How to Think Like an Investor When Evaluating Executive Compensation Plans
October 14, 2021
|
Business Strategy
- Keywords:
- corporate advisory
October 14, 2021
|
Business Strategy
Our extensive work with private, family owned companies often leads to conversations concerning how to bring in outside management to propel the business to the next level. Executive compensation plans are often a logical starting point of these conversations.
Think like an investor
Tapping an outsider for an executive position can be a difficult decision. Even more so for family owned businesses since it requires you to give up a certain level of control. You’ve invested your time and you’ve built the business into what it is today. At first blush, establishing an executive compensation plan that offers an economic interest worth a 15% stake to an executive team can appear unsettling. However, if that 15% upside interest translates to a significant increase in value over five years, then your residual equity value—after paying out the executive team—has the potential to be worth far more than your equity value would be without the value the new executive team delivered.
When you think like an investor, you understand that you’re not losing money. You’re investing money, and you expect a return on that investment. As an example, what if “investing” $4.5 million in a new equity-like compensation package could result in $20.0 million of additional equity upside? Working with a trusted adviser can help you assess how much growth is possible with, and without, investing in the right executive leadership. Armed with that knowledge, the business owner wearing the business investor hat can work with those advisers to create the right kind of compensation plans to deliver the return on investment that’s right for them and their company.
Focus on compensation
Businesses can’t attract, let alone retain, the right kind of new management without defining a clear philosophy around executive compensation. Defining your approach requires an understanding of the competitive marketplace for talent and the different types of compensation that can be deployed combined with what makes sense for your culture.
The best compensation packages properly align executive incentives with measurable metrics to improve the value of a business. Attracting the right kind of talent to enhance a business’ value requires more than offering a competitive salary and bonus; the best talent expect a share in the value they help to deliver.
As you approach this topic, you should consider the background and experience of the talent you are hoping to hire. The outstanding CEO or CFO that you may target likely has considerable experience delivering results. He or she is probably near the peak of their career. They have more career options to evaluate, and their time horizon for wealth accumulation may be shorter than that of the internal personnel who helped build the business up to this point. Bottom line: they’ve worked hard to build up enough experience and accomplishments to be able to deliver value to your business and they expect to be properly rewarded, especially if they are delivering the type of transformational results you may expect.
You want leaders with the skill set of a tested executive, coupled with the mentality of a seasoned investor. That is, someone who’s motivated by having an “equity-like” stake in the company’s performance.
Establishing the appropriate compensation plan
Remember, you’re looking for executives with proven skills who can achieve measurable results. With that in mind, you generally have two market-based equity compensation plans to evaluate.
Stock appreciation rights (SARs):
This type of plan only provides compensation to the executive when the company’s stock price rises. When the company wins, the executive wins. Because of that, SARs provide an incentive for the executive to grow the company’s equity value. SARs are a longer-term play to help drive value creation for the business.
Phantom stock units (PSUs):
PSUs provide the benefits of stock ownership without transferring any shares. The value is based on the share price at vesting, even if the price has fallen since the shares were granted. The incentive for the executive is that the “shares” have value even if the company doesn't accrete value. The executive has a real economic interest in the business and a hiccup in performance doesn’t destroy his or her incentive. There is upside when the company accretes equity value, but the value to the executive is not solely dependent on value creation at the enterprise level.
Both SARs and PSUs are typically structured as equity-like instruments. Therefore, the equity holder doesn’t have any shareholder rights like a common stock owner, such as voting rights or board seats. The instruments are paid out at a set time, retirement or upon the sale of the company.
Determining the right kind of compensation plans means understanding your company's position and marketplace dynamics. For example, a company in an inherently low-growth industry may prefer a heavier weighting toward PSUs, because those provide executives with an incentive even without outsized growth. Conversely, a company that has been stable but still has the potential for significant upside may prefer more SARs to incentivize an executive to deliver that untapped potential. More often than not, a mix of both is the best solution to align incentives and reward behaviors that are accretive to value.
You also need to be open to creative and innovative approaches that address the tax consequences of certain plans and the unique situation of the individual executives.
Deciding who qualifies
Another key consideration is how many people you want to incentivize. That begins with asking:
- Which roles have the greatest potential to drive future value?
- Where are the biggest gaps in your internal roster to fill those roles?
You may determine that you only need a CEO, or that a full C-suite is in order. You’ll also have to determine what value you’re willing to give up to reach your target growth. In other words, how much equity value are you willing to offer? How much of the growth that they deliver are you willing to share? In general, a plan providing up to 10% of the total equity value and up to 15% of the upside growth is typical, although each case is different. Another way to think about sizing the awards is a multiple on cash compensation. Individual awards are often targeted to deliver equity value worth 1.0x to 1.5x an executive’s anticipated five-year cumulative cash compensation. Given these plans are equity-like, the result is a future cash payout versus a transfer of equity ownership
From there, it’s a matter of determining the executive’s ability to drive your growth projections. For example, a COO largely tasked with leading internal operations may not get as much of a share of the upside as the CEO, who is tasked with driving the strategy and creating new opportunities for your business.
It’s also important to pick the appropriate vesting period. We typically see a five-year period, vesting 20% each year. So if after three years the company isn’t meeting its targets, you’re not fully paying out on an executive compensation plan that hasn’t achieved its financial goals.
Establishing an executive compensation plan also means relinquishing some control. Regardless of the compensation package you offer, an executive at the level you’re looking for won’t have the incentive to remain with the company for long if they don’t feel empowered to make key decisions. No compensation plan will keep an executive in place who isn’t empowered to enact the change necessary to realize the value of that plan. You’re not just making a financial investment; you’re making an investment in leadership and the results you hope these leaders will achieve.
An objective look
Having an investor mindset also involves being able to take a step back and examine your business as an objective observer would. What kind of return would a private equity firm or a public company buying your type of company expect? Shouldn’t you be seeking that same kind of return?
Owners at this juncture must understand the business they started isn’t the same as the business they are running today. You might have started the business out of your garage, but now you’re bringing in $100 million in revenue. The person who managed your finances as a $5 million company probably isn’t the same person managing your finances as a $100 million company (or at least it shouldn’t be). Avoid the “we’ve always done it this way” mentality.
Instead, use executive compensation as another way to professionalize your business for the scale of what it has become rather than what it once was.
Ultimately, an executive compensation plan is designed to align the incentives of both shareholders and management. Bringing in the leaders who can drive results while achieving upside on the equity growth they help deliver could look a lot better for you while certainly looking far more attractive to high-caliber C-suite candidates.
Daniel Murphy, Director, Corporate Advisory, BMO Commercial Bank and Steve Suckow, Director, Corporate Advisory, BMO Commercial Bank contributed this article.
Read more
Our extensive work with private, family owned companies often leads to conversations concerning how to bring in outside management to propel the business to the next level. Executive compensation plans are often a logical starting point of these conversations.
Think like an investor
Tapping an outsider for an executive position can be a difficult decision. Even more so for family owned businesses since it requires you to give up a certain level of control. You’ve invested your time and you’ve built the business into what it is today. At first blush, establishing an executive compensation plan that offers an economic interest worth a 15% stake to an executive team can appear unsettling. However, if that 15% upside interest translates to a significant increase in value over five years, then your residual equity value—after paying out the executive team—has the potential to be worth far more than your equity value would be without the value the new executive team delivered.
When you think like an investor, you understand that you’re not losing money. You’re investing money, and you expect a return on that investment. As an example, what if “investing” $4.5 million in a new equity-like compensation package could result in $20.0 million of additional equity upside? Working with a trusted adviser can help you assess how much growth is possible with, and without, investing in the right executive leadership. Armed with that knowledge, the business owner wearing the business investor hat can work with those advisers to create the right kind of compensation plans to deliver the return on investment that’s right for them and their company.
Focus on compensation
Businesses can’t attract, let alone retain, the right kind of new management without defining a clear philosophy around executive compensation. Defining your approach requires an understanding of the competitive marketplace for talent and the different types of compensation that can be deployed combined with what makes sense for your culture.
The best compensation packages properly align executive incentives with measurable metrics to improve the value of a business. Attracting the right kind of talent to enhance a business’ value requires more than offering a competitive salary and bonus; the best talent expect a share in the value they help to deliver.
As you approach this topic, you should consider the background and experience of the talent you are hoping to hire. The outstanding CEO or CFO that you may target likely has considerable experience delivering results. He or she is probably near the peak of their career. They have more career options to evaluate, and their time horizon for wealth accumulation may be shorter than that of the internal personnel who helped build the business up to this point. Bottom line: they’ve worked hard to build up enough experience and accomplishments to be able to deliver value to your business and they expect to be properly rewarded, especially if they are delivering the type of transformational results you may expect.
You want leaders with the skill set of a tested executive, coupled with the mentality of a seasoned investor. That is, someone who’s motivated by having an “equity-like” stake in the company’s performance.
Establishing the appropriate compensation plan
Remember, you’re looking for executives with proven skills who can achieve measurable results. With that in mind, you generally have two market-based equity compensation plans to evaluate.
Stock appreciation rights (SARs):
This type of plan only provides compensation to the executive when the company’s stock price rises. When the company wins, the executive wins. Because of that, SARs provide an incentive for the executive to grow the company’s equity value. SARs are a longer-term play to help drive value creation for the business.
Phantom stock units (PSUs):
PSUs provide the benefits of stock ownership without transferring any shares. The value is based on the share price at vesting, even if the price has fallen since the shares were granted. The incentive for the executive is that the “shares” have value even if the company doesn't accrete value. The executive has a real economic interest in the business and a hiccup in performance doesn’t destroy his or her incentive. There is upside when the company accretes equity value, but the value to the executive is not solely dependent on value creation at the enterprise level.
Both SARs and PSUs are typically structured as equity-like instruments. Therefore, the equity holder doesn’t have any shareholder rights like a common stock owner, such as voting rights or board seats. The instruments are paid out at a set time, retirement or upon the sale of the company.
Determining the right kind of compensation plans means understanding your company's position and marketplace dynamics. For example, a company in an inherently low-growth industry may prefer a heavier weighting toward PSUs, because those provide executives with an incentive even without outsized growth. Conversely, a company that has been stable but still has the potential for significant upside may prefer more SARs to incentivize an executive to deliver that untapped potential. More often than not, a mix of both is the best solution to align incentives and reward behaviors that are accretive to value.
You also need to be open to creative and innovative approaches that address the tax consequences of certain plans and the unique situation of the individual executives.
Deciding who qualifies
Another key consideration is how many people you want to incentivize. That begins with asking:
- Which roles have the greatest potential to drive future value?
- Where are the biggest gaps in your internal roster to fill those roles?
You may determine that you only need a CEO, or that a full C-suite is in order. You’ll also have to determine what value you’re willing to give up to reach your target growth. In other words, how much equity value are you willing to offer? How much of the growth that they deliver are you willing to share? In general, a plan providing up to 10% of the total equity value and up to 15% of the upside growth is typical, although each case is different. Another way to think about sizing the awards is a multiple on cash compensation. Individual awards are often targeted to deliver equity value worth 1.0x to 1.5x an executive’s anticipated five-year cumulative cash compensation. Given these plans are equity-like, the result is a future cash payout versus a transfer of equity ownership
From there, it’s a matter of determining the executive’s ability to drive your growth projections. For example, a COO largely tasked with leading internal operations may not get as much of a share of the upside as the CEO, who is tasked with driving the strategy and creating new opportunities for your business.
It’s also important to pick the appropriate vesting period. We typically see a five-year period, vesting 20% each year. So if after three years the company isn’t meeting its targets, you’re not fully paying out on an executive compensation plan that hasn’t achieved its financial goals.
Establishing an executive compensation plan also means relinquishing some control. Regardless of the compensation package you offer, an executive at the level you’re looking for won’t have the incentive to remain with the company for long if they don’t feel empowered to make key decisions. No compensation plan will keep an executive in place who isn’t empowered to enact the change necessary to realize the value of that plan. You’re not just making a financial investment; you’re making an investment in leadership and the results you hope these leaders will achieve.
An objective look
Having an investor mindset also involves being able to take a step back and examine your business as an objective observer would. What kind of return would a private equity firm or a public company buying your type of company expect? Shouldn’t you be seeking that same kind of return?
Owners at this juncture must understand the business they started isn’t the same as the business they are running today. You might have started the business out of your garage, but now you’re bringing in $100 million in revenue. The person who managed your finances as a $5 million company probably isn’t the same person managing your finances as a $100 million company (or at least it shouldn’t be). Avoid the “we’ve always done it this way” mentality.
Instead, use executive compensation as another way to professionalize your business for the scale of what it has become rather than what it once was.
Ultimately, an executive compensation plan is designed to align the incentives of both shareholders and management. Bringing in the leaders who can drive results while achieving upside on the equity growth they help deliver could look a lot better for you while certainly looking far more attractive to high-caliber C-suite candidates.
Daniel Murphy, Director, Corporate Advisory, BMO Commercial Bank and Steve Suckow, Director, Corporate Advisory, BMO Commercial Bank contributed this article.
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