain goals for return-on-investment and profitability. “They can make a substantial bonus if they hit it for three straight years,” says Ben Betty. And at Bloomberg Financial Markets, employees are given certificates based on the number of Bloomberg terminals leased during the ensuing two years. Employees who leave before the two years are up forfeit their certificates.
One way or another, Benesh says, “there’s an expectation in the market that managers will share in the success of the organization,” and family companies need to respond to that.
Supplemental benefits
The other pillar of attractive compensation plans comprises supplemental benefits. These “wealth-building” programs include a potpourri of ways to defer income and deliver it in ways that put more beyond the reach of the tax collector. And by accumulating but not immediately receiving these benefits, executives have an incentive to stay with the company.
The M Financial Group survey found that 39 percent of the private companies responding provided supplemental plans of some kind: 51 percent offered supplemental, nonqualified retirement plans, 35 percent offered voluntary deferred compensation plans, and 35 percent offered supplemental death and survivor benefit plans.
These plans are “non-qualified” for tax purposes in order to circumvent anti-discrimination rules requiring companies paying large pension benefits to senior executives to offer sizable benefits to lesser employees as well. Many supplemental plans use the tax-exempt status of money building inside a cash-value life insurance policy to amass a bundle of money for an executive to draw down later.
In addition to retirement and insurance packages, there are a host of ways of topping off an executive’s pay, notes Tom Ferrara, president of Future Value Associates, a Greenwich, Connecticut, firm that specializes in designing executive benefits. For example, he says, a medical savings account can defer salary and transform it into tax-free income that is used to pay family medical expenses.
At one time, these benefits could be offered only by giant firms with large numbers of employees. But vendors have now created off-the-shelf packages for smaller companies. A Vanguard or a T. Rowe Price will set up a 401(k) plan at the tiniest of employers, and insurance companies will sell pretty much the same coverage to mom-and-pop operations as they will to GM and GE. Although the plans are pretty much available to any firm, size still matters, according to Ferrara: “Because of the smaller size of most closely held businesses, they don’t have the people to research alternative benefit options. If you’re a larger company, you can hire people to do this.”
Nonetheless, M Financial Group chairman Fred H. Jonske says, “Companies need to look at these supplemental benefit programs; they’re becoming more necessary to compete with what’s in the marketplace.”
Money isn’t everything, of course. In hiring and retaining executives, McMahon says, “There are other things, including the corporate culture, which aren’t to be taken lightly. Private companies can be very attractive places to work for some people. Unlike public companies they’re not subject to the vagaries of the market and changes of control.”
Kevin Sauder agrees: “I feel there are inherent benefits to working for a family business because of the stability and the corporate culture. Most people would say that’s what keeps them here, all other things being equal.” But all other things need to be equal or close to it. A warm and fuzzy environment, Sauder adds, “shouldn’t substitute for market-based compensation.”
When business owners think about compensation, Benesh advises, they should be wary of asking whether they can afford it. “In today’s environment, you can’t afford not to have the best talent.”
Harvey D. Shapiro is a writer and consultant in New York City who specializes in finance.
