Private Company Incentives Face Transparency Hurdles

Equity vs. cash is a key issue for privately held firms

By Joanne Sammer March 3, 2015

When it comes to finding the right mix of incentives and metrics to drive executive and employee performance, privately held companies face unique challenges. Questions about extending ownership through equity-based incentives, regulatory concerns and information sharing are just some of the issues they need to consider.

That private companies need to have some type of incentive for their executives and key employees is a given. A 2014 report on findings from a survey of 190 privately held companies mostly based in North America, conducted by WorldatWork and Vivient Consulting, found that:

Almost all (97 percent) had some form of short-term incentive plan in place.

Long-term incentives were far less common, with just over half (56 percent) of the companies offering a long-term incentive plan in 2013, down from 61 percent in 2011.

The decline in long-term incentives could be a result of the growing complexity of the rules governing long-term incentive plans under Internal Revenue Code section 409A, the survey report suggested.

The falloff in the use of long-term incentives among S corporations and limited liability corporations (LLCs) was particularly sharp, from 63 percent in 2011 to 33 percent in 2013 among S corporations and from 55 percent to 32 percent among LLCs, according to the survey results. With these declines in usage, private companies with specific types of corporate structures, including C corporations and subsidiaries, are now the most likely to offer long-term incentives.

Driving Results

Although regulatory requirements are an important consideration when designing incentives, private companies also need to consider whether their current incentive mix is meeting their need for competitive compensation that rewards strong business performance and results.

Like any other organization, private companies need to structure their incentive plans around what they want to accomplish. “What do owners want from the business?” asked Scott Rollin, president of consulting firm Management Compensation Resources. “Whether it is an increase in sales or managing expenses or making some acquisitions, where do you want people focusing their efforts?” Well-designed incentives with the right performance metrics should be focused on those elements of the business.

Once management sets the performance metrics for employees, continually communicating and providing feedback on performance, expectations and results is critical. If employees don’t know how they can impact business value and how they are doing relative to their performance goals, then incentives are much less powerful. So freely sharing information about strategy, results and business priorities is a key element of successful incentives.

Lack of Transparent Metrics

Yet for privately held companies, the need for communication can be a stumbling block. These businesses, by definition, are private; unlike public companies traded on a stock exchange, they are not required to share any information about their performance or operations. As a result, owners and other senior leaders may have fostered a culture where business information is tightly controlled.

Owners may have fostered a culture
where business information is
tightly controlled

“Private companies are private for a lot of reasons, and sometimes they are very private in terms of sharing financial information or metrics,” Rollin said. “That can be problematic because people need to know what they are supposed to do and to see measures of their progress.”

Another issue is ensuring that the owners know how the plan will pay out under various performance scenarios. While owners may be concerned that the plan pays out too much under certain circumstances, they need to ensure that awards are meaningful enough to drive executives and key employees to the highest levels of performance and to keep them working for the company.

High-level modeling of performance scenarios and payouts conducted before rollout of an incentive plan can be a good test of the plan’s effectiveness.

Equity or Cash? The Ownership Issue

Equity vs. cash is another key consideration for private companies developing incentive plans. Although private companies, by definition, have no public market for their stock, they can still offer equity-based compensation. The question is, do they want to?

There are pros and cons on both sides of the equation. The pro-equity side focuses on the motivational value of having a direct stake in the company’s fortunes. The pro-cash advocates argue that private company stock is an inconvenient form of pay. “The stock is not going to be liquid,” said Douglas Smith, an attorney with Arnall Golden Gregory LLP in Atlanta. “And the company will have to pay to have a stock valuation done every year.”

Many private companies, particularly family-owned firms into the second or third generation, often already face difficult ownership questions among current shareholders without adding a new group of owners to the mix. “Owners, ownership groups and families often already have issues related to how the company is owned and how that stock is transferred to other family members,” Rollin said. “They do not want to inject nonfamily members into that ownership group by offering stock.”

Although they want to ensure that people have a stake in creating more value for the business, many private companies prefer to do so without stock-based compensation. More than half (51 percent) of the companies in the WorldatWork/Vivient survey relied on long-term cash incentives, while 23 percent offered stock options and 21 percent offered restricted stock.

When relying on cash incentives, companies can reward key contributors with cash payments based on high-level measurements of business value. “If the owners pay only for business value growth, that is a powerful way to draw attention to what needs to be done rather than just paying a cash bonus each year,” Rollin said.

The one situation where equity-based pay usually makes the most sense for a private company is when there is a clear plan and strategy to sell the business in the near future. “Short of an actual sale on the near horizon, employees often don’t want their rewards tied to a stock that requires a distant or not-quite-certain sale to liquidate,” Rollin noted.

Emphasize Total Rewards

Driving business value and motivating stronger performance are the main reasons for offering incentives. These plans are also an important part of a competitive rewards package designed to attract and retain strong talent.

At the same time, private companies, particularly smaller ones, should emphasize the positives that are unique to their own organizations. For example, smaller companies can offer workplace flexibility and emphasize a strong quality of life for employees and executives. For the right people, those elements of the work experience could be more important than stock grants.

Joanne Sammer is a New Jersey-based freelance writer.

Related SHRM Articles:

Employers Award a Wider Variety of Incentive Pay, SHRM Online Compensation, March 2014

Apply Long-Term Incentive Plans at Private Firms, SHRM Online Compensation, August 2013

Designing and Managing Incentive Compensation Programs, SHRM Toolkits, June 2013

Phantom Stock—It's Alive! SHRM Online Compensation, August 2010

Equity Compensation at Private Firms: How to Compete for Executive Talent, SHRM Online Compensation, January 2009

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