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Designing Executive Compensation in an ESOP Environment

Part 1: Begin from a Compensation Philosophy

Anthony Mathews

August 1996

The potential conflict of interest between corporate officers' salary and incentive desires, and the earnings desires of shareholders, is an old problem that is revisited constantly in the financial marketplace. In most closely held corporations, the key management employees comprise the same group as the shareholders (or at least a closely related group) and so the conflicts are relatively easily resolved. In public companies, the oversight of the accounting community, SEC, and the public market tends to keep things under control.

The Basic ESOP-Executive Compensation Conflict

In an ESOP company, neither external safeguard exists. The guardians are most often the management fiduciaries of the company (and their agents), and finding the right balance between the interests of the shareholders and the desires of those same management employees can be particularly tricky. Obviously, where the management employees of the company are also the only fiduciaries of its ERISA-protected retirement plan, which happens also to be a substantial (often even majority) shareholder, the potential conflicts of interest are numerous and seemingly insurmountable. Yet surmount them you must if, as an ESOP company in this situation, you are to compete successfully for the most talented executives in a world that is largely unimpressed by the fact that you are "employee owned."

This basic problem is considerably exacerbated by the nature and terms of certain ESOP transactions that commit high levels of equity, future earnings, cash flow, and other financial resources to a project that is unproductive of profit and that often brings the most key management personnel very little, if any, direct benefit. In fact, many ESOP transactions actually damage the non-selling management employees' net worth, resources, and terms of employment. Clearly, we cannot let the ESOP become a significant disincentive for management, and designing around these problems is a real challenge for every ESOP company.

How do we adequately compensate and incentivise key management employees in an ESOP company where presumably we may not simply bonus out all the earnings at the end of the year or issue large numbers of favorable stock options? It is very likely that reality creates special requirements of ESOP company management, but is it foolish to rely on that for a pool of ESOP company managers in the future? Clearly, members of ESOP company management are not as free to use corporate assets for their own benefit as are key officers of most other closely held companies, but where does one draw the line?

We think the answer is careful planning, effective use of outsiders (consultants and/or outside directors) to make and/or support key decisions, and thorough documentation of your due diligence. There is nothing inherent in an ESOP company that requires management to accept less for the same effort than it would expect from an equivalent non-ESOP company. The key is figuring out and documenting exactly what that means.

Develop a Compensation Philosophy

As in any company, an ESOP company should begin the exploration of compensation issues with an examination of its objectives and a comprehensive statement of its compensation philosophy. This statement incorporates the company's goals and objectives and basically lays out a philosophy of compensation that approaches those goals. Formulating a compensation philosophy statement often seems like an academic exercise, but, if comprehensively done, can save considerable time and effort and minimize potential misunderstanding for all concerned. More important, it serves as the basis for developing a compensation strategy and specific compensation programs for specific executives.

Also as in any organization, each ESOP company will have its own focal points--areas in which the company wants to encourage or discourage activity. These individual interests will be reflected in both the process and the outcome, and the practical objective will be to formalize the company's position with respect to specific compensation arrangements in order to foster those goals.

In general, every company's compensation strategy will reflect its philosophy (and ESOP companies are not usually exceptions) and can be described in terms of the following ratios (whether consciously included in the process or not.) And, in turn, the ratios play a significant role in determining the specifics of the resulting compensation strategy. The basic descriptor ratios are:

Secure vs. At-Risk: The ratio of secure compensation to at-risk compensation is the first spectrum to be examined. With neither positive nor negative judgment implied, this ratio reflects a company's attitude toward its growth potential, its sense of employees' contributions to growth, and its sense of obligation to and relationship with its employees. Secure compensation is basically compensation that depends only on the employee's meeting the minimum requirements for continued employment. At-risk compensation is compensation that relies on either individual or group achievements or both. Commission is probably the oldest form of "at-risk" compensation and in many ways is a good key to determining at-risk incentives even where a specific commission structure would not be appropriate. These generally parallel base and incentive compensation in common terms, and, for our purpose here generally, the higher level executives in entrepreneurial companies will tend to have higher ratios of at-risk pay.
Short-Term vs. Long-Term: The ratio of immediate or short-term compensation to deferred or long-term compensation is the second feature of the compensation equation. While this overlaps, to some extent, each of at-risk and/or secure compensation, there will be a mix of short- and long-term incentive values that must also be considered. Retirement benefits are obviously a long-term incentive, but we can find long-term elements in virtually every aspect of compensation. Direct base salary, for example, is definitely a short-term incentive; however, salary increase policies (which are certainly part of a complete compensation strategy) are long-term components. In any case, the mix of short- and long-term elements also reflects the company's attitude and intentions and should be a logical outgrowth of the compensation statement.
Cash vs. In-Kind Compensation: Finally, in any compensation philosophy there will a mix of cash compensation (salary, cash bonuses, etc.) and other non-cash types of compensation (fringe benefits, stock options, etc.). Without regard to the presence of an ESOP, older, more established companies frequently grow to focus on secure, cash compensation and long-term, incentive types of pay (established salary scales, pension-type retirement plans, tenure-related term bonus and option programs, etc.).
Newer or more entrepreneurial companies often concentrate on short-term incentives and at-risk, in-kind types of compensation (profit sharing, salary reduction stock plans, commission-based pay scales, stock option programs, etc.). At any point, however, rethinking the compensation structure along these lines can be very instructive.

Rethinking is particularly necessary where an ESOP transaction has caused a significant shift in the focus of a company that almost certainly has numerous agreements, programs, contracts, and even expectations already in place with employees that may or may not fit in with the new ESOP direction.

Whatever decisions you reach in this process, the result will give you a basis from which to select from among the design alternatives we'll be looking at in future installments of this column.

Biography and list of other "Administrator's Notebook" installments

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