How the CEO gets paid

| November 18, 2015
Money, money, money!

The employee compensation practices of publicly listed companies are of great interest to employees, investors, business media and researchers alike.

They are also influential in shaping public expectations and by extension, the policies and practices of private companies.

Here, my analysis draws on disclosed employee plan features of some 40-50 ASX300 companies, plus anecdotal information from direct exposure in this area to provide some insights on employee compensation practices to privately owned businesses.

1. Remuneration structure and mix

The first thing to observe is the structure of a remuneration package for employees whose duties and key decisions are expected to have a long-term impact on a company. For these employees, their total package comprises the following components:

·                     Base pay

·                     Short-term Incentive (STI)

·                     Long-term Incentive (LTI)

This structure generally covers the CEO and direct reports. It typically extends to some or all of the next management tier, while some companies make selective awards to high potentials and high performers below the top management tier.

While the base pay is a fixed annual cash amount, the STI and LTI components are entirely discretionary, dependent on agreed performance.

The mix varies widely by company size, industry and company specific strategic considerations. However, for companies in the bottom tier of the ASX300, a typical mix might comprise the following components:

CEO  Base 50-55% STI 25-30% LTI 20-30%
CEO direct reports     Base 60-65% STI 20-25% LTI 15-25%
Other participants  Base 75-80% STI 15-20% LTI 5-15%

Smaller companies tend to have a more conservative mix, with less reliance on LTI.

2. Basic incentive design

The vast majority of listed companies (at least 90%) deliver executive STI in cash and LTI in the form of equity.

STI is typically based on performance in a single accounting period whereas LTI is subject to performance or vesting usually of 3 or more years. In some cases, vesting of LTI is staggered, that is partial vesting at say 3 years followed by residual vesting at 4 or 5 years.

In formulating suitable performance measures, STI generally focuses on the drivers or lead indicators of shareholder value, while LTI emphasises the value actually delivered.

LTI is generally based on company-wide performance and often includes a relative performance measure. For this reason, a measure such as relative total shareholder return (TSR) is most predominate.

The Boston Consulting Group (BCG) introduced an internal TSR measure known as total business return (TBR) that extends TSR to private companies.

TBR compares the sum of the estimated future value of the business (the capital gains) and the free cash flows (dividend yield) to the current investment or business valuation. This is a direct internal analogue to TSR.

3. Performance measures

Research sourced from Hewitt Associates Pty Ltd found that the prevalence of various performance measures for publicly listed companies is as set out in the table below. Note that the percentages sum to more than 100% as some listed companies apply multiple measures.

·                     TSR (total shareholder return), including Relative TSR 86%
·                     EPS (earnings per share) 35%
·                     ROCE (return on capital employed) 13%
·                     Cash Flow 7%
·                     Other profit measures 5%
·                     Revenue 3%
·                     Other 8%

ESOPs: Peak Performance Trust

Equity remuneration for employees of a privately owned businesses is achieved through specialised structures or employee share ownership plans (ESOPs).

One of the most innovative vehicles through which to provide employee share ownership in a privately owned business is a customised Peak Performance Trust (PPT). A PPT is an effective tax vehicle developed by and only available through Succession Plus.

While ESOPs are effective in providing a vehicle for delivering the equity component of employee compensation in a privately owned business, ESOPs are also known to bestow significant other advantages to both employees and business owners.

Savings vehicle: Employees are able to accumulate savings through share ownership.

Participation: Employee ownership gives employees a sense of community, allows employee engagement and involvement, as part owners they feel part of the decision making process.

Performance Enhancement: Getting employees to think and act like business owners can make a substantial difference.

Succession planning: ESOPs can be an effective employee buy-out instrument where owners looking to exit.

Buyer Attractiveness: ESOPs are effective in retaining key employees long after the founding owners have exited reducing a major risk for buyers.

Closing Thoughts

Good governance on employee compensation that is modelled on public company experience suggests:

· Employee compensation for senior employees in most businesses consists of both a fixed and a variable component.

· The variable portion might comprise both an STI and LTI component which are generally tied to measures of business performance that are connected to the business’ primary goal of maximising shareholder value.

· Measures of economic profit are suited when measuring and tying performance to STI and marked based measures for LTI.

· STI is typically paid in cash and LTI in equity.

· A Peak Performance Trust is an ESOP developed by Succession Plus that offers significant tax advantages. It is used in privately-owned businesses to help remunerate, retain and motivate key employees.