CompDoctor June 1998

Q: We are reviewing our executive compensation program and want to make sure that we are both competitive in the amount of pay but also in how the total pay is distributed. Can you give us any guidelines to follow? K.N.

CompDoctor: Have you ever heard that if it isn't illegal or fattening that it's OK? No? Neither have I. But it does bring up a point about using guidelines for making pay decisions. Sure there are guidelines that you can follow, but, what is really important is that it makes sense for your business. Since your business is as unique as you are, then it makes sense that if it feels good, and makes sense to you and your employees, then do it. Of course, having said that you don't want to stray too far from the standard.

Before we get to the guidelines, I have to tell you about two conversations that I have had with CEO' s about pay. One CEO headed up a 4,000 person utility. The other, was the CEO of a small, $60 million revenue, high tech firm, that was growing at a fast clip.

The CEO of the utility wanted to conduct an executive pay review and was questioning why we pay what we pay and the manner that we pay them. At each juncture in the conversation about base compensation, bonuses, stock options, retirement packages and perks, he continued to ask why these levels of pay, what makes that the right answer and where did these levels and percentages come from. My answer was that these other organizations have found these answers to be effective and overtime, lots of other companies have followed suit. To which he replied, but that doesn't make it right. To which he was right. Lots of lemmings can fall over th cliff if you simply follow everyone else.

We will leave this one to go to the CEO of the high tech firm. His question was a little different but, nonetheless, outlined the power of market averages and the use of guidelines that you ask about. This CEO was engaging me in a discussion about the most creative compensation plans that I could think of that would drive a new culture and inspire top notch performance. The more we talked the more it became evident that he was also describing a special type of employee that could accept these new compensation approaches. As for creative, we ventured into such areas as: firing everyone and hiring them back as self employed contractors; reducing base pay for everyone to $20,000 and creating a short term bonus plan that paid substantial amounts of money for achieving awe inspringin goals; to a variety of stock options plans and reward programs. In the end, the company did nothing because it was too radical, no one else was doing it and maybe it was just too creative.

The moral of these stories is that its good to know why you are paying what you are paying, but it's a good idea to see what others are doing too.

Which now gets me to the guidelines. I have said before that you can't stray too far from the market averages so one of the first things you need to do is get hold of some good market data for the jobs that you are reviewing. Use proxy data and/or published surveys, and limit your search to other companies in the same industry and about the same revenue size. If you use proxies, you can only get the top five executive salaries. You may need to look at both. In addition, you will find that the average base pay level from the proxies will be higher than from the published surveys. You can be sure the data from the proxies is the most accurate, but, remember that the proxies represent a very narrow look at the market, although it probably represents your industry better than the published surveys.

From these data, you should look at the median, 50th percentile or the average from the proxies of the data collected. These numbers are the best benchmark for you and you will find, at least in the published data, where most of the data are. You can find base and bonus data in both of these sources.

Finally, if you want to find out about stock options, until recently, the only place that you would find out information on these data was from the proxies. In the last two years, there are now some good surveys which try to identify the average pay practices for stock awards.

So, now that you have more information in front of you than you can possibly summarize (that's why many companies call consultants in to help them), is there a short cut? Of course, and here it is: It all depends on the size of your company and the stage of growth that you are in. Assuming you are not mega-corp, you are in the classic growth stage of development, meaning that you have an established business and you are trying to accelerate market share, then here is what I can tell you.

1. Base compensation will be low in relation to the other components of pay and in relation to other growth stages. In addition, it will constitute about 40-50% of the total compensation package, regardless of what that total amount is.

2. Incentive compensation, (a.k.a., annual bonus) will be low, but will be about 20-40% of the base compensation. The percentage of bonus will depend on level of the position, a greater percentage to the CEO than to the VP of Human Resources (ouch!). some companies will want to use the bonus as a real motivator and will boost the percentage, but, that's why it makes sense to design something that makes sense for you, and not follow the guidelines too strictly.

3. Long term is usually stock options or performance units or phantom share plans, depending if you are publicly traded or privately held. These are usually granted every year and the trick with stock options is do you calculate a future value based on the grant date (which will be estimated) or if you simply calculate the current price times the number of shares. The answers will be different, and only an estimate, because the future value will be dependent on the stock market and company performance, which I'll bet you cannot predict with much certainly 5 years down the road. Any way, the standard guidelines are that anywhere from 5% to 15% of the company stock should be allocated to your executive team. This will usually amount to (using a future value estimate) about 1 to 2 times annual base compensation. The typical vesting schedule is 4-5 years, or 20 to 25% per year.

So you say you can't afford such largesse? Which brings me right back to where we started. Pay attention to the market, but do what is right for your business.

We are a new venture and are trying to figure out how to pay our executives. You keep stating that we need to compare our salaries to other companies of our same size and in the same industry, but we have looked everywhere and can't find any data on start ups. How can we feel comfortable with our pay levels? S.M.

CompDoctor: You know, if you keep asking me all these questions, you might find an answer that you can use. So, just to keep you targeted in the right direction, I will give you one of my secret techniques. Now, I would normally charge my clients thousands of dollars for this, but, for you, and all your buddies out there in venture capital land, I'm going to give it to you for the price of a year's subscription to this magazine. For you slow thinkers, that means free. I trust that the advice will be worth much more than that.

You hopefully have a business plan, right? Good. Because if I'm going to give you this secret, I don't want it to fall in the hands of someone that just fell out of a tree and hit all of the branches on the way down. Look in you business plan under the section that is labeled financial projections. Find the columns that are listed 3-5 years out. What are the projected gross revenues in year 3 and in year 5? Hopefully they are greater than they are the day you started. If not, lock the door and take up golf. You will be happier in the end, or find some very deep pockets because this thing is going to lose money for a long time. If you project positive revenue in years 3 through 5, take the average of these years and use this as the size of the company. Then, where you look up data in the published surveys, you should find a revenue range that fits your company. If the development of the company is going to take longer, because you are in the bio-medical field and you may need to go through clinical trials and/or FDA approval, then I would use a revenue number that is close to your projected revenues once the product is approved.

As for bonuses, since there may be no or very little profit, you will have to use milestones as the bonus plan targets. For example, let's assume that you are developing a product and one of the first milestones is development of a prototype. This is the first milestone, and a bonus or a grant of stock options is in order. Then the next milestone is setting up the manufacturing processes. This is milestone two, and deserving of another bonus or stock option award. You get the idea. What happens if the target dates are not met? If they are early, this is probably a good thing and the bonus should be bigger, but if they deliver it late, then the bonus will be smaller in accordance with the degree of delay. Don't forget, that bonuses can go to zero. They are, after all, a reward for meeting the goal. If they didn't do it, don't fall in the habit of paying for effort. There isn't enough money in the world to pay people for trying.

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