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Private firms get creative: to compete with public companies and their big CEO bonuses, closely held firms need new tools

Private firms get creative: to compete with public companies and their big CEO bonuses, closely held firms need new tools

David Saltman

When Dick Grasso’s $187.5 million compensation package was revealed at the New York Stock Exchange, it triggered an outcry that forced his resignation. But it also struck a delicate chord with the CEOs of privately held companies, who perceive they are not sharing in the same sorts of bonuses and other forms of compensation that their counterparts at publicly traded companies typically receive. “It’s a clear case of bonus envy,” quips Graef S. Crystal, a leading authority on executive compensation.

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Large all-cash salaries have become increasingly hard to justify, even at private companies that don’t have to answer to skeptical shareholders. So CEOs of privately owned companies have gradually become compensated in other ways: required notice, severance, deferred compensation and vesting, as well as long-term incentives, including ingenious variations on stock options when no public stock is available.

Long-term incentives remain the largest component of CEO pay, in private as well as public companies. “If a CEO has 100 percent of salary as a short-term incentive, it would be fairly typical to have 400 percent of salary for the long term.” says Peter Chingos, a leader of the compensation practice at Mercer Consulting in New York.

Many sizable private companies have owners who are willing to pay their executives a lot of money but are reluctant to give them even one share of stock. To do so would mean sharing some of their power. One example, notes Crystal, is Continental Grain, which despite being the world’s largest private company, remains tightly held by its nonexecutive owners.

Another common scenario is a private company whose owners resist taking the business public because they want to preserve ownership for the next generation. Towers Perrin, the global consulting firm, is a case in point, says Crystal, a former vice president and director of the firm. “The argument was,” explains Crystal, “that we inherited the company from the previous generation. And if we went public, the future value would be reflected in the stock price and we’d all get rich, but we’d deprive the next generation. So even though it’s a multimillion-dollar company. it’s still privately held.”

Different But Equal Pay

Nevertheless, many public companies are compensating their CEOs better than ever, creating stiff competition among both public and private concerns in terms of recruitment. “The equity incentives became so big and so powerful in public companies that private companies had to come up with something, whether it’s an extra fancy bonus plan or a synthetic stock plan,” says Crystal. “It’s a difficult thing for these private companies because they have to come up with a way to share the results and for the people to see that at the end of the day you’re doing pretty well or reasonably well compared to your public counterparts.”

That forces private companies to become more creative with their compensation schemes. “We understand what the market values are for certain jobs and our aim is to be as competitive as possible with public companies,” says Jim Porter, senior vice president for human resources at Carlson Cos., the privately held travel services giant in Minneapolis. “I’m talking about total compensation–salary, long-term incentives, bonuses and benefits.”

The pay structure in private companies largely depends on whether the owners are “holders” or “traders.” At multigenerational family-run companies like Carlson, they’re holders, while at venture-funded companies that plan to go public, they’re traders, says Alan Sklover, a New York attorney who specializes in CEO contract negotiations. In contrast to the more conservative approach of family holders, traders are striving “to grab the gold ring,” he says. “They tell the CEO, ‘You’re along for the ride. You make it profitable, and after five years we go public and we’ll all go to the Riviera.'”

The danger of such compensation deals is that, in the end, the CEO never shares in the wealth. Frequently, says Sklover, the backers “concoct cause” after four years and 11 months, and the gold ring slips out of the CEO’s reach at the last moment. The backers simply don’t answer their cell phones when they ring on the beach at Cannes.

Thus the need for risk management when negotiating with trader-owners, Sklover says he had a case like this not long ago in which the founder of a private company was selling it to a venture firm, “It was a rollup, an acquisition on behalf of other investors, where the plan was to go public in five years,” the attorney explains. The owners needed to hold the cash costs down during that time to make the numbers look as attractive as possible to prospective investors. “They offered my client a yearly salary of $225,000, with bonuses limited to 50 percent of the salary but pegged to cash flows and revenue,” Sklover says. “My position was. ‘Hey, if you pay peanuts, you get monkeys.’ But they stood firm. It was, ‘Take it or leave it.’ That’s an example of a company with a short-term focus.”

Such a company may also try to prevent the CEO from collecting any due payments in case of bankruptcy. In Sklover’s example, the company was being restructured so that a limited liability corporation would hold all the assets in trust, the attorney says. The CEO’s contract proposal specified that he would receive no preference; he’d just be a general creditor. With Sklover’s counsel, the CEO negotiated something a little better: The company’s owners agreed to hold his deferred compensation funds in escrow. But they still wouldn’t commit to providing life insurance or long-term disability. Frustrated, Sklover says, he insisted on a clause stipulating that “whatever preferences or opportunities the company’s founder has, my guy gets the same.” That way, the attorney adds, “he’s as protected as possible.”

Sklover cited another current case with 21st-century overtones. “This was a startup company funded by some very big business successes–household names who have built up more than one major company,” he says. “They are involved in a build-out to realize substantial profits in the area of children’s apparel.” Sklover’s client had more than 25 years’ experience in children’s apparel and the investors wanted him to run the company. The company had two stores, and their goal was to build that to 200 stores within five years. They said they had a war chest of about $50 million and would be looking for new financing.

“So what do they offer? They propose that he take a pay cut to $175,000. They won’t commit to a car. No benefits, no bonuses, not even an assistant or secretary. They do offer one thing: a significant chunk of the privately held stock–eight to 10 percent. But they admit that there will be a significant dilution when they’ve sold more stock to second- and third-tier investors. So his 10 percent could turn out to be one-millionth-of-one-percent in the future. When I complain about this arrangement, they say they want to conserve cash for the opening of the stores. And they say to my client. ‘You will become as wealthy as we are.'”

Twice, the prospective CEO walked away from the offer. The deal required moving his family to another city, and to him life insurance and an assistant were musts. When the company finally gave in on those items, the client said ‘yes.’

Why die he agree to the pay cut? “He’s in the same boat as a lot of CEOs today.” Sklover explains. “He’s around 55. He has enough money to cope with whatever life might deal him. He sees this as an opportunity to cap a career, with a reasonable chance of grabbing the brass, or golden, ring and cashing out big time.”

At family-run companies led by holder-owners. it’s another story. The compensation picture is dramatically different. As long as there’s no pressure to sell or go public, cash compensation–salaries and bonuses–tend to be higher, while long-term incentives tend to be lower, says Chingos of Mercer. “Private companies have to distinguish themselves some way, and they tend to say, ‘We’ll pay more cash.'” he says. “They don’t want to dilute the ownership of the business.” Atypical CEO salary offer at such a company might be $500,000 or more, plus certain formula-driven bonuses and long-term incentives.

But there’s tremendous variation in how CEOs are compensated even in private companies with the “holder” mentality, says Carlson’s Porter, who until recently was a senior compensation executive at publicly traded Honeywell. “That would be reflected in bonuses, for instance, anywhere from 50 to 60 percent at the low end all the way up to 100 percent,” he says, “The reason for that variance is that some companies want pay for performance at the highest level so they put more money at risk on an annual basis.”

Paying Whatever It Takes

At the CEO level, large private companies simply have to pay whatever it takes to get quality people. “We need to align ourselves with our peers and we don’t care as much whether our peers are public or private,” says Jeff Lundberg, director of compensation at Carlson. “We’re looking at what the market is. We’re competing for customers and for talent. The compensation strategies need to be aligned with the business strategies.”

One of those strategies–the one that got Grasso in hot water–is deferred compensation. Many companies, private and public, allow executives to defer some percentage of their compensation for tax purposes. One question is how much interest the company should pay on the deferred compensation. Grasso’s guaranteed 8 percent interest helped fuel the outcry, even though it was contractually agreed upon and apparently legal. Deferral plans carry an element of risk: If the company goes bankrupt, for instance, the executive might get nothing at all and 8 percent of nothing is still nothing.

Another unique private company wrinkle is “phantom stock,” a grant of the right to profit from appreciation of the company’s profits or sales, with a fixed exercise date and a formula for calculation. It’s the private owners’ answer to stock options. In many family businesses, all the real stock is held by family members. But for outside-the-family CEOs, many private companies have a form of what Carlson offers top executives, a “legacy plan.” “At a point in time there’s a value determined for the plan and that value is divided by the number of shares outstanding to come up with a per-unit value. We publish that quarterly,” says Lundberg. The phantom stock has a six-year life and a three-year vesting lag. Over the next three years the executives can exercise the “option” to sell in any quarter. The vesting provisions are designed to retain key people, the company says.

Because of the new compensation climate, thanks to the Sarbanes-Oxley Act, experts say that CEO pay at public companies is becoming more like it is at private companies. Stock options, for instance, will have to be expensed by 2005, they predict. That should make competition for top talent between public and private companies more evenly matched. But even so, private-company CEOs will almost certainly keep pressing for greater parity with their public cousins.

RELATED ARTICLE: HOW PHANTOM STOCK WORKS

To provide better compensation for CEOs, privately held companies create an unusual instrument. Here’s how it works:

* CEOs are granted a “right to profit,” based on increases in the company’s revenue or profit.

* These phantom shares have a fixed exercise date and formula for calculation.

* The shares typically have a six-year life and a three-year vesting lag.

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