Short-term incentives (STIs) have become nearly universal at private companies to align pay with short-term performance, according to a recent survey by CAP and WorldatWork. “2019 Incentive Pay Practices: Privately Held Companies” found that STI prevalence reached 99 percent in 2019, up from 96 percent in 2017 and 94 percent in 2015.
Other key survey takeaways include:
- Spending on STIs increased to 6.5 percent of operating profit at median in 2019, up from 6 percent in 2017 and 5 percent in prior years.
- The prevalence of Annual Incentive Plans (AIPs) increased to 86 percent in 2019, up from 82 percent in 2017. The prevalence of all other types of STIs (i.e., spot awards, discretionary bonuses, team/small group incentives, project bonuses and profit sharing) fell in 2019. This indicates that firms are consolidating their STI spending on structured AIPs that incorporate companywide financial metrics and other objectives.
- AIP plans continue to be offered across the organization, with two-thirds of organizations providing eligibility to all employees.
- Long-term incentive (LTI) prevalence increased in 2019 to 62 percent. This is up from 54 percent in 2017 and 53 percent in 2015. The increased prevalence reflects that private firms are competing for top talent with publicly traded peers in a tight labor market.
- LTIs continue to be awarded to top management only.
The full results of the private company survey are available to WorldatWork members.
This report summarizes the Compensation Advisory Partners analysis of survey data collected in May 2019 in collaboration with Family Business and Private Company Director magazines.
Private companies face unique challenges relative to their publicly traded peers when compensating top officers and directors. Private companies lack publicly traded stock, which is a key component of top officer and director pay packages at public companies. Private companies face an additional and formidable challenge with regard to setting director pay: Little to no market pay data exists for board service at private companies. Because of the lack of competitive data, private companies often resort to using board pay levels at public peers, if any are available. Private company board pay programs have been based on a combination of the cash portion of public company director pay and the best judgment of decision-makers at the private companies.
To address this lack of competitive market data, Compensation Advisory Partners (CAP), and Private Company Director and Family Business magazines (both of which are published by MLR Media) worked together to survey private companies about their director pay programs. The response was enthusiastic, with more than 600 companies submitting data during the May 2019 survey period. This article provides a high-level summary of the survey data and describes how private companies can approach the design of effective and competitive board compensation programs.
About the Survey Participants
The private companies that responded to the survey represent a broad array of demographic categories. This broad representation results in a robust and unique data set detailing board of director compensation levels and practices.
The survey asked about company size because that typically has an impact on board pay levels. Survey respondents have median revenue of $90 million and average revenue of $631 million. The companies in the survey span many revenue sizes as shown in Exhibit 1.
Survey participants were also asked about their number of employees and shareholders. The median number of employees for survey participants is 250, while the average is 1,570. The median number of shareholders is seven, with an average of 131.
The companies that responded to the survey represent a broad range of industries. The largest industries represented in the survey are manufacturing (31%); finance and insurance (9%); retail trade (8%); wholesale trade (7%); professional, scientific, and technical services (7%); construction (7%); real estate, and rental and leasing (5%); and health care and social assistance (5%).
With regard to company ownership, the largest portion of the sample by far is made up of family-owned businesses. Other ownership groups represented in the sample are companies that are closely held by unrelated owners, private equity-owned or -invested, and employee-owned. (See Exhibit 2.) The “other” ownership category in Exhibit 2 includes mutual companies, tax-exempt entities, and cooperatives.
The survey also asked respondents to provide information about their corporate structures. The most prevalent corporate structures are S corporations and C corporations. Smaller numbers of respondents reported that they are limited liability corporations (LLC) and partnerships. (See Exhibit 2.) The “other” category in Exhibit 2 includes mutual companies, sole proprietors, B corporations, cooperatives and trusts.
The vast majority of survey respondents are headquartered in the United States, but the survey drew responses from companies headquartered all over the world. (See Exhibit 2.)
Private Company Board Compensation Basics
According to the survey, 87 percent of private companies provide some form of compensation to eligible directors. In public companies, those eligible for compensation are typically outside directors, or those who have no ties to the company through employment. (At times, representatives of private-equity investors do receive cash compensation.) In contrast, 45 percent of private companies compensate board members who are shareholders, family members or executives (“inside” directors). Another 7.5 percent of respondents have “other” compensation arrangements for inside directors. This likely means a hybrid approach that involves some level of compensation for such inside directors, but not to the same degree as outside, independent directors. The high number of private companies that compensate shareholders, family members and executives likely reflects the high percentage of family companies responding to the survey.
Private-company board compensation programs have two common cash components: An annual retainer and per-meeting fees. An annual retainer, which is an amount paid to each eligible director on an annual or quarterly basis for board service, is offered by 72 percent of private companies surveyed. Per-meeting fees are smaller amounts paid to eligible directors for attendance at each board meeting, and they are offered by 54 percent of the companies surveyed. (See Exhibit 3.)
According to the survey, the median annual retainer is $30,000, and the median per-meeting fee is $2,000. Annual retainers and meeting fees increase with company size. (See Exhibits 4 and 5.) Some companies also pay eligible directors a lesser amount for participation in telephonic meetings, with the median payment being $1,000.
Private companies continue to use both an annual retainer and meeting fees, while the trend for director cash compensation at public companies is to pay a higher annual retainer only (i.e., no meeting fees). Public companies have adopted this approach because directorship requires time and effort beyond meetings, so retainers better reflect the requirements of the overall role. In addition, advancements in technology have made meeting participation easier and have blurred the lines for what constitutes a meeting, and public company directors are expected to attend at least 75 percent of board meetings. Incentivizing meeting attendance is, therefore, less of an issue for public companies. Finally, retainers are easier to administer than meeting fees, which require attendance tracking.
Retainers and per-meeting fees are also used to compensate individuals who take on different roles above and beyond basic board service. According to the survey, 37 percent of private companies offer incremental retainers and/or per-meeting fees for the board chairperson or lead director. In addition, 35 percent of private companies offer incremental retainers and/or per-meeting fees for committee service. In contrast with retainers and meeting fees for basic board service, the retainers and fees for differentiated board roles do not track the company’s size in terms of revenue.
Private companies recognize the value that board members bring to the table; however, only about 20 percent of the private companies surveyed provide long-term incentives to their board members in the form of phantom equity, cash multi-year incentives or actual equity grants, such as stock options or full-value shares. This low prevalence is not surprising, as private companies do not have publicly traded stock. This contrasts with public-company practice, where the vast majority grant equity to their directors. Publicly traded firms provide at least half of a director’s total compensation in the form of equity, typically full-value shares.
Table 1 summarizes the board compensation elements reported in the survey. (Additional data is included in the full survey report, which is provided exclusively to survey participants.)
|Board Member Base Cash Compensation|
|Board Chair Additional Cash Compensation|
|Lead Director Additional Cash Compensation|
|Committee Chair Additional Cash Compensation|
|Committee Member Additional Cash Compensation|
|Long-Term Incentive (Restricted Stock, Options, Cash)|
A final prevalent practice for private companies is to reimburse directors for their travel expenses. While this iteration of the survey did not ask about benefits and perquisites, some companies referenced them in their “other” responses. Future iterations of the survey may quantify such compensation elements.
Designing a Private Company Director Compensation Program
Private companies that wish to evaluate the design of their director pay programs should first determine what are the primary objectives of the program. Most board pay programs, whether at private or publicly traded companies, will strive to compensate directors for their time, and for the value received by the company for the director’s contributions. Other common objectives of board pay programs are to:
- Compete with other companies, including public companies, for board talent,
- Attract individuals with needed skills, knowledge and interpersonal networks to the board to supplement the executive team and shareholders,
- Reward directors for contributing to the company’s success, and/or
- Align director interests with shareholder interests.
Companies that are trying to compete for talent or attract special skills should strive to provide a competitive board compensation program, although director pay does not need to be as high as at a public company. Private company boards have a lower level of risk, disclosure and regulation than their publicly traded counterparts.
Once the objectives of the compensation program are defined, the next steps are to conduct internal and external reviews:
Internal review – This step involves looking at the company’s situation and the board dynamics. Issues to consider during the internal review are the complexity of issues facing the company; the likelihood of mergers, acquisitions and/or divestitures; whether the company plans to pursue a value-realizing event; any potential leadership changes or a generational transition in a family business; the company’s executive compensation philosophy and programs; the shareholders’ desire to share equity or not; whether the board’s role is fiduciary or advisory; directors’ expectations and other boards on which the directors serve; the board’s expected time and meeting commitments; non-compensatory benefits of serving on the board; and which board roles and/or committees are more involved and time-consuming. In general, boards and board roles with greater complexity, risk and challenges merit higher compensation.
External review – The external review involves considering how the company compares to its peers and collecting board compensation information for similar companies and/or boards. Sources of compensation information may include informal information from executives and directors about what other companies offer, and more formal information such as public peer company proxy data (generally excluding the equity data) and published survey data, such as the CAP-MLR Media survey. (Companies that participate in the survey have access to specialized data cuts by revenue size, industry and other parameters.) The goal of the external review is to understand competitive compensation practices and ranges, and to inform the company’s decision-making.
Once the internal and external reviews are completed, company shareholders can make decisions about the director compensation program. The shareholders will need to decide what type of pay model to adopt: retainers only, meeting fees only, or a combination of the two. As mentioned previously, publicly traded companies are moving toward a “retainers only” approach for cash compensation. However, the private-company survey indicates that more than 50 percent of private companies use per-meeting fees to compensate directors. A “retainers only” pay model makes sense for companies that wish to pay for overall board roles rather than time spent at individual meetings. Indicators that favor a “retainers only” pay model include material director time required outside of meetings, frequent interaction between board members outside of meetings that could create ambiguity about whether a formal meeting is taking place, a more predictable board workload and a desire for administrative simplicity. Under this model, retainers will need to be set at a level to compensate for all board work. Retainers also can be used to differentiate compensation for board roles. For instance, a basic retainer can be provided to all directors for board service, and incremental retainers can be provided to committee chairs and the board chair to recognize the additional time, effort, skills and knowledge required for those roles.
At the opposite end of the spectrum, some companies may choose a “meeting fees only” pay model. This pay model makes sense if most of the board work is tied to the meetings themselves. Per-meeting fees can be set to take into account typical meeting length, and preparation and follow-up time. Indicators for this pay model include an unpredictable number of meetings, comfort with the administrative efforts required to track and compensate meeting attendance, and most work requirements corresponding to board and committee meetings. Under this pay model, committee work can be compensated through meeting fees that are the same as board meetings or less if committee meetings require less time. In addition, roles such as chairman or lead director could be recognized with a higher per-meeting fee.
For companies that fall somewhere in the middle, a combination of retainers and meeting fees might make sense. Some companies with the potential for a flurry of meetings can stipulate that the basic retainer covers a certain number of meetings. If meetings are required above the number covered by the retainer, then meeting fees will be paid to directors.
In addition, the shareholders will need to decide whether to offer any sort of long-term incentive, such as phantom or real equity, for the directors. Companies that wish to reward directors for contributing to the company’s success and to align director interests with shareholder interests may want to consider providing directors with phantom or real equity stakes, or a multi-year performance bonus. However, according to the CAP-MLR Media survey, most private companies do not do this. However, the practice is common for start-up companies that are cash-constrained, and for private-equity owned companies. In both of those situations, stock options are a common vehicle.
Before implementing a new director pay program, companies should consider the prior year’s board schedule and workload, and calculate what the company’s board compensation expenses would have been last year using the proposed compensation program. This step is particularly important for companies that offer meeting fees. Modeling payouts under a new pay program will help validate the proposed program and flag any potential issues. The company should look at the modeled expenses of the new program relative to past spending on board of director compensation, and determine whether the new program’s costs are reasonable.
While private companies have historically had challenges with regard to competitive board compensation data, the CAP-MLR Media survey helps private companies address this issue. The survey shows that private companies have unique practices from public companies with regard to board of director compensation. Private companies are more likely to compensate a large group of directors, including those who would be considered “insiders” at public companies, and are more likely to use meeting fees. Only a small minority of private companies use long-term incentives, such as phantom and real equity, in their director pay programs. Companies can design an effective and competitive board compensation program by understanding the company’s and board’s unique situation, and by taking external market data into consideration.
Board Composition and Governance
The CAP-MLR Media survey asked a number of questions about the board composition and governance. Almost 60 percent of the private companies surveyed have fiduciary boards. Another 26 percent of companies have advisory boards only, and 12 percent report having both fiduciary and advisory boards. (See Exhibit 6.)
According to the companies surveyed, the typical board has five to eight directors, with seven being the median. Inside directors outnumber outside, or independent, directors, with a median of four inside directors and three outside directors.
With regard to diversity, each private-company board typically has one female director and no minority directors. Diversity is becoming a bigger issue for public-company directors. Since private companies – especially those preparing for a value-realizing event – tend to follow public-company practices, CAP and MLR Media expect that diversity will become a more important issue for private-company boards going forward. The survey asked respondents about the importance of diversity to private-company boards, with most responding that diversity is moderately important. (See Exhibit 7.) Tracking this question over time will show whether public-company issues are making their way to private companies.
Slightly more than half of the survey participants have formal board committees. For companies that have committees, the committee structure of private-company boards follows that of public-company peers, with audit/finance, compensation and nominating/governance committees being prevalent. Most private-company boards are led by independent directors, with the exception of executive, strategy and other committees. (See Exhibit 8.)
Private-company boards typically meet four times per year, as do the committees. Respondents estimate that private-company board members spend 50 hours per year at median on board service and 20 hours per year at median on committee service.
MLR Media sent the survey to contacts in its Private Company Director and Family Business subscriber databases. Compensation Advisory Partners, a leading boutique executive compensation consulting firm, analyzed the unattributed data responses and produced the survey reports with the assistance of MLR Media.
For purposes of analyzing the compensation data elements, only companies that provide the compensation element were included. Some companies that do not offer a particular compensation element provided “zero” as the answer for that pay element. Zeros were omitted in the analysis.
The definitions of several terms used in the survey follow:
Advisory Board – A more informal board that provides guidance and advice to the company’s management team and shareholders, but the board has no legal obligations.
Fiduciary Board – A formal board with voting rights and legal obligations to a company. Fiduciary boards oversee the chief executive officer and management.
Independent or Outside Director – An individual on a company’s board who has no ties to the company through employment or family status, and who has no ownership other than compensatory stock provided for board service.
Inside Director – An individual on a company’s board who works at the company or who has ownership of the company, including through family status.
Median – The data point at which half of the responses are higher, and half of the responses are lower.
For questions or more information, please contact:
Compensation Advisory Partners
Compensation Advisory Partners
Editor and Publishing Director
Private Company Board
Short-term cash incentives continue to be popular motivational tools at U.S. privately owned companies, nonprofits and government organizations (NGOs), according to recent research conducted by Vivient Consulting and WorldatWork. The 2017 executive and employee compensation research spotlights short- and long-term incentive pay practices and is unique in its focus on entities that are not publicly traded.
Vivient and WorldatWork surveyed WorldatWork members in late 2017 and published the results in May 2018 in two reports:
- “Incentive Pay Practices: Privately Held Companies”
- “Incentive Pay Practices: Nonprofit/Government Organizations.”
This 2017 compensation survey provides a long-term view of typical incentive pay practices at private companies and NGOs as well as a snapshot of current and emerging pay practices and compensation trends.
Typical Incentive Pay Practices
What do typical incentive pay practices look like at non-publicly traded entities? Nearly all private, for-profit companies provide some form of short-term incentive (STI), with annual incentive plans (AIPs) being the most common type. Other STIs include:
- Discretionary bonuses
- Spot awards
- Team/small-group incentives
- Project bonuses
- Profit sharing.
The survey excludes sales and commission plans. Although not as prevalent as at for-profit counterparts, some form of short-term incentive compensation is used by 80% of the NGOs represented in the survey. And short term incentives at nonprofit organizations have increased in the decade that the survey has been conducted, as these organizations have to compete for talent with the for-profit sector.
On the long-term incentive (LTI) side, more than half of private companies provide LTIs, with multi-year, cash-based performance awards being the most common vehicles. Other types of long term compensation incentives include:
- Real equity, which includes restricted stock and stock options
- Phantom equity, which includes phantom stock and stock appreciation rights (SARs).
Long term incentives at private companies continue to be primarily reserved for executives. Private companies reported using LTIs for retention, alignment with long-term goals and market competitiveness. At NGOs, longer term pay incentives continues to be rare, but prevalence increased to 24% in 2017 from 16% in 2015. Future compensation research will determine whether this trend continues.
Incentive Pay Trend: Increase in Short Term Incentive Spending
Private companies are spending more on STIs to motivate employees and compete for talent in a tight labor market. Private-company spending on short term incentives increased to 6% of operating profit at median from 5% in prior years. In addition, spending on STIs increased to 3% (from 2% in 2015) at the 25th percentile. At the 75th percentile, spending increased to 14% from 12% in 2015.
At NGOs, compensation survey respondents provided nonprofit estimated spending on short term incentives as a percentage of net organizational surplus (revenue minus expenses). In contrast to private companies, NGO spending on STIs slightly dropped at the median to 2.3% in 2017 from 3% in 2015. Similarly, reported spending by NGOs at the 75th percentile dropped to 9% in 2017 from 10% in 2015. However, participants expected STI spending as a percentage of their operating surplus to increase to 3.5% at median in 2018, as the budgetary outlook for 2018 appeared positive.
Incentive Pay Trend: Increased Annual Incentive Plan Eligibility
At private companies, the prevalence of exempt, salaried employees and nonexempt (salaried or hourly) employees included in Annual Incentive Plans increased in 2017. The biggest jump occurred for nonexempt employees. About two-thirds of nonexempt employees are now eligible for annual incentives, a significant increase from half in 2015. Annual incentive plan eligibility is now offered organization-wide at most private companies, reflecting the tight labor market and increased competition for talent. Eligibility for incentive plans is good news for employees who are now able to earn annual incentive awards and increase their overall compensation levels based on performance.
For nonprofit and government organizations, AIP eligibility increased for all organizational levels from manager/supervisor and above. Annul Incentive Plan eligibility decreased slightly for exempt employees and remained stable for nonexempt employees. The increased AIP eligibility for supervisory and management positions and above at NGOs indicates that these entities are using their limited annual incentive dollars within their salary and compensation budgets to compete with for-profit peers for top managerial and executive talent.
Incentive Pay Trend: Annual Incentive and Long-term Incentive Targets as a Percentage of Salary
For the first time in the Vivient/WorldatWork Private Company & NGO Compensation Survey’s history, participants were asked to provide typical AIP and LTI targets as a percentage of salary for broad position levels. For-profit, private companies that provide Annual Incentive Plans offer CEOs a median target award of 80% of salary. Target AIP awards decrease by approximately half for each broad position band below CEO. NGOs that provide Annual Incentive Plans tend to offer more modest target awards than for-profit counterparts.
Target Annual Incentive Award at Private Companies & NGOs
(Percent of Salary)
|Exempt Salaried||10%||Insufficient data|
Nonexempt Salaried and Hourly
NOTE: Excludes companies that do not offer Annual Incentive Plans
For Long Term Incentive Plans, private companies reported target long-term awards as a percentage of salary for executives. Data specific to private companies is difficult to find in published compensation surveys, which shows the value of this survey to WorldatWork members. The survey findings indicate that private companies offer an annual Long Term Incentive benefit that is approximately equal to the Annual Incentive Plan opportunity. This rule of thumb provides private companies that offer long-term incentives with a starting point for evaluating appropriate LTI levels for executives.
Target Long Term Incentive Awards at For-Profit Private Companies
(Percent of Salary)
|CEO’s Direct Reports||50%|
NOTE: Excludes companies that do not offer Long Term Incentive Compensation
Incentive Pay Trend: Concerns About Annual Incentive Plan Effectiveness
Both private, for-profit companies and nonprofits reported a downward trend in the effectiveness of their Annual Incentive Plans. The risk-reward trade off was the biggest AIP weakness noted at both private companies and nonprofit/government organizations. This indicates that award payouts may not be adequately calibrated with results in terms of employee performance. For example, outstanding performance may result in only a moderate increase in the annual incentive payout. Conversely, below-target performance may result in a disproportionately small decrease from the targeted award level.
The level of discretion also was cited as a common weakness in Annual Incentive Plans, especially at private companies. The survey asked participants to provide information on strengths and weaknesses in the use of discretion. Private companies cited communication of the rationale for discretion, and the perception of fairness and consistency across the organization as the biggest weaknesses in the use of discretion. In contrast, NGOs do not seem to use discretion as much as private-company counterparts and did not report on specific weaknesses in its use. This lack of response may indicate that NGOs may see the need for a greater role for discretion in their AIPs, as it is more difficult to quantify performance at these organizations.
Incentive Pay Trend: More Cash-Based and Less Real Equity for Private-Company Long Term Incentives
With respect to Long Term Incentives, LTI performance awards — long-term cash plans, performance units and performance shares — continue to be the most popular vehicles at private companies. Because private companies do not have equity that is traded and valued on a stock exchange, cash-based plans are simpler and less expensive to design, operate and administer. The use of real equity decreased in 2017 after an uptick in the use of stock options in the 2015 survey. Private companies appear to now favor simpler, cash-based long-term incentives to avoid equity-related complexities such as valuation, liquidity and the dilution of ownership.
Incentive Pay at Family-Owned Private Companies
Nearly one-third of the private-company sample was family-owned, and these firms mirrored the broader private-company sample results although with some key distinctions:
- Higher short term incentive spending at family-owned companies
- Family-owned companies reported higher spending on short term incentives as a percentage of operating profit relative to the broader sample. Family-owned companies spent 10% of operating profit at median in 2017 and project an 8% STI budget for 2018. In contrast, the broader sample of private companies spends a median of 6% of operating profit annually.
- The higher spending on STIs at family-owned companies may be a strategy to attract external talent to help manage the business. Also, family-owned businesses typically provide a pay mix that is heavier on short-term cash compensation, as they tend to be more selective in providing longer term incentives.
- Lower use of long term incentives at family-owned companies
- Family-owned companies are less likely than the broader sample to offer an LTI plan. Only 44% of family-owned companies offer LTI plans, compared to 54% in the broader sample.
- Like the broader sample, family-owned companies favor performance awards, such as cash plans or performance units, over real equity or phantom equity that requires a company valuation.
Compensation Trends at Private Equity-Owned Companies
For the first time in this 2017 compensation survey research, respondents were asked to report whether private-equity firms own a stake in their companies. About a quarter of the respondents reported private equity investments in their companies and had some key distinctions in survey findings:
- Lower Short term incentive spending at private-equity owned companies
- Private equity-owned companies spend slightly less than the broader sample on STIs. These companies spend 5.5% of operating profit at median on STIs, in contrast to 6% for the broader sample.
- Private equity owners have the strategy of aligning executives’ economic interests with their own (i.e., creating a value realization event). As a result, executive compensation is focused more on LTIs than on short-term incentives.
- More long-term incentives and real equity ownership at private-equity companies
- Private-equity owned companies are more likely to provide LTIs than the broader sample. Almost two-thirds of private-equity-owned companies reported having an LTI plan.
- LTIs based on real equity — stock options and restricted stock — are favored by private equity investors, as these vehicles align the incentives of management with the shareholders and provide a retention mechanism. Also, private-equity owned companies tend to grant LTIs deeper into the organization versus the broader survey sample.
Where Private Company and NGO Compensation Preferences Are Trending
Private companies and NGOs continue to favor short-term and cash-based incentives. Future compensation research by Vivient Consulting and WorldatWork will focus on whether the tight labor market and competition for talent continue to drive non-publicly traded entities to spend more on incentives and broaden incentive participation across more employees.
Principal Bonnie Schindler discusses the compensation survey research conducted by Vivient and WorldatWork around incentive pay practices for private, non-profits and government entities.
The transition from a private company to a public company is an exciting time for most organizations. For employees, moving from private to public status provides the first opportunity to potentially gain liquidity from equity-based. For venture capital or private equity investors, it typically represents the first opportunity to realize gains from their investment and risk-taking. However, becoming a public company creates new disclosure requirements and opens up compensation programs to scrutiny from a new group of public shareholders and shareholder advisory firms.
Not all newly public companies are the same. In this white paper, we will speak generally about newly public companies, but also address differences that may apply across categories. The categories we most typically see are the following:
- Recent Start-ups: Companies that have been funded primarily by venture capital backers and are in early stages of development
- Often these companies are in the biotech or internet/technology industry and some, in particular in biotech, may be pre-revenue and likely pre-profit when they go public.
- Companies in this category are usually emerging growth companies (revenue less than $1 billion at IPO) under the JOBS act, subject to less stringent disclosure requirements and exempt from Say on Pay votes for up to five years following IPO
- Private Equity Portfolio Companies: More mature businesses that may have been taken private to improve operating performance
- Typically are profitable businesses and trade based on multiples of earnings or EBITDA
- May or may not be “emerging growth companies” under the JOBS act
- Private equity owners may continue to maintain a majority interest following IPO
- Spin-off Companies: Business units of a publicly traded company that become public through a spin-off event
- Spin-off may occur in one stage, an initial IPO and then a spin-off of remaining shares, or a multi-stage sell-down
- In most cases, the spin-offs are mature companies that are viewed as being able to generate more value on their own through greater strategic focus than as part of the parent company
Establishing Public Company Compensation Processes
As a public company, there is an increased requirement for processes governing the company’s compensation decisions. All public companies (other than those controlled by a 50% or greater shareholder) need to have a Compensation Committee of two or more independent directors. The Compensation Committee needs to have a Charter that lays out the responsibilities of the Committee, including its responsibility for overseeing the pay of the CEO and the other executive officers of the company.
In practice, there is a lot of work to set-up a functioning Compensation Committee. Key steps to get a Committee up and running include the following:
- Identify Members: The Board needs to determine which directors have the capabilities and experience to effectively serve on the Compensation Committee;
- Appoint a Chair: The Board needs to identify a Chair for the Committee who can ensure that the Committee operates effectively and meets its responsibilities under the Charter;
- Draft Charter: Company’s counsel needs to draft a Charter outlining the Committee’s responsibilities in compliance with the listing standards of its respective exchange and addresses the expectations of the Board for the Committee;
- Establish Committee Calendar: Human resources needs to work with the Committee Chair to develop a calendar of activities for the year (including the timing and number of Committee meetings) and cross-reference with the Charter to ensure that all responsibilities are addressed;
- Assess Need for External Advisor: The Committee needs to assess whether or not they need an advisor; if they elect to use an advisor, they need to conduct a selection process and assess the independence of the advisor;
- Develop Committee Meeting Process: Establish protocols for the companies interaction with the Committee and preparation for meetings; best practices include the following:
- Provide Committee Chair with a draft agenda for the meeting at least one month in advance of the meeting;
- Review draft materials with the Committee Chair (and Committee advisor) at least 1-2 weeks in advance of the meeting;
- Make materials available to Committee members one week in advance of the meeting;
- Ensure that at least 2 meetings are provided for major decisions; one meeting to review and second meeting to approve; and
- Follow-up with Committee Chair following Executive Session to confirm decisions made in the meeting.
Many companies adopt some of the above practices in advance of going public and this tends to make the transition easier. We find that new Committees have some room to learn as they go; however, the fundamentals of the process should be in place upon going public.
In most cases, prior to going public, the compensation program likely was comprised of a relatively modest base salary and annual incentive and significant stock option grants. This approach to compensation is very common for emerging growth companies and private equity-backed companies. Spin-off IPOs may vary from this approach, as they often have relied on the more traditional compensation models of their parent companies. Upon going public, the company may need to rethink its approach to compensation. At the very least, there has to be recognition that employees may have opportunities to recognize significant wealth from past equity grants and the company needs to ensure that the compensation program will be effective in retaining top talent following the IPO. In addition, while the company may have had a relatively small shareholder base to address as a private company, once public, there is a larger group of shareholders and the company needs to make sure that the compensation program of the public company is designed with all shareholders in mind.
Pay Philosophy, Peer Group and Target Pay Levels
For a newly public company, one of the most fundamental compensation decisions is to establish a compensation strategy and pay philosophy. Most companies will want to ensure that the compensation program addresses the following objectives:
- Align executives with shareholders’ interests
- Support achievement of the business strategy
- Attract and retain required talent
A company’s compensation strategy and design can work to achieve these objectives in a variety of ways and there are tradeoffs among the objectives. For example, compensating executives with equity can serve to align their interests with shareholders; however, executives may place a higher value on cash compensation. Companies will take a variety of approaches based on the relative priority of the different objectives and their views on which compensation design elements best meet the objectives.
As part of the compensation philosophy, while not required, companies will frequently identify a peer group. The peer group is comprised of publicly traded companies and used for pay and/or performance benchmarking. Since one of the primary purposes of the peer group is to assess the competitiveness of pay, a key factor in identifying peers is whether the companies are potential competitors for executive talent. In addition, for external credibility, the peer group should be comprised of companies that are comparable in size (e.g., ~.5x – 2x) your company’s size in terms of revenue and from comparable industries. Ideally, some of the peers will also be newly public companies, though this is less important for more mature companies that are going public.
Most public companies establish a pay philosophy discussing the positioning of target pay levels. The most common pay philosophy statement is along the lines of “our company targets total pay levels at the median of our peer group with variation around median based on individual circumstances.” There is flexibility to have a pay philosophy that targets pay levels above median, but these pay philosophies often attract criticism from shareholders. Alternatively, the company could target below median base salaries and annual incentives and deliver above median long-term incentives. This approach to pay may be more appealing to shareholders, especially with growth companies, with its emphasis on long-term compensation.
Annual Incentive Program
Pre-IPO companies may or may not have a formal annual incentive plan. For some emerging growth companies, there may be a focus on conserving cash and therefore limited cash available for compensation and as a result, the companies may deemphasize annual incentive compensation. In addition, early stage companies in some industries (e.g., biotech, internet) may not have strong income statement performance (e.g., revenue or profitability) and may tie the incentives they pay to the achievement of strategic objectives (e.g., successful clinical trials, product launches, etc.)
Once companies are public, there are greater expectations from shareholders and shareholder advisory groups that if the company pays an annual incentive, it will be based primarily on the achievement of financial results, with only a small portion based on more qualitative performance criteria. The larger the annual incentive opportunity is as a percentage of total compensation, the greater the expectation that the incentive will be based on financial performance. Shareholders will generally not be happy if a CEO can earn a bonus equal to 50-100 percent of base salary, unless the company has delivered strong financial results. Our analysis of 30 recent IPO’d companies found that 70% have adopted formal bonus plans with quantitative metrics following the IPO.
Note: For both annual and long-term incentives based on the tax code rules (IRC Sec. 162(m), the “performance based compensation” tax exemption for select executive officers), if a company gets an annual and long-term incentive plan approved prior to the IPO and discloses such plan documents in any S-1 filing, the company is exempt from IRC Section 162(m) rules for approximately three years.
Pre-IPO companies typically use stock options as the main long-term incentive vehicle as they tend to closely align the interest of the venture capital or private equity investors. Rather than making annual grants to executives, pre-IPO companies will generally make large up-front grants to lock in on an early (presumably lower) valuation for purposes of determining the exercise price. In many cases, the equity grants are established as a percentage of the company’s common shares outstanding rather than a targeted dollar value. If an executive has served with the company for a number of years prior to the IPO, then it is possible that all or a majority of the stock options that the executive holds are vested by the IPO. This may be a concern for shareholders for potential shareholders and the company needs to demonstrate it has a game plan for locking in the executives post-IPO.
An important first step for the company as it approaches the IPO is to assess whether its existing reserve of shares set aside for grants to employees and directors will be adequate to cover future grants. It is generally preferable to obtain approval of additional shares for future grant prior to the IPO, as the equity plan needs to be approved by shareholders and it is simpler to gain approval from the VC or private equity shareholders than the new public shareholders. We recommend that the equity reserve and overhang (i.e., share reserve plus outstanding awards relative to total shares outstanding) be benchmarked relative to peer practices to ensure that the reserve will not be viewed as excessive by external shareholders, as eventually the company will have to go to public shareholders for purposes of 162(m) compliance and/or additional shares.
In situations where executives’ equity is largely vested by the time of the IPO, the company may use the IPO as an opportunity to “re-up” equity grants to senior executives to “lock them in” for the next few years following the IPO. However, in order to size any grants made at IPO, the company will likely want to rely on competitive market practices for annual grant values among the peer group. In addition, the company may want to consider shifting to an annual grant frequency, as this is the most common equity granting approach among publicly traded companies.
Public companies have moved toward an annual grant frequency for several reasons, including the following:
- Limits the impact of stock price volatility on option values (e.g., lowers the risk that all stock options end up underwater)
- Facilitates compliance with target compensation positioning (i.e., easy to adjust annual compensation to market competitive levels)
- Results in consistent disclosed compensation values over time and tends to be better received by shareholder advisory groups
Over time, larger newly public companies (particularly those with revenue over $1 billion) may be expected to incorporate a long-term incentive vehicle with explicit performance measures into their long-term incentive designs. Institutional Shareholder Services (ISS) expects that 50% of the long-term incentive opportunity be delivered in a performance-based vehicle and they do not view time-vesting stock options as highly performance-based. In practice, newly public companies may have legitimate reasons to delay adopting a performance-based long-term incentive (e.g., limited stock trading history, challenges in forecasting long-term financial performance).
If you decide to adopt a performance-based long-term incentive, the most common design is a performance-share plan. These plans provide for a target opportunity denominated as a number of shares. Performance is typically assessed over a three-year period, with the number of shares earned ranging from a threshold amount (typically 25%-50% of target) to a maximum amount (150%-200% of target) based on an assessment of performance relative to pre-established performance criteria. Plan designs are mixed among measuring performance relative to financial criteria (e.g., EPS, revenue growth), stock price performance (e.g., total shareholder return relative to peers or the broader market), or a combination of financial and stock price performance. Performance share plans are now the single most prevalent form of long-term incentive for executives at large public companies. In our analysis of the post-IPO practices of 30 recent IPOs, we found that the LTI mix for post-IPO grants shifted away from stock options with weight shifted towards time-based restricted stock and performance-based LTI.
Other Compensation Design Features
Severance provisions should be established as part of a formal severance program (change in control or not change in control) or through severance agreements, or less frequently, as part of an employment agreement. These programs should be implemented after careful consideration of potential costs and benefits to the participants, competitive practices for comparable organizations and if the company desires to maintain a formal program. Gross-ups for any 280(g) CIC tax liabilities are no longer common and should not be included. If not already in place, non-compete and non-solicitation provisions should be put in place for the company, as standalone policies or as part of LTI award agreements.
Lastly, other good governance features such as stock ownership guidelines, clawbacks (recoupment policy), and anti-hedging and pledging are considered good practice and are also generally in the best interests shareholders (see data on post-IPO adoption below). How quickly the company adopts these practices depends on how far the company wants to go to be viewed as shareholder friendly.
The IPO is an exciting time for executives and private company shareholders. From a compensation perspective, it is also an exciting time as the company transitions from a model built around an eventual liquidity event to a compensation program that is expected to be maintained over time as a public company. As a public company, the compensation program will be under additional scrutiny and the Compensation Committee will be accountable to a much larger shareholder base. By developing strong compensation governance practices and understanding competitive practices for pay program, Compensation Committees can move forward with confidence that their approach to compensation will meet the strategic needs of the company and stand-up to external scrutiny.
In November 2015, Vivient Consulting and WorldatWork invited a sample of WorldatWork’s non-publicly traded members to participate in their second “Incentive Pay Practices: Privately Held Companies” compensation survey. Approximately 200 private, for-profit companies responded to the survey, representing manufacturing, consulting, professional, scientific and technical services, finance and insurance, media, software and retail trades. This compensation survey updates the original survey completed by Vivient and WorldatWork in 2013.
The new 2016 compensation survey research shows that short-term cash incentives and bonus programs continue to dominate the incentive-pay landscape as a vast majority of organizations use and rely on incentive-based pay practices to recruit, motivate and reward employees.
Vivient’s Bonnie Schindler reports: “While cash continues to dominate long-term incentives at private companies, we are seeing an uptick in the use of real equity in the form of stock options.”
Key Findings from the 2016 Compensation Survey for Private, For-Profit Organizations
- Between 2013 and 2015, the prevalence of short- and long-term incentive programs remained steady at private companies. Short-term incentives decreased slightly to 94% from 97%, while long-term incentives also decreased slightly to 53% from 56%.
- In 2015, almost 75% of privately held companies with a short-term incentive plan offered at least three programs.
- Annual Incentive Plans (AIPs), the most prevalent short-term incentive plan at private companies, are offered to employees at the exempt, salaried level and above at most organizations.
- At the 75th percentile, the majority of private companies increased their short-term incentive budgets to 12% of operating profit in 2015. They forecast an increase to 14% of operating profit for 2016.
Increasingly we find that private companies are adopting public company governance practices such as using formal Compensation Committees consisting of internal or external Board members.
Unlike publicly traded companies where a Board Compensation Committee is a requirement, private companies establish formal Compensation Committees for reasons such as the desire for:
- A more defined and objective process. This is welcome in delicate situations such as where there are conflicting shareholder interests that need to be aligned, or there is a perception that management has undue influence on setting their own pay levels.
- Additional Board-level attention and/or external compensation expertise. This may be necessary when companies establish new key executive compensation plans or need to have one point of contact to negotiate employment contracts with key executives.
A Compensation Committee is able to take a “deep-dive” into specific compensation issues in a manner that would be more difficult and/or impractical with an entire Board.
Below we outline the key aspects of well-run Compensation Committees:
Purpose: Typically, the Compensation Committee’s purpose is to carry out the responsibilities delegated by the Board relating to the review and determination of the performance and compensation of the Chief Executive Officer and the executive team. Each company’s Board needs to decide whether the Compensation Committee itself has the authority to approve compensation decisions, or makes its recommendation for Board approval.
Membership: Compensation Committees are usually comprised of a small select number of members, which can be a sub-set of the Board of Directors and can be supplemented by independent outside advisors, if desired. As an example, one of our private company clients has a Compensation Committee which consists of internal Board members supplemented by an external compensation consultant and a long-time outside advisor. Ideally, the Compensation Committee should include at least one member with compensation experience and/or a member with related, although not necessarily direct, subject matter expertise.
Duties: The duties of the Compensation Committee are to review the compensation and performance of the Chief Executive and, to some extent (to be defined by each company), the members of the executive team. The Compensation Committee also typically reviews compensation levels and plans (annual incentive, long-term incentive, supplemental benefit and perquisites) and major agreements (employment, severance, change of control, etc.). It may also review non-executive officer compensation and broad-based plans on a periodic basis, as and when appropriate. Increasingly, the role of CEO succession planning is also being assigned to the Compensation Committee.
Operations: We recommend that companies establish a Compensation Committee Charter and Calendar. The Charter specifies the Compensation Committee’s role, duties, responsibilities, and membership, as well as its operations (such as the number of meetings per year, review of its own performance, etc.). The Calendar sets the schedule of topics to be addressed at each of its meetings throughout the year. For instance, at the Q1 meeting, the Committee will review and approve salary increases for the upcoming year, bonuses for the prior year and equity grants. Topics would also be outlined for the remaining fiscal quarters. By having both of these documents, the purview and process of the Compensation Committee are clear to all constituents (Board members, shareholders, and management).
While it takes some time for private companies to recognize the benefits of establishing a Compensation Committee, we find that Boards come to appreciate having a dedicated and knowledgeable resource that can regularly address compensation issues on its behalf.