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Designing Executive Compensation in an ESOP Environment

Part 2: Developing a Reasonable Program for an ESOP Company

Anthony Mathews

September 1996

As we discussed in the first installment of this series, the first step in addressing executive compensation at an ESOP company is to develop a specific compensation philosophy that suits your situation. The beginning point must be your specifics, but your specifics will not suffice by themselves. A compensation strategy must be implemented with a reasonable (and defensible) program. Our focus here is to discuss how you arrive at the parameters for that.

Refer to Comparison Group Benchmarks

The first stop on the way to a reasonable and incentivising compensation package is to determine a range of levels and types of compensation that are typical for your particular industry, adjusted, as appropriate, for the particulars of your company. There are several private and public databases for this purpose, but in most cases you will need to consult a compensation specialist.

The important reference points are the general level of compensation, the mix of current and deferred, secure and at-risk, and the nature of compensation paid. It is also important to adjust the data for industry (getting comparisons in the same or similar SIC code is usually sufficient), geographic references (identical job classifications can vary as much as 25% or more simply based on location) and for the specific job description. Other, more subjective, adjustments can also come into play such as extraordinary earnings, etc.

It is important to keep in mind that the comparison groups do not create any obligation one way or the other. Your executive compensation can take any form or level the parties agree is appropriate. The value of the comparison group is to definitely establish a range of reasonable levels and types of compensation for different job classifications and to demonstrate due diligence on the part of whomever is making the decisions.

And Don't Forget Special ESOP Considerations

With ESOPs we get a sizable basket of specifically ESOP issues to address. This is particularly true where the ESOP is a majority shareholder and even more so where the ESOP has provided Code Section 1042 Rollover benefits to the seller. In both these cases, key executive employees may not only have their continuing compensation to concern them, but may have suffered serious reverses along the way as well.

Section 1042 Backwash: It is very common for a substantial or majority shareholder to establish a leveraged ESOP for the purpose of setting up a rollover and deferral of gain on the sale of his or her stock. Several side effects of that transaction are relevant here. In fact, key executive personnel at an ESOP company often find themselves in a significantly worse position after the transaction. First, the debt burden taken on the company usually reduces the ability of the company to continue to fund special bonuses. This would be bad enough if it were fully offset by ESOP participation, but most often these key employees' participation in the ESOP is cut back because of the artificial limits on compensation that may be used for plan purposes. Where these key employees are either related to the seller or shareholders in their own right, the matter just gets worse. Often these key people will not only be limited in the ESOP, they may well be eliminated altogether. Finally, adding yet another injury, on top of the fact that a key employee's ownership interest in the company may have the effect of prohibiting ESOP participation, that key employee will probably also have seen a significant decrease in his or her equity value as a result of the decrease in value of the company brought about by the leverage.
There is no perfect solution for these problems. It does take a dedication on the part of remaining management to the ESOP concept to make it work. Some steps can, and should, be taken, though, to insure equitable treatment for these people. Without them, even if an ESOP deal is somehow made to occur, the company will very likely not survive or at least will have serious problems to overcome.
Limits on Competitive Compensation Packages: No one disagrees that an ESOP company must compete for talented personnel in a surprisingly limited market. As we look at the methods most companies use to attract and retain employees, many are either intuitively inappropriate, financially impractical or just plain illegal when a company is owned substantially by an ESOP. Yet, if ESOP companies are to survive and succeed in the world that is largely unimpressed with our employee ownership, ways to do so must be found. Typically, this means that the ESOP trustees, just like other shareholders, may have to create special programs outside of the qualified plan arena and, indeed, may have to share ownership with these key executives in order to keep their level of incentive as high as desirable and properly compensate them for their contributions to the process.
ESOP Lender Requirements: Frequently, the very existence of the ESOP itself requires the creation of ownership interest among a class of management employees outside of the ERISA-protected trust fund. Where the only shareholder in a company is legally prohibited from guaranteeing the debt of the corporation (as is the case in a 100% ESOP company), it is difficult to get lender interest in banking the company, and it is difficult to come up with a convincing rationale for a non-shareholder manager to do so, even assuming the bank were willing to accept that. To be sure, many such managers have stepped up to the plate over the years, but even where that has been the case, the inequity is a clear one, and ESOP companies cannot afford to rely on the altruism of a very small pool of such managers.
Existing Agreements/Expectations: On top of any legal or financial issues that arise, most companies have formal (or even informal) agreements with management employees that may or may not be compatible with the existence of the ESOP. Promises of stock ownership interest to several key employees are fairly common, but if they are not firmly in place by the time the ESOP is installed, the entire process can well be reset to zero. One very important part of any ESOP installation is determining the extent of these issues and structuring programs to address them.
Fiduciary Conflicts of Interest: In resolving all these problems, ESOP company management face clear and difficult conflict issues. Even if they are allowed to participate in the ESOP, management employees will almost invariably be both employees with their own self-interest which may or may not be identical to the interest of the shareholders and fiduciaries who are specifically charged with a significant responsibility for the well-being of shareholders who are not usually in a position to look after themselves.
In general, ESOP company management employees should never be in the position of unilaterally making up their own compensation package. Outside directors are a very useful addition to the board of any ESOP company, if for no other reason than to establish an arguably objective compensation committee. ESOP company management and directors should consistently abstain from decisions where the conflict of interest exists because even where an objective third-party might have reached the same decision, the act of a conflicted party is automatically suspect and must be proven to be reasonable and consistent with the fiduciary duty to shareholders and under ERISA. That is obviously much more difficult than defending the decision of a disinterested (or at least non-conflicted) party.

Outside directors and constant use of competent, recognized professional advisors is a virtual must for an ESOP company to avoid these pitfalls.

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

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