What are you worth?

Melanie stern is section editor of Families in Business.

To stay ahead of the game, businesses need to recruit and retain top-quality staff at all levels – but especially at the top – so incentives and rewards are key. Melanie Stern examines the changes ahead in executive compensation for non-family CEOs

Much has been made of the compensation packages awarded to today's top executives, with pay packets expanding faster than the waistlines of most well-dined CEOs – all too often, while their companies underperform.

Oddly, family companies tend to escape this criticism, perhaps because, even if they are publicly-held, they are still seen as private entities with the right to operate beyond accepted best practice or even rule. And then, there are family businesses that seem to do well year to year, causing their shareholders few problems, led by family chief executives, such as Constellation Brands, the US drinks giant whose second-generation CEO Richard Sands has produced an annualised return on shareholder's investment of 21% over his 12-year tenure to date – and after securing his company's acquisition of family-owned Robert Mondavi wineries last Autumn, is now spearheading a $1.2 billion hostile bid for Canadian rival, Vincor. Sands' contribution to Constellation's growth and shareholder value belies his basic wage – £468,830 with a £465,197 bonus last year – although the family owns around 88% of the stock in the NYSE-listed company.

 But increasingly, family companies whose shareholders include the public markets as well as flesh and blood are responding to the trend towards professionalisation by loading their boards with outsiders, selecting non-family chief executives, and balancing compensation with performance. Additionally, some powerful investor groups have made it clear that they will not go on accepting a situation in which shareholders lose money or miss out altogether on dividends while chief executives enjoy multi-million dollar rewards whatever their performance.
 
Last November, the California Public Employees' Retirement System (CalPERS) said it would go after companies and individual compensation committee directors that advocated 'egregious' executive compensation packages, citing Business Week figures published in 2003 that found the average US CEO salary had grown 535 times the salary of an average worker, from just 40 times in 1980. In 2003, CEO median cash pay – base salary and bonus – was up 14% to about $2 million from $1.74 million, according to a study by research outfit Euilar, citing constituents of the S&P500 index.

Still, while it has been exposed and to some extent tackled, the explosion in exorbitant executive pay packages is in some ways self-perpetuating. The increase in high-profile corporate blow-ups and fraud exposés makes leading a company an ever more risky and thankless task, factors that push up compensation expectations – not unlike the way insurance premiums build. Those approached by family businesses to take the chief executive job will be mindful of the additional issues they may come up against, such as family scions finding it hard to hand over full responsibility and control, difficulty with making power-sharing agreements really work, and the politics of family employees not pulling their weight. They will also likely wonder how they can fully reap the rewards of their efforts in both financial and non-financial terms if they have no opportunity for actual ownership of the company. Finally, many non-listed family companies will only be considering an outsider for the top job if the company has not been performing well, and could be looking for a white knight – another factor that will push up CEO premiums.

But as business success only becomes harder, companies are in ever greater need of the finest corporate talent, and being able to attract it is simply a paramount issue. What to do?

"For private company owners, attracting and retaining top talent to help run their companies is a continuing challenge – they face it when they have been unsuccessful in hiring a top executive who just could not pass up stock options from a public company, or when they lose a valued executive who was lured away by options and other public company benefits. Compensation approaches that are highly motivational – in other words, deeply aligned with company performance – may provide little in the way of retention," says Pete Collins, survey director of PWC's North American Private Company service unit. "On the other hand, approaches designed for strong retention, usually premium pay levels relative to the competitive market, may not provide sufficient incentives to drive business results and could end in substantial costs to the company owners."

Family businesses need to focus on addressing the question of how much their pay programs need to be competitive with both its private and publicly-quoted rivals to impact its chances of attracting and retaining key talent. Aligning a non-family CEO with family owners can also send a psychological signal to the former that they are valued by the latter as equals, laying the foundations for a strong owner-manager relationship.

Phantom stock is one way non-listed family businesses more frequently compensate their non-family executives, and demonstrate efforts towards giving key employees some equity in the rewards their companies gain from their work. Structured as an agreement between the company and the executive, phantom stock represents financial compensation based on the growth of the company, mirroring dividend payouts, and can be used as one or all of the three typical forms of compensation – base salary, annual incentive packages, and long-term compensation, which incentivises people to resist the temptations of headhunting approaches from rivals. Additionally, this option satisfies the expectation of stock options while preserving family control of the company in actuality. "Clearly, awarding stock options is an adverse development for entrepreneurs who do not want to give up control," says Genus Resources' Harvey Widger, who also founded private company compensation advisory the Fulcrum Group. "Everyone knows someone who has benefited from stock options, and everyone wants a piece of the company from day one. Armed with this tool, private companies regain recruiting clout based on their inherent advantages, which include stability, flexibility, and lack of bureaucracy."

As a private company has no formal market value, phantom stock is evaluated by the company itself, often by retaining a professional audit company or valuation firm who structure the right valuation method for the company, and determine the final value of a company share. Phantom stock is usually awarded as a three to five-year compensation plan, and is settled in cash – avoiding any dilution of family ownership. Additionally, US law allows the company to count the award as tax deductible for income recognised by the executive, who has not had to invest in the company in the first place. Listed family businesses can much more easily award stock options to their non-family executives – Wal-Mart president and CEO Lee Scott owned a little over 845,000 shares in the Walton family supermarket giant in mid-August this year, according to Yahoo Finance, though their value has dropped some 22% since his appointment.
 
Scott's position is exemplary of the reasons why, although a long-standing compensation staple, stock option awards to CEOs are actually in decline. As shareholders become tired of hearing about failing dividends at the same time as reading about the exorbitant pay of executives driving those dividends – and the various corporate scandals including those at family firms like Parmalat, Rite Aid or Adelphia – corporations are re-evaluating whether they should award equity to their chief executives. Additionally, the advent of the US' Financial Accounting Standards Board's new accounting rules have had a knock-on effect to the award of stock options to CEOs, requiring the expensing of stock options – still a controversial decision in the eyes of many – and making it harder for entrepreneurial companies, and listed family companies to take this route without incurring hefty expenditure. As a result, many companies awarding stock options are either awarding less, or using restricted types of stock.
 
According to Mercer Human Resources consulting, the number of CEOs receiving stock option grants dropped from 278 in 2003 to 273 in 2004, while the number of CEOs receiving restricted stock grants rose from 138 in 2003 to 166 in 2004. Additionally, the use of stock options within CEO compensation packages at the US' 350 largest public companies in 2005 declined from 76% of Long-Term Incentive (LTI) value in 2002 to 57% in 2004, though restricted stock rose from 12% to 23% of LTI value. Meanwhile, long-term performance shares rose from 12% to 20% of LTI value over that same period.
 
The days of CEOs being able to turn in poor performance and retain multi-million pay packets, and fat equity stakes, are grinding to a halt. "Management and corporate boards have heard and responded to the calls for change in executive compensation," says Peter Chingos, a senior executive compensation consultant for Mercer in New Yok.  "For the last few years, we've seen boards revising compensation programs, adopting new performance metrics, and enacting tougher performance standards – all designed to strengthen the connection between executive pay and company performance. Now, we're seeing the results of these efforts."