Executive compensation in ESOP companies has become a much more complex issue in recent years. To begin with, S corporation anti-abuse rules, the standards established by Sarbanes-Oxley, and the Section 409A deferred compensation rules can pose problems. The good news is that those problems can be successfully avoided, as this book explains. But there is much more to executive compensation than complying with the rules or maximizing tax benefits. ESOP trustees and company boards must ensure that executive compensation is properly used. So in addition to exploring the rules for executive compensation, the chapters in this book help ESOP companies find the best strategies for executive compensation.
The fifth edition includes revisions and updates to every chapter, including the replacement of the old survey chapter with one on the NCEO's latest survey, conducted from October 2016 to January 2017.
Table of Contents
1. Overview of Executive Compensation for ESOP Companies
2. Legal and Regulatory Issues
3. Fiduciary Issues for Trustees Regarding Corporate Governance and Executive Compensation
4. Sharing Equity with Key Employees in ESOP Companies
5. Valuation Issues
6. Special Issues for S Corporations
7. Using Compensation Studies Wisely
8. Findings from the 2016 ESOP Executive Compensation Survey
About the Authors
About the NCEO
From chapter 1, "Overview of Executive Compensation for ESOP Companies"
Advisors universally agree that the gold standard for a board is to have a compensation committee made up entirely or primarily of independent board members. It is very difficult for insiders to set the pay of another insider; one is likely to report to the other.
However, most ESOP companies see a fully independent compensation committee as too burdensome. In many cases, they do not see CEO pay or the pay of other key people as a difficult issue, believing that what they have been doing all along is working well enough.
The NCEO's 2016 compensation survey of corporate governance practices in ESOP companies found that 55% of the respondents had board compensation committees, up from 45% in 2012, and of those with committees, 83% had at least one independent director on that committee and 26% were comprised solely of independent directors. Just having a structure in place, of course, does not mean that the board is actively involved in setting executive pay, but the trend seems to be in this direction.
Boards must make another fundamental choice. Do they want to actually set executive compensation levels each year, or do they want to create a fixed process to determine compensation? Boards generally make a decision about base compensation on a yearly basis, but the story for incentive compensation is different. Just 17% of equity awards are granted on a discretionary basis, while 47% are granted based on a performance metric. The rest rely on a formula, such as an annual fixed grant to a percentage of pay. No matter who makes the decision, a process needs to be in place for what guidelines to use to set pay each year. The most common, if not necessarily the best, model is for the CEO to make a recommendation and the board to approve or suggest modifications. Inertia often is the driving force: the most important factor in both the level and form of pay is whatever was in place the year before with some adjustment for inflation, a built-in escalator, or a performance trigger.
At the other extreme is an annual reassessment in which services of a compensation consultant and data from compensation surveys are used to help make decisions. A compensation committee will certainly use prior year formulas, but the goal is to make a careful determination each year. If that seems onerous, a compensation committee or the full board might do a periodic review every few years to rethink pay.
When using a compensation consultant, keep in mind that the companies such consultants have experience with tend to be larger than average and pay employees more than average. They also are companies that are performing well enough to afford the consultant's fees. Very few compensation consultants have experience with ESOP companies, and some may not be very sensitive to ESOP-specific legal, tax, or cultural issues.
Another potentially important issue is whether an executive is getting a smaller percentage of an annual ESOP contribution than other employees because the executive's pay is above the allowable cap on pay that can be considered for contributions that year ($270,000 in 2017). Some companies provide an additional equity grant, often in phantom stock, to make up the difference.
Finally, we at the NCEO recommend, as do leading experts in this field, that incentive awards, including equity, be granted periodically, such as every year, rather than in large one-time awards. Few companies do one-time awards for cash incentives, but many companies make one-time grants of equity to executives. This can be problematic in many ways. First, for options and SARs especially, but other grants as well, an executive who joins in a down year and gets x dollars worth of awards is better off than one who joins in an up year and gets the same dollar value, because the first group of executives will get stock at a relatively low price with more upside potential. This adds a kind of lottery effect to compensation. Second, regular grants are more controllable in terms of size, form, and terms because these can be changed year-to-year as needed. Finally, regular awards keep the incentives more in front of people.
Similarly, we recommend mid-term payouts for at least some of the equity awards. Awards that do not pay out for a very long time may be excessively discounted by recipients.
From chapter 5, "Valuation Issues"
To help protect the ESOP from the potential dilutive impacts of an equity compensation plan, a minimum metric or benchmark requirement is often included to trigger the awards. Given that earnings or EBITDA (earnings before interest, tax, depreciation, and amortization) are often used as financial metrics to which a multiplier is applied for purposes of calculating a company's value, many plans require a particular level of earnings or EBITDA before allowing for equity compensation to be awarded. However, this type of protection is only required for certain types of plans.
In the example above, the company's stock is currently valued at $50 per share. Therefore, the value of the phantom stock award is $50,000 ($50 per share x 1,000 units) upon grant. All else being equal, the value of the company just declined by $50,000. If there were a minimum earnings or EBITDA target in place before an award could be granted, the company would have greater assurance the stock value would increase even with the award being granted. The mechanics of this analysis are discussed below.
With a SAR award, the value is zero at the grant date because the underlying stock price must appreciate for the SAR to have value. As such, there is a built-in safeguard in that there is only value to the award if the stock value increases, which generally would require a minimum level of earnings or cash flow to drive stock value growth. Therefore, a minimum target may not be required for this type of plan.
From chapter 8, "The 2016 NCEO Executive Compensation Survey" (tables omitted)
Table 8-3 presents a summary of median total compensation. To calculate total compensation, we summed base pay, cash incentive pay, and stock-based compensation for each executive at each company and then calculated percentiles. Deferred compensation is excluded from the total pay calculation.
Next we present a more detailed picture of the compensation data. Table 8-4 shows base pay, cash incentives, stock-based incentives, and total pay for each position, broken down by percentiles. Note that some companies offer all three categories of compensation, while others do not; therefore, the total pay at a given percentile is not necessarily equal to the sum of the three corresponding compensation categories in the table.
Note, too, that percentiles for each pay category are calculated among only those respondents that offer that pay category, and exclude respondents who entered a zero or left their response blank. For example, cash incentive pay for CEOs is $80,000 at the 50th percentile (median), but this is the median among only those companies that pay cash incentives to their CEO.
The next two tables provide further detail by breaking down compensation data by company size. Table 8-5 shows data for companies with 100 or fewer employees. Table 8-6 shows data for companies with more than 100 employees.