April 30, 2007

Executive Compensation

A few months after the end of the fiscal year, publicly traded multichannel businesses are required to share Executive Compensation with the public.

It is always easy to pick on Executive Compensation. There are hundreds of examples of leaders being rewarded, while employees are downsized, or shareholders struggle to receive an adequate return on investment.

Compensation works in different ways, depending upon where an employee stands in a multichannel company.

The vast majority of employees are placed in "salary bands". These bands are determined by competitive reviews of comparable jobs at similar companies. Once an employee is "banded", s/he will earn an annual salary increase that is roughly similar to the increase in the cost of living over the past year. Outstanding performers may earn a bigger increase, employees at the bottom of the salary band may earn a bigger increase.

Executive Compensation is more complex.

Take a CFO at a multichannel company. Her compensation is comprised of at least three components:
  • Annual Salary. Let's say her annual salary is $350,000 per year.
  • Performance Bonus. The bonus is usually based on the company achieving sales and profit objectives. This bonus might vary between 0% and 100% or more of her salary. During an average year, the bonus might be 50% of base salary --- maybe $175,000, paid after the close of the fiscal year.
  • Stock Options. If the business is publicly traded, the employee is granted shares that can be redeemed. The employee might be granted 100,000 shares at a price (say $10 per share). The shares usually vest in increments, so that they are fully vested in four years. After four years, the share price should have hopefully increased enough to please investors. Say the share price, after four years, is $20. This employee could earn in 100,000 * ($20 - $10) = $1,000,000 in four years. The brand may elect to grant new shares each year, at the current price of the shares of stock.
So, the humble Executive can earn maybe $1,000,000 a year, about a third is guaranteed, about twenty percent is variable on annual performance, and close to half is based on market performance.

In a bad year, the CFO earns the base salary of $350,000.

In a good year, the CFO earns $350,000 base salary, $350,000 bonus.

If the business has numerous good years, the CFO can earn $350,000 base salary, $350,000 bonus, and $1,000,000 in stock options.

So, we established that about 2/3 of the Executive's salary is "variable", highly dependent upon company performance.

Now, let's go back to the base salary. Compensation Committees like to review "peer" businesses. In other words, the Compensation Committee will look at the salary of the CFO, and compare it with the salaries of CFOs at major competitors.

Let's assume that company performance is "average", compared with the peer group.

Let's also assume that this CFO is "under-compensated", from a base-salary standpoint, verses CFOs within the peer group. In other words, maybe the average CFO in the peer group earns $420,000.

Here's the situation: You like to pay your leaders at the mid-point of your peer group. Do you increase the salary of the CFO to $420,000 a year, so that your CFO is compensated at a "fair" level, compared with other CFOs?
  • If your answer is "no", why? Do you risk losing your CFO to a peer company that pays a better base salary, and if you do lose your CFO, what is the risk to your company?
  • If your answer is "yes", why? What kind of message do you send to your garden-variety employees, who are earning $50,000 a year, and are struggling to pay bills with their 3%, $1,500 cost-of-living increase? What kind of message do you send to your hourly staff, who are earning $25,000 a year, and are really struggling to pay bills with a 3%, $750 cost-of-living increase?

2 comments:

  1. Anonymous4:37 AM

    Assuming your CFO is a great asset and worth keeping, I'd pay her 420k.

    Rather than make raises based on an emotional level, I feel its important to build a corporate culture that allows the hourly worker opportunities to move to the 50k level, and the 50k level employees an opportunity to move to the 420k level. (opportunities such as education support / on the job training.)

    The CFO's skill set is likely so unique that they command the high salary. Ideally the org could support the C-level and build opportunities for others as well.

    If you're the CFO - what can you do to help the situation?

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  2. Very thought-provoking! I’d like to invite you to republish this entry as a posting on the SRI Open Forum. My firm, Marc J. Lane Investment Management, Inc., hosts the online community bulletin board called The SRI Open Forum (just Google the name to find it) which was built as the central location for the free exchange of ideas and experiences around everything related to socially responsible investing, corporate governance, environmental issues, social enterprise, etc. I invite you to visit the site, and feel free to republish this article as a posting. Hope to see you there!

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