How to structure executive compensation in a competitive market
Attract and motivate key executives while driving company performance
INSIGHT ARTICLE |
Designing the right executive compensation plan may be a critical tool in driving your company’s performance. Compensation plays a significant role in attracting, motivating and retaining highly qualified executive officers and leadership teams necessary to achieve a company’s goals. Each component of compensation should serve the objectives of your business.
A well-balanced compensation package generally includes: base salary, short-term and long-term incentive pay, and benefits in various flavors (e.g., retirement, snacks, gym memberships, etc.). The structure and elements of an executive compensation plan may vary among companies due to size, industry, objectives, competitive challenges and company culture, but the process of choosing the right compensation strategy for executives looks very similar.
The first step when designing executive compensation plans is to identify primary objectives. For many employers these include:
- Attract and hire executives
- Reward and incentivize executives
- Retain executives
- Minimize after-tax cost to the employer
Establishing clear objectives allows your decision-makers to formulate a compensation arrangement which aligns with company goals. Depending upon your organization’s life cycle and the level and tenure of various executives, your objectives may be different.
For example, a new organization needs to focus on attracting new executives. A newly promoted executive may be better incentivized with metrics more aligned with the responsibilities of that new position than the same metrics from the previous position. However, no matter the event causing the need for executive compensation planning, the process starts with understanding the goals.
Construct a well-balanced compensation package
The next step designing executive compensation is determining the most attractive and effective compensation components. Compensation packages given to the executives of corporations often consist of common components:
- Base salary
- Short-term incentive (bonus)
- Long-term incentive
- Other benefits and perquisites
To determine which elements of compensation are given, you should consider competitive pay analysis, industry practices, compensation philosophy and company culture.
In many cases, a well-balanced compensation program, tailors pay packages specifically to a role or individual. Every element of the your compensation design may not be applicable to every executive, and likely will not be in the same proportions for each executive. The objective is to craft a distinctive and personal compensation package that tells the executive you value his or her relationship with the company and motivates the executive to meet set targets.
A typical compensation package designed to maximize the effectiveness of each executive role includes a mix of the various compensation components. These may be modified annually, periodically or on a discretionary basis according to the company needs.
In most cases , increasing executive base salary is one of the easiest and least cumbersome elements of compensation planning in any given year. The key factors in determining appropriate base salary for executives are competitiveness and reasonableness. MMarket data is readily accessible for companies to examine and develop comparable pay, including monitoring the reasonableness executive base salary within your competitive group. Once determined, base salary is generally adjusted on an annual basis.
Short-term incentives, typically structured as annual bonuses, are intended to reward executives for achieving your short-term business objectives and are usually set by annual performance goals. The nature of these goals varies depending on the type and maturity of your business, company strategy, market conditions and other factors. Annual bonus metrics may be financial or non-financial. Financial metrics include revenue growth, return on capital, or net profit, while non-financial metrics may include operational goals, such as safety, quality assurance hurdles or innovation. Bonuses often include an element of individual performance as well. Bonus plans are typically constructed to provide threshold (minimum), target and maximum levels of bonus payouts based upon performance.
Similar to base salary, providing a short-term incentive or annual bonus is an easy way to offer more cash to an executive when considering compensation planning opportunities. When setting the performance goals and appropriate levels of bonuses for the executive team, considerhow they may be different for this team than for other employees throughout the organization. For example, since the executive team should be driving company vision and strategy, the formula for reaching the maximum payout might be more closely tied to company performance than to individual performance. Strong company performance is usually a result of good leadership.
Although base salary and bonuses are often different for the executive team than the majority of employees, long-term incentives are what really sets executive compensation planning apart. Companies typically seek to provide longer term compensation incentives to executives (usually ranging up to three to five years) because turnover at these levels is more costly, and this team is often driving strategies that take multiple years to implement. A long-term incentive plan is an award granted contingent upon achievement of objectives set over a multi-year period. Like short-term incentives, the performance conditions placed on long-term incentive awards are typically based on either financial or operational performance. Grants to the executives may be made in any year, overlapping a previous grant or following the end of a previous multi-year grant.
Long-term incentive compensation comes in a variety of flavors and is very flexible. As part of a balanced compensation strategy, you may choose to include a cash-based or equity-based long-term incentive. To determine which long-term incentive plans are best for the company, you will want to consider several factors such as:
- Is it desirable for executives to be owners? How does this affect current owners?
- What does the executive consider a valuable incentive that would motivate the achievement of the company’s goals?
- Is equity compensation needed to attract talent until the business generates enough cash flow?
- Are the existing owners of the company seeking exit plans from the business?
- What are the tax consequences to the employer and the executive?
- What group of leadership does the company need to incentivize differently?
Thinking through these factors in addition to the goals established at the beginning of the planning process will help you whittle down which type of program might best suit the needs of your business.
Equity programs are often attractive, but aren’t always viable. Equity compensation can be a great tool for incentivizing executives because a portion of the executive’s overall pay is aligned with the value of the company. If considering equity compensation, your existing owners must be willing to share ownership. Carefully consider whether any changes to governance or decision-making creates an undesirable situation if ownership is opened to a wider group of individuals.
- Common forms of equity-based incentives include:
- Company stock
- Stock options (incentive and non-qualified)
- Restricted stock
- Stock bonus and employee stock purchase plans
- Phantom stock
- Stock appreciation rights
- Profits interest and capital interests (in partnerships)
Setting performance-based criteria
Whether cash-based or equity-based plans are chosen, most long-term incentive compensation is based on strategic drivers that will encourage or discourage certain behaviors in the company. In other words, long-term incentives provide a carrot dangling into the future that promises additional compensation if certain conditions are met. Similar to annual bonuses, the conditions may be financial such as margin, earnings before taxes, depreciation and amortization or profit. Long-term incentive compensation typically has higher goals than annual bonuses.
Non-financial measures, such as customer or employee satisfaction surveys, the completion of a project or quality control measures, can be another criterion. Tailoring the metrics to important measures for your company and areas that can be affected by the individual executive will creative incentive to improve performance in those areas.
Long-term incentive programs allow companies to set up time-based vesting schedules as well. Time-based vesting requires the executive to provide future services to receive the benefit (e.g., he or she must be employed three years from the date of grant to receive the payment). These time-based restrictions can stand alone or be in addition to performance-based conditions. In this way,they may act to encourage both retention and performance.
Eecutive compensation is often attached to non-qualified plans, so there is great flexibility in choosing specific plan terms and in tailoring those terms to individuals. Your company can choose the conditions for earning payments, as well as establish flexible payment timing (within certain parameters). This allows you to plan for the cash needs differently than you do with annual compensation payments.
Other benefits and perquisites
All of the above components of compensation focus on cash or equity that will result in future cash payouts. Don’t forget that a well-balanced approach often includes smaller, more immediate recognition as well. Executive perquisites, or "perks”, constitute a form of indirect pay or non-cash privileges that recognize the value of the executive and demands on his or her time.
Perks are generally non-cash fringe benefits that provide immediate financial rewards, in addition to wages or other incentives. When considering compensation packages, consider the benefits and perquisites an executive might find attractive, as not all executives are solely motivated by pay. You may consider doing market research or involving an executive in crafting the full compensation package to offer benefits that would be important to their specific needs.
Bringing it all together
Ultimately, how you structure executive compensation depends on well-established goals, an appropriate mix of components and reasonable metrics that are closely aligned with your overall goals and objectives.
Expanding the executive compensation plan beyond base salary and short-term incentives comprises a number of cost and tax effects, as well as accounting, regulatory and documentation considerations. There are many details to each and it is often best to seek the advice of knowledgeable professionals.
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