This is the seventh edition (2021) of our standard reference on executive and director compensation in ESOP companies. The topic raises complex issues, from S corporation anti-abuse rules to ESOP trustee and company board duties. There is no simple solution to executive compensation in ESOP companies, of course. This book, however, provides an up-to-date guide to the legal, financial, fiduciary, and tax issues involved with various compensation strategies. It also provides best-practice guidelines for how to set executive and director pay. Chapters 1 through 7 cover legal, fiduciary, valuation, and S corporation issues, plus sharing equity and using compensation studies. Chapter 8 discusses compensation for outside board members. The final chapter then provides a detailed report on the NCEO's 2020 survey of executive compensation in ESOP companies, while also pulling in complementary information from the 2016 NCEO survey. The combined data provide a detailed picture of the forms and size of compensation being used in ESOP companies.
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. Compensation for Outside Board Members
9. Findings from the NCEO’s ESOP Executive Compensation Surveys
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 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. Thirty-eight percent of companies grant equity awards on a discretionary basis, while 68% grant awards based on a performance metric (the numbers are over 100% because some companies do both). 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.
From chapter 3, "Fiduciary Issues for Trustees Regarding Corporate Governance and Executive Compensation"
The ESOP trustee is responsible for making sure that the value of the ESOP shares is not negatively affected by excessive compensation levels, and the trustee has a fiduciary duty to take action if it determines that the executive compensation is unreasonable and too dilutive. There is a wide variety of actions an ESOP trustee could take to deal with excessive compensation, such as consulting with the board of directors to express concerns about compensation levels or seeking to change the composition of the board of directors. In an extreme case, the trustee may contact the U.S. Department of Labor, or commence a shareholder derivative suit if the board is not responsive to the shareholders’ concerns.
The ESOP trustee initially relies on its financial advisor to make an assessment as to the reasonableness of the executive compensation. The benefits offered under the executive compensation arrangements must be analyzed and compared with their dilutive effect on the company stock price to determine whether the compensation arrangements are reasonable and appropriate. In many instances, it is prudent for the ESOP trustee to engage a third-party compensation consultant if the financial advisor believes the executive compensation is unreasonable. The NCEO provides significant survey data that measures the market rate of equity-based compensation for executives in ESOP companies. This applies not only to ongoing ESOPs but also to cases where an ESOP company is being sold.
From chapter 8, "Compensation for Outside Board Members"
Almost all boards pay all outside members the same, even if they have different skills and make different contributions. Doing otherwise would create difficult measurement issues and potential resentment among those board members getting less. Boards might pay small additional amounts for being the chair or chairing committees.
While board pay can and often is set simply by a company picking some number it is comfortable with, using survey data to determine appropriate pay helps assure companies they are paying reasonable amounts and board members believe they are being treated fairly. Ultimately, though, the test is whether the pay level is adequate to get the board members a company wants and keep them over time.
Companies also have to decide how to pay board members. Pay most often is either in the form of an annual retainer or a per-meeting fee. The former helps set a controlled, reliable price; the latter can limit costs if a company decides to have fewer meetings. Pay can also have an equity component, most often phantom stock or stock appreciation rights. Using synthetic equity is especially vital in S corporations because if directors own stock directly, they get K-1 statements and will want distributions to pay their taxes. The ESOP then has to get a pro-rata share of distributions that would be many times more. In non-S corporation ESOPs, stock options or grants can be made. As the data below show, however, few companies use equity-based pay to compensate board members.
From chapter 9, "Findings from the NCEO’s ESOP Executive Compensation Surveys" (tables omitted)
Table 9-3 presents a summary of total compensation. Total compensation is calculated by summing base pay, cash incentive pay, and stock-based compensation for each executive at each company and then calculating percentiles. Deferred compensation is excluded from the total pay calculation.
Following this is a more detailed picture of the compensation data. Tables 4 through 8 show compensation percentiles for base, incentive, and stock-based compensation for each position, broken down by company revenues in the most recent fiscal year. 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 respondent companies that offer that pay category, and exclude respondents who entered a zero or left their response blank. For example, cash incentive pay for CEOs among all respondents is $80,000 at the 50th percentile (median), but this is the median among only those companies that pay cash incentives to their CEO.
Compensation numbers for categories with fewer than 10 responses are omitted.
Tables 9 and 10 present data on the makeup of total compensation, again broken down by company size. These tables show the percentage of total pay made up by base pay. Base pay accounts for 79% of total compensation for the median CEO; base pay makes up a greater proportion of total CEO pay in smaller companies (a median of 87% in companies with under $10 million in revenue) and a smaller proportion in larger companies (a median of 50% in companies with over $200 million in revenue).