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Executive and Director Compensation in ESOP Companies

All companies need to find mechanisms to compensate their key executives in ways that attract, motivate, and retain the right people, while aligning their goals with the goals of the company. That's true for ESOP companies, but executive pay in these companies is also subject to higher fiduciary standards, and, often, cultural expectations about what is fair. Especially in S corporations with ESOPs, there can occasionally also be limitations on how much synthetic equity can be provided, as well as tax considerations that limit what kinds of equity should be awarded. ESOP company boards need to be responsible for balancing all these concerns, and ESOP trustees must be comfortable that the ultimate result is fair.

In most closely held companies, the owner or owners are the top executives and set their own pay. Their pay may be based on a combination of their self-assessment of their own merits, their sense of how much they need to make, their need to balance current and deferred income, and tax strategies. While the CEO's pay (and, occasionally, the pay of one or more other officers) is formally set by a board of directors, pay is effectively determined by the CEO and then simply approved by the board. While some ESOP companies follow the same approach, many companies in the employee ownership community want to be more thoughtful and systematic about executive compensation. One of the most notable trends in recent years is that the boards in a significant majority of ESOP companies are taking a more active role and seeking independent voices in compensation decisions. Doing so is clearly a best practice.

Executive compensation also has profound implications for corporate culture, both in the behavior it encourages by executives and in the way it is perceived by the workforce as a whole. ESOP companies often have deep commitments to organizational values and need to make sure that their compensation programs reflect those values.

Boards should consider all of the forms of compensation instead of settling on a form simply because it has been the common practice at the company in prior years. Various components have different strengths and weaknesses: base compensation (or the fixed annual salary), cash incentive pay, cash deferred compensation, stock options, stock appreciation rights (SARs), restricted stock and restricted stock units (RSUs), phantom stock, equity compensation in general, benefits (such as the ESOP itself), and intangible items (often hard-to-describe things like a good quality of life).

Company boards must decide whose pay they will be determining. Most often, it is only the CEO, with the CEO then setting pay for everyone else. In some other cases, the pay of other officers, most often the CFO or COO, is set as well. More often, a board becomes involved in non-CEO pay when it seeks to attract a key executive, especially one who might become the CEO's eventual successor. Decisions here involve not just the level of pay, but its components, including incentive pay, equity, relocation costs, sign-on bonuses, etc.

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. Many ESOP companies choose not to have a fully independent compensation committee but have one or two outsiders on the committee. The best practice is clearly to at least have a majority of outsiders.

The right way to design a compensation system depends on issues including taxation, corporate goals, the competitive environment, and profitability, but boards must decide what they believe about human motivation. The threads of this analysis come together in a compensation philosophy of the company. In some cases, this may be an explicitly considered issue; more often, it is implicit. But there always is one. There are several alternative approaches, none of which is inherently right, and more than one of which usually is part of the model.

Executive compensation affects organizational culture in many ways. For one, some companies choose to evaluate, and therefore compensate, their managers in part on how effective they are at building the organizational culture the company wants. PC Construction, a Burlington, Vermont-based ESOP company, for example, has specific expectations related to ownership culture built into all job descriptions. More broadly, the factors that determine executive compensation can encourage behavior that supports or directly undermines the development of an ownership culture. That impact comes through two broad channels: the perceived fairness of the compensation system and the company's communications.

This article is adapted from NCEO founder Corey Rosen's introduction to our book Executive and Director Compensation in ESOP Companies, 8th Ed.

These and other issues are discussed in Executive and Director Compensation in ESOP Companies, 8th Ed. Also see our book ESOPs and Corporate Governance, 5th Ed. We conduct surveys of ESOP company executive compensation, and provide detailed reports on the results plus a free summary for members. And if you're an NCEO member, watch our live and replay webinars on executive compensation and related topics. If you're not a member, consider joining.