From our experience working with companies who transition ownership of a business from a structure in which shares are held by individual taxable shareholders to an Employee Stock Ownership Plan (“ESOP”), where shares are owned by a tax qualified ESOP trust, we have identified several considerations for structuring an effective executive compensation program.
Importance of Benchmarking
Prior to establishing an ESOP, shareholder-run companies typically pay themselves and their executives with several considerations in mind. For instance, the company may be interested in minimizing taxable income at the company level, maximizing returns to shareholders that are not subject to payroll taxes plus a number of other factors that do not necessarily consider the competitive market. The company’s compensation philosophy simply needs to make sense to the shareholders.
However, when an ESOP is formed, the company’s governance structure will change. An ESOP trustee, who has a fiduciary duty to act in the best interests of the ESOP participants, will be added to the mix. In addition, independent board members may join and form a compensation committee. Collectively, these new parties are tasked with establishing a compensation philosophy that is both reasonable to the ESOP participants and motivating to the members of the management team.
When ESOP companies benchmark selected executive positions, they are often doing so to understand the competitiveness for talented members of the management team. The newly formed ESOP company will want a stable and motivated management team to lead the company. When turnover occurs, ESOP companies may look to recruit talent from companies that provide stock options or other forms of equity-based incentives.
To understand the market for competitive executive compensation practices, ESOP companies and their compensation committees use a variety of benchmarking tools. Factors to consider in evaluating the market for compensation include the company’s size, industry, geographic location, and primary duties and responsibilities of the executive.
Industry salary surveys can be a valuable resource, as can surveys of other ESOP-owned companies. Participating in a survey may also enable the ESOP company to receive survey results at a reduced price than what is available to other survey participants.
Professional recruiters are another source of competitive market data. Additionally, there are salary databases and software tools that allow compensation committees to benchmark selected positions. If the committee decides to engage a compensation consultant to assist in a benchmarking analysis, independence is important, along with an understanding of the tools and resources the compensation consultant intends to use.
Compensation Components
Total compensation is usually calculated by summing the executive team’s base pay, short-term incentives such as cash bonuses and stock-based compensation. Deferred compensation, such as qualified retirement plans and the employer’s contribution towards medical benefits, are excluded from the total pay calculation when assessing cash compensation.
Often, the cash compensation paid to the executive team is considered prior to considering mid-term and long-term incentives. For example, as discussed more fully in the next section, if an analysis establishes that the base pay and annual cash incentives paid to the executive team are below the market median as determined by independent sources of market compensation, the analysis may indicate there is room to expand the incentive compensation program.
The ratio of base salaries to total compensation is also considered by compensation committees. In general, the more influence and responsibility an executive has to affect the company’s performance, the higher percentage of incentive or “at risk” compensation that compensation committees tend to prefer.
Role of Incentives
ESOP companies often highlight the ability for employees to be rewarded for their performance through increasing the company’s value and, thus, their retirement benefit. While ESOPs can provide a significant benefit, since most employees are years away from retirement, they tend to view the ESOP as a long-term benefit. Conversely, short-term incentives, such as cash bonuses paid annually or more frequently, can be effective in recruiting and motivating employees, provided the bonus criteria is achievable and understood.
To enhance the retention aspect of an executive compensation program, many ESOP companies utilize mid-term incentives such as stock appreciation rights (“SARs”). SARs are generally designed to compensate participants every three to five years based on the increase in the appraised value of the company’s shares as compared to the value on the date of grant (also known as the “strike price”). Because it is participants’ only benefit from the appreciation in value from the time of grant, SARs differ from full value awards such as phantom stock. For example, suppose an employee is granted a SAR when the strike price is $150. Subsequently, that value grows to $170 at the time of vesting. The employee’s SAR is worth $20 in this example, which represents the appreciation in value from the time of grant until vesting. However, had the employee received phantom stock instead of a SAR, the value would be $170 per phantom share, the full value of a share of company stock.
When carefully designed and allocated among a management team, synthetic equity plans like SARs can align the interest of ESOP participants and management and provide an incentive for retention and performance.
Design Considerations
Determining which employees will participate in an incentive program is a key step in the design process. Generally, those employees who have the most ability to affect the stock price through their performance are the best candidates to receive equity-based incentives such as SARs. For key employees with less ability to impact the overall performance of the company, such as a single store manager of a large retail organization, an incentive compensation program that is not directly tied to employer stock may be considered.
Understanding the timeframe for payouts is important. Some plans are designed to provide periodic payouts to participants over their working careers. While not very tax efficient, these periodic payouts can be effective from a retention standpoint, particularly when participants are years away from retirement when they will receive their ESOP benefits.
Summary
When companies transition ownership from individual taxable shareholders to an ESOP, the governance structure concerning management compensation often changes due to the introduction of the ESOP trustee. In addition, the boards of many new ESOP companies also form a compensation committee, which is often a new concept for the company.
Carefully considering how the compensation program works effectively to attract, motivate and retain management employees is important to all stakeholders. Undertaking a periodic review of compensation levels through benchmarking, determining the right mix of compensation components and considering the role of incentives are important considerations for a high functioning ESOP compensation committee.
Dave Horvath is a Managing Director at Prairie Capital Advisors, Inc. He can be contacted at 630.657.8157 or by email, dhorvath@prairiecap.com.
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