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Executive Compensation in My Investor Controlled Company

Martin Babinec, Founder, President and CEO, TriNet

All entrepreneurs have the dilemma of how much to pay themselves balancing the need to keep financial resources inside the company for fueling growth versus shifting cash out of the company as they reap rewards for their own labors. For closely held companies that evolve to take on outside equity investors, at the point majority ownership passes on to other parties, so goes the final authority for determining compensation of both the entrepreneur and other executives.

As a founding entrepreneur who has been minority shareholder for more than half the life of my nineteen-year old company, my views on handling executive compensation have been shaped by what's worked for our company. One primary strategy I've used is to harness the advantages of working alongside outside investors and non-executive members of the board of directors. That exposure has given me appreciation for the value of looking at executive compensation through the lens of outsiders and realizing that a properly constructed program based on principles of transparency found at public companies has had greater impact on growing the value of our company than I would have likely achieved had I remained the majority shareholder.

Developing Compensation Structure and Process

The higher the percentage of outside shareholder ownership, the more impact external influences such as compensation consultants and non-executive board members will have in defining the structure and process for determining how executives will be compensated. Since my company went through a more gradual transition, the background I share in this article reflects what we learned through a period of several years albeit also influenced by the presence of three public company CEOs on my board.

The basic components of executive compensation include:

  • Cash (base pay and short term incentives)
  • Long term incentives (e.g., deferred compensation and equity incentives); and
  • Perquisites (non cash or deferred compensation benefits not provided to the workforce at large).

Since my firm makes little use of perquisites and the company-specific nature of long-term incentives involves variables beyond the scope of what this article can reasonably cover, my remarks focus on the cash component of executive compensation.

My context is also one of a later stage company that has an established annual operating budget and an independent board of directors that is instrumental in guiding the setting of high-level company goals. Our board not only tracks progress against defined goals but insures a measure of accountability, compliance, and oversight that then cascades down the organization. These same controls are analogous to what you would find in public companies. Private companies that advance to this stage of transparency will increase their value in the eyes of potential outside investors.

Compensation Principles Drive Structure

Here are a few basic principles we adopted that have guided development of our executive team compensation structure:

  • What gets measured gets managed . Our most difficult and evolving task is refining clear measurements for the executives' performance that are specific to their respective roles. Senior executives are held accountable for both company metrics as well as individual performance goals that are defined in advance each year. All team members are also rated on a set of executive skill factors and their actions in support of the company's core values.
  • Compensation levels begin with examining an executive's replacement cost . Since the measurement system puts a spotlight on any non performers (and ultimately drives them out), the starting point for determining overall cash compensation is determining what a company would expect to pay to find a qualified replacement.
  • Compensation plans vary by position and must be defined in advance . Our board's compensation committee is composed of independent directors who develop and/or provide oversight to the compensation plans for each senior executive role. Ultimately, they also make final decisions in regards to the actual distribution of executive compensation rewards.
  • Highest positions carry the greatest compensation risk . All positions inside our company have some level of variable or incentive compensation. We consider 5-10 percent of total compensation to be the minimum range for incentives to have any influence on behavior. The higher the role in the organization, the greater the percentage of total compensation we tie to performance. At the senior executive level, variable compensation ranges is in the 30-50 percent of total cash compensation.
  • Transparency rules. We believe strongly in avoiding situations that could potentially be labeled a "related party transaction." That means no company assets for personal use, no sweetheart deals or loans—in short, the compensation an executive receives is fully outlined in the employment agreement and is restricted to elements made available to the larger team. As compensation decisions get made, we use the additional filter of "How would this look from a disclosure standpoint if we were a public company?" Even though we're still private, as we get closer to public status this is an increasingly useful filter for a variety of corporate-level decisions.

Compensation Process Tied to Annual Financial Cycle

We've chosen to build the executive compensation process around the annual budget and financial reporting cycle. Here are the basic steps in our process:

  • Executive Compensation plan updated annually. A plan document summarizes the overall structure and formula for funding a variable compensation pool from which bonuses will eventually be paid. The compensation committee reviews the plan proposed by the CEO and periodically retains an outside compensation consultant to review the plan and provide independent input to ensure the consistency of overall compensation levels and practices with current market conditions.
  • Annual operating budget includes target bonus compensation . Accruals are made each month based on operating results as compared to the plan. The formula for funding the bonus pool is tied to the budgeted operating income (or other metrics as defined by the plan) and provides guidance on the amount to be accrued into the bonus pool whether overall company performance is at, above, or below the targeted level.
  • Single variable compensation payout after fiscal year close . The distribution of annual bonuses is withheld until the company's annual financial audit confirms the amount of bonus pool funding. The compensation committee then makes the final distributions, ensuring consistency with individual compensation plans while retaining some discretion for allocations achieved for above target performance.

As founder and large minority shareholder, I've found that having an open process with independent directors has actually been better for me than if I had retained the role of final decision maker as majority shareholder. Not only has it helped reduce the built-in conflict of determining how much of the company's resources would be removed for my own compensation, but in keeping true to the principles outlined above, we have been able to maintain a measure of pay competitiveness that has led to our retaining top quality executive talent while steadily increasing the resources being invested for growth.

And if we're doing things right, over time our process is also growing the value of my equity holding. That outcome, while not paying the bills today, is where the true long term payoff for a founder's efforts will be rewarded—something all entrepreneurs should not lose sight of when grappling with the nuances of developing an executive compensation structure for their own companies.

© 2007 Martin Babinec. All rights reserved.

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