Balancing Management Pay and Shareholder Returns
Like publicly traded companies, privately held businesses struggle to balance executive compensation and earnings for shareholders. The challenge for privately held businesses, specifically, is that ongoing operations must support management compensation and shareholder earnings, while executives at public companies receive equity that is liquid, helping fund and reward them for increasing company value. For private companies, then, compensation plans must be designed to align with shareholders’ interests, be financially sustainable in the short and long term, and provide a competitive pay package and meaningful incentives for management.
From the shareholder perspective, earnings are either distributed or reinvested in the business, much like dividends and stock price returns at publicly traded companies. Private company shareholders need to determine their required return on capital, the portion that is distributed annually versus reinvested for growth, and the achievement time horizon.
The emphasis on and structure of management’s long-term incentives (LTIs) vary based on the type of private company ownership and shareholders’ objectives and return requirements. Key LTI design parameters center on the following questions:
How is performance or value defined?
What ratio of earnings or company value sharing should go to management?
What are the payout or liquidity provisions?
For companies driving toward a value-realizing event such as a sale, merger, or initial public offering, it is easier to align incentive plans with shareholder interests. The transaction allows both shareholders and management to receive money, and the event provides an objective and quantifiable definition of value. If the transaction does not occur, there is no liquidity or reward. The objective of incentive plans in such an instance is often to motivate executives to grow the company and to retain them until the transaction occurs. The most common incentive vehicle is real equity such as stock options or profits interest where management participates in the value created at the time of the transaction. Shareholders that do not want to provide real ownership to management can deliver the economic equivalent in the form of phantom equity or a cash transaction bonus.
The aggregate management sharing ratio varies by industry, company size, time to transaction, and type of ownership. Smaller and early venture-funded companies share more with their management teams (15 percent to 25 percent of value created), whereas private equity portfolio companies tend to share less. In some situations, such as with private equity sponsors, shareholders may first earn a preferred return prior to management receiving its share or require the sale price to exceed a specified multiple of invested capital before awards can be earned by management.
For “evergreen” companies, such as multigenerational family businesses, long-term incentive plan design becomes more challenging, as there is no anticipated value-realizing event. In order to be competitive with public companies, close to 60 percent of privately held companies provide long-term incentives, according to a Compensation Advisory Partners and WorldatWork survey on private company incentive pay practices.
Defining specific shareholder objectives for the incentive program is key. Are long-term incentives designed to reward for performance, retention, or both? Only by articulating the objectives can performance, payouts, and liquidity provisions be defined. However, there is pressure from leadership candidates for privately held companies to mimic public company long-term incentives. Where this rings true, companies define their value as the market value of the enterprise. However, private organizations must fund long-term incentive awards through the operations of the business, resulting in a potential disconnect when the market value delivers awards that must be paid out of earnings that are a fraction of the value definition.
It is important to extensively test the incentive plan under different performance scenarios (best, worst, and cyclical cases), enabling boards to understand potential earnings and cash flow impacts at the outset of the plan. Given that payouts are funded out of shareholder earnings, incentive plans can also include “safety valves” where payouts can be limited or deferred to ensure company financial stability. Due to the potential financial consequences, long-term incentive plan eligibility is only offered to a limited number of management participants and the cumulative sharing ratios of such plans are lower (generally 5 percent to 10 percent of market value).
Boards of privately held companies should understand the size and timing of incentive payouts in comparison to shareholder earnings requirements and total company value—and clear communication to shareholders is key to earning their support.
Bertha Masuda is a partner in the Los Angeles office of Compensation Advisory Partners.