There is much publicity about Executive compensation. It’s understandable when last year’s top CEO’s of the Fortune 500 received an average compensation of $5.1M each with 60% of the total compensation tied to stock grants and exercised shares. The market has been on a tear with the S&P 500 seeing annualized 3 – year returns of 17%. 2013 rewarded the Dow Jones Industrial Average with its’ best year since 1998 while the Nasdaq surged 38%. These market results fueled an aggregate compensation increase of over 15% for the CEO’s of the largest companies.
How Does Private CEO Compensation Compare to Public Markets?
With 99.7% of all businesses having fewer than 500 employees, how does the privately held company owner/CEO compensation stack up? Do the compensation packages of our privately held company leaders mirror the headlines of the top 1% of CEO’s in the public markets?
Working predominantly with privately held business owners with revenues between $3M and $75M, we can attest that the majority of business Owners/CEO’s are not paid “fairly”. The reality is that many of these owner’s could often make more money, with less personal risk, working for someone else. Fueled by their passion, optimism, perseverance, and desire to grow, many owners defer their financial gratification in favor of legacy creation, a future sale, or in their overriding passion to innovate markets.
Why Privately Held CEOs Underpay Themselves
In the small and middle markets, the average owner has 85% of their asset base locked inside of their business, reinvesting excess earnings back into the business to fuel growth. Contrary to popular belief, we find most owners don’t pay themselves enough for the value they bring to their business. When asked, most owners cite:
Common Reasons for Underpaying
I’m essentially the bank so why borrow from myself?
My employees won’t like my success.
I need the excess capital to reinvest in my growth.
My business is my largest asset and I want to keep my money in it.
I cannot afford to pay myself more.
The Risks of Underpaying Yourself as a Business Owner
While these are understandable objections, keeping 85% or more of your asset base locked inside your business and not establishing an equitable compensation plan creates a host of unintended future consequences. As a closely held business owner ask yourself:
How Underpaying Affects Business Valuation
When you go to sell your company, what will it cost to run the business when you aren’t in the equation? If you systematically understate your compensation you are artificially enhancing earnings. A reasonable buyer will quickly uncover your actual value, knowledge, and time commitment and deeply discount the valuation based upon a fair appraisal of the cost to replace you (often with multiple people).
Is your business strong enough to pay you a fair market salary and bonus program while achieving an acceptable level of profit? If it isn't, what real organizational fundamentals are you not addressing? Have you become a “human doing” by working longer hours to mask the inefficiency and non-accountability that surrounds you?
Impact on Organizational Culture
What example are you setting for the organization when you don’t pay yourself for performance? What is the cultural tone you establish when you don’t insist on creating a “meritocracy” where employees (including you) are rewarded for their performance?
Why are you afraid of “success”? Do you perceive that your employees would rather be led by someone without fiscal discipline, asset diversification, or personal accountability? Would your employees really prefer to see their leader drive to work in a 1995 Dodge Neon with $100 in your checking account?
Establishing a Balanced CEO Compensation Plan
So where do you start? How do you arrive at a formula that establishes an appropriate balance of personal compensation and business capitalization? Below are a handful of things to consider when arriving at a balanced compensation design:
Steps to Determine Fair Market Wage
Establish the fair market wage for the role you play in the organization. Determine a reasonable formula to compute the base and bonus for your role.
Recast your annual budget with your new comp plan. What does the impact of this compensation plan have on expected profit? What can be addressed in your sales and business operations to achieve the appropriate level of profit while honoring your new compensation plan?
Financial Guidelines for CEO Compensation
To ensure you retain appropriate capitalization, you might consider establishing guidelines that must be achieved prior to bonus payouts by asking:
Do you have a minimum of 115% of your rolling 6-month average monthly SG&A expenses in your operating account?
Have you funded your up-to-date expected tax liability in a segregated account (outside of your operating account)?
Have you accumulated a minimum of 2% of expected annualized sales in a liquid reserve account?
Have you attained a current ratio of at least 1.5 as of the most recent balance sheet?
After 3-6 have been satisfied, are you taking x% of retained earnings each quarter as distributions and utilizing them to diversify your asset base?
Creating a Performance Culture with Fair CEO Compensation
Establishing these guidelines for yourself and your business will facilitate greater accountability, transparency, and create a deliberate path to achieve balanced growth. Closely held owners that do not address their own compensation have lower employee accountability, increased operational costs, higher turnover, higher customer churn, lower quality, and a culture of non-performance.
Leadership begins at the top. The example you establish and consistently model will provide the framework for your organizational culture. If you want your employees to start “acting like owners” make certain that your current compensation structure and behavior is something that is worthy of replication.
Contact us at info@flvcp.com for more information on how to create a performance culture and develop transferrable value in your closely held business.
