The Design of Compensation Packages for C Level Execs and Senior Management

Big Red Car here.  The Boss and I had a nice long ride today.  It was a bit cloudy but warm.  I love a good ride through a warm afternoon.

He had coffee with a pal of his and they got to talking about the design of compensation packages for “C” level executives and senior management.

C Level Execs and Senior Management

When we are talking about C level executives, we are talking about Chief Executive Officers and Chief Operating Officers and Chief Financial Officers and CIOs and CTOs and CMOs — yada yada yada.  Sheesh.  There are a lot of C level executives.

Also senior management as that might be defined in your company.  All depends on the size of your company.

Pay attention even if you are a 4-man entrepreneurial startup because one day you may become a huge behemoth of a company and you will wish you had payed attention.

These are the folks who are “mission critical” to the company or who might be a huge blow to the company if lost or who might be the target of recruitment by competitors.

Designer of the compensation package

Who is the designer of the compensation package?  It will depend on the experience of your CEO.

If he is a salty, serial entrepreneur, he will likely bring it to the Board’s attention early on and he will deal with the Chairman of the Board’s Compensation Committee.

If the CEO is not as experienced, then the Board Compensation Committee will initiate this activity typically by tasking outside corporate counsel — employment counsel — to draft a sample contact for the CEO.  The Board Compensation Committee will review the contract and move forward from there.

The Board’s Compensation Committee will be composed of folks who will recommend the overall scheme of C level and senior management compensation for approval to the entire Board.

The entire Board will approve the design and specifics of the overall scheme of compensation and will authorize the Chairman of the Board to execute the Employment Agreements (as drafted above), if any, which will memorialize the arrangement.

1.  Again, Board Compensation Committee recommends the overall plan or scheme of compensation to the entire Board.

2.  The Board discusses and approves the final plan.

3.  The Chairman of the Board signs any contracts with the CEO, in particular.

The Components of a Compensation Package

A well constructed and balanced compensation package should include the following elements:

1.  Salary

2.  Benefits

3.  Short term incentive compensation

4.  Long term incentive compensation

5.  Something special, including deferred compensation

By hand fashioning the compensation package this way, it is possible to finely dissect the overall compensation package so that it is tailored to the individual.  Not every element of this design may be properly applicable to every employee and it obviously will be in different proportions for different employees.  It may be so finely designed that the benefits will reflect something that is unique to the individual.

The objective you are seeking with this bespoke approach is to create a unique and personal link with the CEO in such a way that they value the entire relationship more dearly because of its thoughtful constituent elements.  Handcrafted and individually targeted but following a clear design philosophy.

For the rest of this discussion, I will pretend we are dealing only with the CEO’s compensation package.

Salary

You have to obtain four pieces of data:

1.  What are the expectations of the CEO;

2.  What is the market value of that specific CEO’s talent;

3.  What can the company afford; and,

4.  What is the Board’s philosophy on the issue of compensation.

There are those who will say that one or more of these elements are not necessary or are otherwise superfluous.  Know that I am not saying that any one element is controlling or solely determinant of the final decision, they are to be weighed and measured as to their importance as part of the process and to be finalized as all other elements are finalized but sometimes one or more will provide some type of guidepost that will make things fall into place.

Most CEOs when confronted with the design that this approach suggests, will quickly settle on a number for compensation which will be very close to the final result.  The Board should give itself a chance to get lucky.  Don’t pick a fight where one does not exist.

As to philosophy, The Boss has almost always subscribed to the notion of paying 125% of the perceived right number.

A laudable philosophy but not necessarily one that can be universally applied in bad times.  Averages are built of the best of the worst and the worst of the best, so seemingly overpaying just a bit is not a huge deviation.  There is a chalk stripe here, stay within the chalkstrike.

The salary component should be adjusted annually and have an automatic annual cost of living and tax impact adjustment.  It should be adjusted annually or alternatively the short term incentive compensation can be used to make annual adjustments.

Benefits

Benefits — health/dental/vision/life insurance, retirement programs (IRA, 401K), ESOP (employee stock ownership plan), ESPP, Cafeteria 125, Health Savings Accounts are an area we shall gloss over a bit other than to say that they also can be tailored to the individual.

An area of special attention is holidays, vacation, sick days, bereavement days, family leave days and compensation time.

The Boss likes to have 9-10 paid holidays and then add two days that he knows he will add but he holds for announcement until just a week or two before the date.  As an example, the day after Thanksgiving.  Or the day before or after Christmas and New Years when they will otherwise make a 4-day holiday when tacked onto a weekend.

Extra vacation for a CEO is usually something that is a token of respect and consideration but really is meaningless.  A CEO is always working even when on vacation.  A CEO should receive 4-6 weeks of vacation and ample consideration to “work remotely” at a lakehouse or ski house or beach.  Do not measure with a micrometer.

A CEO who has children should always receive part of his vacation as the local Spring Break.  This consideration will be perceived as targeted and special.

The other benefits we will discuss in a separate post.

Short term incentive compensation

Short term incentive compensation can take the form of cash or stock options (we use the term options interchangeably with any equity based compensation such as restricted stock units or other forms of equity based value) for the attainment of specific objectives which can be accomplished during the pendency of the calendar year.  These objectives should be SMART — specific, measurable, attainable, reasonable and constrained by time.  You either hit them or you do not.

Of course, they should be in writing.

This is a bonus arrangement and Boards are alerted to the ability for this bonus to be a particularly important message especially when it signals a high level of satisfaction.

Long term incentive compensation

Long term incentive compensation should be the veritable “golden handcuffs” which ensure longevity and the creation of wealth.  This will almost certainly take the form of stock options subject to vesting requirements or performance objectives.  They should be generous and the vesting period should truly accomplish the purpose of ensuring that the CEO is still employed by the company at the end of the vesting period.

The sheer magnitude of the compensation should keep the CEO from getting restless.  Anything else fails to accomplish the company’s continuity objective.  You are buying longevity.  Pay up, buy it and don’t take half measures.  Over a 5-year time period it will be peanuts.

Something special

This is the one that Boards wrestle with and it can be the most important element because it is entirely personal.  Sweat the details.

1.  Have a CEO who flies a plane, then pay for his recurrent training and his expenses for company travel.

2.  Have a CEO who has three kids, then put aside some shares for the kids’ college education that are forfeitable if the CEO leaves — golden handcuffs again.

3.  Does the CEO want some deferred compensation — this is a very difficult thing to do correctly with current tax laws but it can be done — make it so.

4.  Three month sabbatical every 5 years.

Use your imagination to create a bespoke approach that will show the CEO you understand his special situation and that your thoughtfulness is targeted on him and him alone.

This is an area to be creative.

Grow into the design

In looking at compensation in general remember that:

1.  it will occur over a fairly long period of time and you must make allowance for the impact of time, changing tax policies and inflation in the design itself; and,

2.  it will also mirror the structure of compensation design for employees lower in the hierarchy — the CFO’s package will be a mirror image of the CEO’s but with slightly smaller numbers.

Know that everyone will eventually understand this linkage.

In designing the overall company program, make a table and spreadsheet that shows each element of each position — down the organization — for easy and quick comparison and judgment.

Contractual v at will employment

The CEO’s compensation will be committed to writing in some form or fashion which leads to the issue as to whether the CEO has an Employment Agreement making him a contractual employee or does not have a contract making him an “at will” employee (dependent upon state law).

The Boss always comes down on the side of having a contract to spell out several very important elements in the relationship other than compensation.  The Big Red Car will provide some insights on an Employment Agreement in another blog post. For now, know that the design of the compensation plan will take root in the Employment Agreement and be spelled out in great detail.

A contract can provide protections for the company that are very meaningful.

Negotiation

Everything in life is negotiable and you do not get what you deserve, you get what you negotiate.

The entire compensation package is negotiable but when built in such precise subdivisions as outlined here the negotiations are more focused and pointed.  Much of the potential negotiation may be satisfied by the thoughtfulness of the design itself.  When laid out in this manner, the negotiation can be taken in bite sized pieces and the goodwill from one area will spill over into other areas.

A great compensation package is not just a big salary, it is also a thoughtful expression of the CEO’s expectations, a response to the necessity and wisdom of harnessing incentive as a component of motivation and objective attainment and the ability to create a long term stable relationship.

When the negotiation is over, you should have a CEO who is happy about his prospects and is now able to focus all of his energy on leading the company.

But, hey, what the Hell do I know anyway?  I’m just a Big Red Car.

Stay sharp, stay safe.  It’s a dangerous world out there.

  • http://www.facebook.com/drew.hardin.3 Drew Hardin

    Does the BRC have an opinion on how this has been portrayed in the media? For example: the thriving capitalists at the AFL-CIO say that in 1980 average CEO compensation was 42 times the average worker, now it is 380 times. Of course the media picks that ball up and runs with it, and it has remained in the national debate off and on for a few years, and garnering comments from our current president, another thriving capitalist, about it being “excessive” and thus appointing a compensation czar.

    • http://www.themusingsofthebigredcar.com/ JLM

      .
      Problem with these comparisons is the classic error of composition.

      If a CEO is able to deliver value to the shareholders — think Apple stock before it took a nosedive — in obscene mountains and gobs, who cares how his compensation is quantified?

      Deliver $200B of value to the shareholders — the actual owners of the company — and why is the compensation of the average worker relevant? Why?

      On the other hand, why do the bosses at the AFL-CIO make so damn much money when the rank file does not? Tee that question up and see if one can get a useful or reasonable answer.

      Capitalism is a flawed system but it is superior to all others. It has delivered to this country the highest standard of living in the entire world.

      The President, on the other hand, has overseen the weakest economy in over a century. He needs to focus on job creation and let capitalism work its magic.

      BRC
      .

      • http://www.facebook.com/drew.hardin.3 Drew Hardin

        I guess my tongue in cheek question was meant to poke fun at the slow dissolution of free market principles in our country, and the “controversy” of executive compensation is the hallmark of that.