Executive compensation has become a controversial topic attracting significant public attention ever since the gap between company executive officers’ compensation and that of average employees started to widen exponentially in the 1980s. The financial crisis of 2008 further widened the chasm when many employees walked out of crumbling businesses with cardboard boxes while their executive officers jumped out with golden parachutes. Responding to public opinion, regulators continue to implement and modify disclosure requirements regarding executive compensation, such as provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”).
Understanding the common practices related to executive compensation is important for companies seeking an IPO, as the elements of the compensation package may greatly influence management performance, talent attraction, tax implication, analyst perception, and public image. Regulators require public companies to disclose executive officers’ compensation in various forms with high transparency; thus, companies should design their compensation packages with strategy and vision since these will be subject to scrutiny by potential investors and analysts.
This article gives a high-level overview of executive compensation, including common types of compensation and required disclosures for public companies.
Named Executive Officers
Generally, an executive officer in a company is a person responsible for running an organization or a principal business unit; this may include the C-suite officers, presidents, VPs, and principals. Specifically, “named executive officers,” or those for whom full compensation disclosure is required under federal law, include the following:
- Principal executive officer
- Principal financial officer
- Three next most highly compensated executive officers
- Up to two former executives who served as executive officers during any part of the last fiscal year, if the total compensation would have made that executive one of the three most highly compensated executive officers for the last fiscal year
Companies preparing an IPO should understand that they will need to disclose executive compensation in registration statements (e.g., form S-1), annual financial statements (e.g., form 10-K), and proxy statements. Note that the JOBS Act does provide some relief to the required compensation disclosures (see “Special Considerations for Emerging Growth Companies” section below). In practice, proxy statements usually give the most thorough disclosure, and other filings often refer readers to find detailed executive compensation disclosures in the proxy statements.
Executive Compensation Package
An executive’s compensation package is usually determined by the board of directors and includes a plethora of incentives and benefits, ranging from old-fashioned salary to executive jets. An overarching principal of corporate governance is that the compensation package should align the goals of the executives and the corporation. Poor design of incentives may lead management to become single-minded, less adaptable, less willing to learn, or tolerant of unethical behavior.
The following paragraphs introduce several common types of executive compensation. Note that some of these compensation types require complex accounting, human resource, and tax knowledge and execution. Many companies rely on outside specialists such as executive insurance firms or executive compensation consulting firms to properly design and implement these benefits.
Salary or base pay is perhaps the most common type of compensation, indicating a base-line reward and is often categorized as a short-term incentive. Though straight-forward and easily accounted for on financial statements, salary is often less than a quarter of executives’ total compensation for most public companies. This may be due to the IRS’s additional taxation of “excessive compensation1” and the fact that salary is not a performance-based compensation.
Bonuses without specific targets or goals may just be another form of salary that does not encourage smarter and better business decisions. However, bonuses associated with specific conditions or goals can stimulate better management performance. Traditionally, specified financial indicators, such as return on assets or revenue growth, serve as metrics to gauge performance. Though bonuses may directly encourage performance, management may temporarily balloon the targeted indicators at the expense of long-term growth. To mitigate this risk, sophisticated bonus plans may incorporate multiple financial indicators to evaluate management performance, set longer term goals, or penalize deficient performance.
Equity compensation or equity grants are non-cash compensation that represent ownership in the company and can be in many different forms such as stock options, restricted stock, performance shares, and stock appreciation rights.
Equity compensation has many advantages, including the following:
- Startups that have limited positive cash flow often choose to compensate employees with equity to conserve cash.
- The value of equity compensation often ties directly to company performance which aligns employee incentives and company interests.
- Most forms of equity compensation have an underlying “vesting period”—a set amount of time required for the grant to appreciate or be exercisable—which encourages employee retention.
Of course, equity compensation has drawbacks, including the following:
- Equity securities are always more complicated than cash, therefore requiring more accounting, tax, human resource, and legal expertise.
- Companies using equity grants risk giving too much ownership away.
- Research indicates that some types of equity grants (e.g., stock options) may encourage risky behavior from management.
Supplemental Executive Retirement Plan
Supplemental Executive Retirement Plan (“SERP”) in simple terms is a 401(k) for executives. Designated as a non-qualified retirement plan2 for key employees, SERPs are usually funded by life insurance plans or company cash flows. SERPs provide much higher payouts than 401(K)s to executives upon their retirement, enabling an executive to continue funding his or her lifestyle as long as the executive met the agreed upon conditions.
A severance package is the benefits and compensation paid to an employee upon termination of employment. A severance package may include any benefits described above and more, and traditionally serves as a “thank-you payment” and a method to prevent potential lawsuits against former employers. Severance packages for executives have different titles based on the scenario. A golden parachute refers to the valuable severance package paid to an executive in the case of a merger or takeover. A golden handshake refers to the severance package paid to an executive upon being fired, company restructuring, and even scheduled retirement. A golden umbrella usually refers to the severance package for a startup executive because it protects the executive from the risks of starting the company. A golden boot refers to the financial inducement to encourage an old executive to take voluntary early retirement.
Executive Benefits and Perks
Most employees enjoy different benefits, such as meal plans, parking reimbursements, gym memberships, and other fringe benefits. However, to attract and retain leadership, companies often provide lavish and even creative benefits for executives. Below are some examples of executive benefits and perks:
- Club memberships
- Corporate aircrafts
- Corporate vehicles
- Lavish corporate apartments
- Professional services (e.g., tax preparation and wealth management)
- Wardrobe allowances
- Security services
- Charitable contributions in the names of executives
- Office space
- Health care
- Life insurance for the executive
- Directors and officers liability insurance (“D&O insurance”)
- Executive disability insurance (“EDI”)
- Event tickets
- Corporate loans
- Relocation reimbursement/compensation
Required Disclosure Items
Businesses should ensure that executive compensation is prepared by qualified personnel and disclosed according to guidance in registration forms, annual financial statements, and proxy statements. Companies may also consider hiring professional legal or accounting firms to help prepare the required disclosures.
The two main sections of executive compensation disclosure are the Compensation Discussion and Analysis (“CD&A”) and the Executive Compensation Tables. Below is a brief introduction to both.
Compensation Discussion and Analysis
Similar to Management Discussion and Analysis (“MD&A”) found in financial statements, CD&A, according to the SEC, “provides narrative disclosure explaining all material elements of the company’s executive compensation programs.” Ultimately, the purpose of CD&A is to use plain language to elaborate on the following topics:
- The objectives of the company’s compensation programs
- The compensation program and what is intended to be rewarded
- The elements of composition and the reason for the weight given to each element
- The method or formula to determine the amount of each element rewarded
- Each element’s fit with company objectives
- Consideration and influence of shareholder advisory vote on executive compensation3
- The role of the compensation consultant
- The role of peer companies and benchmarking
- Shareholder feedback and shareholder outreach
- Relationship between compensation practices and corporate performance
Executives Compensation Tables
The Executives Compensation Tables present an overview of named executives’ compensation and schedules in table and narrative format, giving comparable numbers of compensation elements and amounts rewarded. According to the SEC, the “cornerstone” of this section is the Summary Compensation Table, which “sets out the total compensation paid to the company’s [named executive officers] for the past three fiscal years.”
Other tables and discussions following the Summary Compensation Table include information on grants of stock options and stock appreciation rights, long-term incentive plan awards, pension plans, pay ratio disclosure, and other employment-related contracts and arrangements.
The pay ratio disclosure is a new provision from Dodd-Frank adopted by the SEC. Starting in 2017, companies are required to disclose the ratio of the compensation of its CEO to the median compensation of its employees. For instance, Honeywell’s March 2018 proxy statement includes the following:
For 2017, our last completed fiscal year, the annual total compensation of the employee identified at median of our company (other than our CEO) was $50,296; and the annual total compensation of the CEO for the purposes of determining the CEO Pay Ratio was $16,753,438. Based on this information, for 2017, the ratio of the annual total compensation of Mr. Adamczyk, our Chief Executive Officer, to the median of the annual total compensation of all employees was estimated to be 333 to 1.
Without discussing the detailed instructions on the presentation requirements for Executive Compensation Tables, it suffices to say that this one-stop location discloses just about every type of compensation paid to the named executives, including cash compensation, equity awards, non-equity incentive plans, pension values, nonqualified deferred compensation earnings, and all other compensation. No element of a named executive’s compensation package, no matter how creative or obscure in nature, can be excluded from disclosure for most public companies.
Special Consideration for Emerging Growth Companies
Under provisions of the JOBS Act, companies qualified as Emerging Growth Companies (“EGCs”) are eligible for less stringent disclosure rules. For example, EGC’s are not required to present CD&A, compensation committee report, and pay ratio. For the still-required disclosures like the Summary Compensation Table, the JOBS Act brings relief to the depth of disclosure requirements. For example, EGCs may only disclose the compensation for a minimum of three top executives (instead of five) for the two most recent fiscal years (instead of three).
To understand other provisions of the JOBS Act, please see our article The Jobs Act.
Executive compensation packages typically involve a variety of elements. Those charged with governance should strategically design the package to align executive’s goals with corporate objectives; consider how the potential investors, analysts, and the public would perceive the package; and, through benchmarking, compare what other companies of a similar size or industry are doing regarding executive compensation. Also, as regulators continue to modify disclosure requirements on executive compensation, businesses should select capable and qualified personnel to prepare compliant and transparent reports.
- Donnelley Financial Solutions: Executive Compensation Disclosure Handbook
- Forbes: Who Really Determines CEO Salary Packages?
- Investopedia: A Guide to CEO Compensation
- SEC’s Fast Answers on Executive Compensation
- SEC’s Press Release on Pay Ratio Disclosure
- SEC’s Press Release on Say-on-Pay and Golden Parachute
- SEC Regulation S-K, Item 402 – Executive Compensation Text
- Society for Human Resource Management: Designing Compensation Plans
- Generally, employers may deduct reasonable compensation (i.e., salary) as a necessary and ordinary business expense, with the threshold of $1 million per covered employee. Any amount over $1 million is not tax deductible except for performance-based compensation such as stock options. However, the Tax Cuts and Jobs Act signed on December 22, 2017 eliminates this exception, subjecting performance-based compensation to the $1 million threshold.
- A non-qualified plan is a type of tax-deferred, employer-sponsored retirement plan that falls outside of The Employee Retirement Income Security Act guidelines. Non-qualified plans are designed to meet specialized retirement needs for key executives and other select employees.
- Shareholder advisory vote on executive compensation is part of the provision of Dodd-Frank adopted by the SEC. Starting in 2011, public companies are required to conduct a say-on-pay voting at least once every three years, a say-on-frequency voting at least once every six years, and a say-on-golden parachute voting when the shareholders are voting to approve a merger, acquisition, consolidation, or disposition. These votes are only to be conducted during annual shareholders’ meetings at which directors will be elected. Though the results are advisory in nature, they are to be disclosed in the proxy statements.