Effective Executive Compensation Plans

An executive compensation plan is a crucial element in recruiting and maintaining a happy, productive workforce.  This area has been affected by Enron, WorldCom, the SEC and the accounting standards board.

On one hand, Boards want a plan that effectively attracts, retains and motivates the top management and, on the other hand, they must exercise due diligence in assuring that pay and performance are properly tied to each other.

The following are suggestions for an effective executive compensation plan:

  1. The plan should be tied to measures of both profitability and growth.  A growing but unprofitable company and a profitable but stagnant company are not desirable investments.
  2. The total compensation should reflect the difficulty of the performance objectives.  The top 25% performance deserves the top 25% compensation.
  3. Analyze the expected compensation level as a percent of expected profits and compare these percentages with companies of similar size and industry.  Determine the percentage of revenues that will be devoted to rewarding the executives.  The plan must have achievable profitability and cash flow before the executives will buy into it.  Financial modeling can test the impact of different allocations on your cash flow and financial statement.
  4. Determine how much of your executive’s cash compensation is guaranteed and how much should be at risk through incentives.  The current salary ranges should be competitive and there should be enough disparity between groups to recognize progression and provide an incentive to move up through the organization.  Consider hiring a third party to candidly talk to your executives about their expectations for compensation, motivational and financial drivers.  It is important to get the executives involved in the plan design.
  5. The financial objectives should be realistic and should reflect a balance of factors including:
    1. The recent financial history of the company
    2. Recent performance of competitors in your industry
    3. Changes in business strategy such as new products, new services and changes in operations that could impact growth and profitability
    4. Whether the company is young and growing (in the growth stage) or whether it is focused on cost cutting (in the mature stage)
  6. Determine who will participate in the plan.  The size and scope of the plan depends upon the ability to fund it but many times those who earn less than $90,000 have no interest in deferred compensation or long-term benefits.  Examine the demographics of your executives to determine their compensation and retirement objectives.
  7. When designing the plan consider the compensation, monitoring and measuring the results, tax, legal and accounting issues, ROI goals and exit strategy.  Each element should actively support achieving corporate goals and strategy.  Find the right mix of the following basic elements:
    1. Base salary
    2. Short-term incentives, usually cash, focusing on individual or team short-term goals
    3. Long-term goals, 3 to 10 years, based upon company valuation or organizational performance such as earnings, market share or productivity
    4. Equity plans such as stock or stock options
    5. Time such as extra vacation, flexible hours, permission to work from home
    6. Increased responsibility and recognition of talent
    7. Training, retreats (these can be in vacation settings) and tuition reimbursement
    8. Benefits like medical, dental and life insurance
    9. Access to equipment such as PDA or notebook computer
  8. Determine who will monitor, track, report and perform the accounting, tax, legal and other administrative tasks.  You may want to consider proper legal advice as your plan may involve tax law, labor law, securities law, corporate law and estate planning law.
  9. When you are ready to implement the plan you can meet with all the executives together to explain the plan and then meet with each executive individually about what will be expected of them, how their performance will be measured and their rewards.  Your commitment and enthusiasm will impact their buy-in.
  10. The best compensation plans evolve over time as they are adjusted and fine-tuned.  Again, financial modeling can be an effective tool.
  11. Reinforce the plan and actively support the achievement of corporate goals and objectives with frequent memos, newsletters and announcements.
  12. The Board should consider what safeguards are in place in the compensation plan should financial results take a downturn.