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HOW PRIVATE COMPANIES CAN
DEVELOP EQUITY-BASED INCENTIVES

Public companies have long used stock options and other equity-based incentives to reward their executives. As a result, stock options have become an extremely lucrative portion of the total compensation for executives of publicly traded companies. Considering the enormous amount of wealth that has been created through stock options for executives, it should come as no surprise that private companies find themselves at a disadvantage in attracting, retaining, and motivating top executive talent, largely due to their limited ability to issue stock options.

Now, however, a growing number of private companies are looking for -and finding - ways to compete for executive talent by offering their own version of equity-based or equity-like incentives. This article presents case studies of two privately held, nationally known companies-a wholesaler of giftware and novelty items and a food ingredient manufacturer-to illustrate three key points:

1. The options available to private companies;

2. How private companies can determine whether some form of equity-based compensation is right for their situation and, if so, in what form; and

3. How private companies can structure equity-based or equity-like incentive plans.

Not surprisingly, the experiences of these two very diverse companies highlight how differently this process can play out depending on the company's specific circumstances. As a result, one company opted to develop a full equity-based incentive program for its executive team, while the other company came to a very different conclusion based on the same analysis. It chose not to offer equity to its executives, but instead developed and offered a plan that mirrors an equity-based plan without diluting company ownership.

COMPANY A: REWARDING WITH EQUITY

Following a successful turnaround, a nationally recognized wholesaler of giftware and novelty items, which has been family owned since its founding in 1946, decided to provide some form of equity-based compensation package for the executive team that helped orchestrate that turnaround. This was not surprising considering that since the turnaround in 1995, the company's sales and gross margins have steadily increased, recently bringing the company back to profitability.

Although initial efforts to work through the downturn brought on by the economic recession of the early 1990s were unsuccessful, the company, led by its core executive team, eventually downsized and refocused its products and marketing. Now, going forward, the company’s strategic plan calls for continued development of highly visible brand names, a focus on the most profitable product lines, and consideration of strategic acquisitions.

As the company's fiscal health improved, recognizing the contributions and loyalty of several key members of the management team in operations, merchandising, and sales became of paramount importance. These individuals had remained with the company through its most tenuous period and helped effect the turnaround. With the turnaround complete, the CEO and the vice president of sales, the two owners of the company, wanted to reward these executives for their loyalty and hard work. Longer term, the owners wanted to ensure that the company would be able to retain these executives, while also having some way of sharing the expected future growth and profitability of the company with them.


The Equity Question from Both Sides of the Fence

Making the decision on whether to offer equity will depend greatly on a specific company's business circumstances. Yet, companies should not overlook some other important considerations when weighing the pros and cons of providing an equity stake in the business.

The Owners' Point of view. In a family-owned business, for example, providing equity-based compensation raises a number of financial and emotional issues for the owners. Over the life of the company, owners often make major personal and financial sacrifices to keep the company afloat and growing, in many cases going so far as to pledge personal assets to obtain financing. Of course, the company's owners have also put up with the inevitable long hours, extensive travel, stress, and other commitments of running a business.

Considering all this, it is not surprising that many owners are not completely comfortable "givingaway" a piece of the business, even if it is to a deserving executive team. From a more practical perspective, equity ownership causes justifiable concerns about sharing detailed financial information with executives who are not part of the family or principal ownership.

The Executive Angle. Even executives receiving an equity stake do not do so without qualms. First of all, equity ownership often requires executives to use their own assets to purchase the equity. In fact, equity based incentives may not appeal to many executives who think that they have enough "at risk" without adding equity ownership in a privately held company with only a few owners. Executives are also likely to be concerned about how the equity should be valued, the future risks of ownership, and the potential for "selling" their equity in the future, i.e., putting the stock back to the company at some later date.

Because of all these issues, executives are likely to name cash, and lots of it, as their pref6rred form of compensation. Unfortunately, smaller private companies find that cash is usually tight, particularly if such companies fall into the lower range of market capitalization (the common stock outstanding multiplied by the market price of the stock) used to rank publicly held companies. Small companies usually manage cash flow tightly, especially if they are leveraged with high-yield debt.

To work through these issues before offering equity-based compensation, it is important for executives and owners to educate themselves about various equity-based and equity-like incentives and how they work. This way, both parties can end up with a plan that suits all their needs.


The owners also felt that it was time that the company rewarded these executives not only for their contributions to the company but also for their sacrifices in accepting modest compensation while the company struggled back to profitability. Not only was these executives’ base pay relatively low, but the company's benefits package was not as generous as istypically found in larger companies that are publicly owned. For example, the company provided no long-term capital accumulation or pension plan other than a 401(k) plan that did not provide a company match.

Balancing Company and Executive Needs

It was clear to the owners that the existing compensation and benefit plans were inadequate to reward the executives at the desired level. However, with the company still strapped for cash despite the turnaround, the owners were not interested in increasing base salary dramatically or implementing generous short-term cash incentive programs. Instead, the owners began considering how to provide the executives with some form of equity ownership that would be tied to the company's future financial performance. The only question that remained was whether the executives were amenable to such a compensation arrangement. (See the sidebar on the previous page for more on owners' and executives' views on equity-based compensation in a private company.)

Fortunately, in this case, the executives believed that the company‘s future growth prospects were good and that it might become an attractive acquisition target in the future. Even though the executives were pressuring the owners for more cash compensation, they were also interested in obtaining a percentage of ownership. The company had recently gone through a valuation exercise in an attempt to obtain additional financing, the results of which it shared with the executive team. Because the valuation was based on a third-party analysis, the executives were confident in the valuation methodology and the company's estimated value.

Designing the Plan

Assured of the executives' interest in equity-based compensation, the owners decided that they would award each of the three executives an outright grant of restricted stock equivalent to 5 percent of the company's equity per executive. The restriction provision simply required that the executives remain employed by the company for five continuous years of service from the date of the grant.

Each executive also received options to purchase additional shares of company stock based on the attainment of specific financial goals, with total equity ownership potential for each executive capped at 8 percent of company equity. Once they reached that cap, the executives would receive any long-term incentive awards in cash.

The next step was to design the specifics of the plan. Overall, the plan would be based on a five-year strategic plan developed by the owners and the executives. The plan detailed specific goals for company revenue, earnings before interest and taxes (EBIT), and profitability. Based on the plan, the sooner the company achieved its EBIT targets, the sooner each executive was entitled to a percentage of the EBIT generated. The executives could then choose to receive payment in either cash or additional equivalent shares of company stock based on valuation at that time.

The company also implemented a short-term incentive program whereby each executive would be rewarded for achieving specific goals geared toward improving operational efficiency, increasing gross sales and target market share, improving gross margin through cost savings steps, and so on. The short-term cash incentive award targets averaged 15 to 25 percent of annual salary, depending upon each executive's functional role. For example, the company provided the head of giftware sales with the highest short-term cash incentive target in the hopes of simulating a sales incentive arrangement.

While the awards were determined on an annual fiscal-year basis, the actual payment schedule of the incentives, if any, correlated with the company’s cash flow dynamics. This approach helped prevent any additional strain on short-term capital flows when the company most needed cash.

And finally, to ensure adequate compensation in the short term, the company reviewed each executive's base salary against current market data and provided modest increases to make up for the shortfall identified.

EXHIBIT 1

Making the choice

The following is a summary of the circumstances surrounding both companies choices regarding equity-based compensation

Type of company

Giftware and novelty wholesaler

 

Food ingredient manufacturer

Company structure

Family-owned corporation

 

Subchapter S corporation with three partners

Situation

Successfully completed a turnaround but still strapped for cash. Major concerns: executive retention and rewarding for past loyalty and future performance

The partners are aware of the extent to which the company’s continued success relies on its three key nonpartner executives. However, the partners cannot agree on whether offering equity is the best way to provide a means of retaining and motivating these executives.

 

Rationale for compensation decision

The owners recognized the importance of these executives to the company’s continued growth and success and was concerned about losing them to better-paying large companies.

 

The partners reach a compromise and design a cash-based long-term incentive plan the mirrors the payout under an equity-based plan.

Resulting executive compensation plan

Outright grant of restricted stock equal to 5% of company equity per executive; overall stock ownership levels capped at 8% per executive.

Incentives based on achieving EBIT targets payable in shares of company stock or cash.

Short-term incentive based on the achievement of specific operation and sales goals: target set at 15% to 25% of base salary.

Base salary levels adjusted to reflect the market.

A short-term cash based incentive plan that awards up to 25% of base salary if the company achieves specific operational milestones.

A performance unit plan ties compensation to long-term targets. The targeted award is a cash payout of 50% to 100% of base salary if the company achieves or exceeds certain revenue milestones.

COMPANY B: DEVELOPING EFFECTIVE EQUITY-LIKE COMPENSATION

Of course, not all privately held companies decide to provide equity participation to nonowner executives. A 40-year-old food ingredient manufacturer was known and well established in its industry and relied heavily on the contribution of three key nonowner executives who were engaged in sales, manufacturing, and distribution, In fact, the three principal owners or “partners” in a subchapter S corporation structure viewed the these executives as critical to the company’s continued growth and profitability. However, the three owners did not agree how that fact should affect the executives’ compensation arrangement.

The company president, who is one of the owners, wanted to provide some form of equity-type participation to the three key executives. However, the other two owners were opposed to providing direct equity ownership for fear of diluting ownership.

Finding a Balance

To reach a compromise, all three owners agreed to a plan that would provide each executive with a significant short-term cash award of 25% of base salary if they achieved specific operational milestones. The executives would also receive cash payouts under an additional long-term incentive plans.

Overall, this pan represented a significant departure from the company’s past practice. For one thing, the new plan offers a significant increase in short-term cash compensation opportunity that is based on clear performance measures the executives can understand and impact upon. In the past, the company offered modest short-term incentives that were based on the discretion of the partners.

To satisfy the president’s desire to tie some portion of executive compensation to long-term company results, the company also adopted a performance-based unit plan. Deciding which measures to use to value the units was relatively straightforward matter since the partners and the key executives had worked together to develop the company’s five year plan. Each executive was familiar with the goals and challenges the company faced. Eventually, both the owners and the executives agreed that the key measure for the performance unit plan would be revenue growth.

Now the Performance-Unit Plan Works

Under the performance-unit plan, each executive was awarded performance units that would be valued over a cumulative three-year period. The targeted award was to be a cash payout equal to approximately 50 percent of base salary when the company achieved each of the targeted revenue milestones. The value of the units could be as much as 100 percent of base salary if the revenue targets were exceeded.

The performance units were awarded each year for a successive three-year cycle. Because the cycles overlapped, unit valuation was the sum of one-third of each of the three-year unit values in the fourth and following years. The company increased its short-term incentive targets during the first two years of the performance-unit plan because the performanceunit plan would not make a payout until the third year.

By using cash in a performance-unit plan to simulate an equity-type plan, the owners were able to provide potentially significant rewards based on performance without diluting ownership in the company. For their part, the executives now had a compensation program with a long-term component that was tied directly to the company's long-term growth prospects.

MAKING THE CHOICE

Whether to provide executives with some form of equity-based compensation is one of the most important decisions a private company can make. After all, the result of those deliberations has tremendous implications for both current owners and the executives. Given the right business circumstances, the owners' willingness to share equity ownership, and the executives' desire to participate in equity ownership, equity-based plans can make sense.

Even if a company chooses not to provide equity, it still has an array of options available when looking for innovative ways to reward executives. In situations in which equity-based incentive plans are not always the best executive compensation design solution, companies can still develop effective cash-based plans that simulate equity ownership as a good substitute for stock.

In either case, companies need to remember that their goal should be to provide as much long-term compensation opportunity to the non-owner executive in privately held companies as to their counterparts in public companies.

THOMAS J. HACKETT and DONALD G. McDERMOTT are partners with D. G. McDermott Associates, LLC,a human resources and compensation consulting firm based in Red Bank, New Jersey. Both authors have served on the faculty of the WorldatWork and have extensivecorporate and consulting experience in thefield of compensation design, human resources, and management consulting.