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Article | Executive Pay Memo North America

Applying Overarching and Operating Principles in Nonpublic Companies

Executive Compensation

By Don Delves and Scott Hippen | October 10, 2019

Creating the right compensation system in family-owned businesses requires a deep understanding of purpose and a delicate approach.

Creating the right compensation systems in nonpublic, family-owned businesses requires a deep understanding of the owners’ evolving business purpose, mission, vision, strategy and objectives. That isn’t to say, though, that the guiding principles that have been covered so far can’t be applied; rather, their application necessitates a delicate approach that helps companies overcome purpose-related challenges.

Before diving in, it’s important to understand what specifically makes nonpublic companies different. Regardless of whether it’s a founder-run organization, a family business owned by family shareholders or an employee stock ownership plan company that is owned by employees, there are certain traits that make nonpublic businesses distinct. Consider:

  • There is a “personal” factor” that makes it easier to understand why closely held companies are in business. You can ask owners about their short- and long-term aspirations and, again, how they connect to the business’s purpose, mission, vision, strategy and objectives. Any themes identified from these queries should be built into the compensation systems’ design.
  • Closely held companies have fewer inherent mandates for size, profitability, growth or other variables, which gives owners latitude to pursue distinct goals.
  • Oftentimes, nonpublic companies have a longer time horizon than their public counterparts, partly because they aren’t subject to scrutiny for short-term results.
  • Because closely held companies may not be able to offer stock-based, long-term incentive plans as easily as public companies, questions arise related to the objectives, form (stock or cash), dilution, voting rights, dividends, valuation and monetization associated with LTIs.
  • Many nonpublic companies face buyouts, intergenerational transfers or other shifts in ownership, resulting in new interests, orientations and objectives that will influence the design of compensation systems.

In Chapter 6 of Executive Compensation “Guiding Principles" , we address the case of Three Pillars Corp., a fictitious company based on a compilation of actual companies and situations that had appointed its first nonfamily CEO and charged him with revitalizing the company’s core business lines after a global recession.

Like so many nonpublic companies, Three Pillars Corp. had to address multiple issues related to defining and realizing the company’s evolving purpose. The owners’ stated purpose reflected an inherent conflict: the family’s desire for greater returns to realize its lifestyle- and community-related objectives while at the same time reinvesting significantly in core brands.

At the end of the day, the owners were able to implement a compromise that would honor the spirit and legacy of its brands while updating them in a meaningful way to boost their long-term value. This solution relied heavily on several operating principles that supported compensation-related decision making.

The overarching principle of purpose plays a critical role related to all aspects of the business, including incentive systems. Many closely held companies embrace a purpose that may include nonfinancial objectives, as was the evident in the case study. Again, this guided the development of incentive systems.

The importance of alignment also surfaced. This principle played a critical role in ensuring the interests of management (as related to purpose) aligns with those of the owners’ interests. In the case of Three Pillars Corp., these interests included both the owners’ goals and objectives as well as the related time horizon.

Also, engagement and retention are particularly challenging in closely held businesses because nonpublic companies have a longer-term focus, often retain talent longer than public companies and use incentive tools that are less liquid than publicly traded stock. Because of this, Three Pillars Corp. learned that LTIs and equity or equity-like vehicles had to be designed carefully.

Ultimately, perhaps the biggest lesson learned is that trying to fit a public company solution into a private company framework could be a mistake. It is critical that the board, top management, human resources and any consulting partners understand, articulate, define and measure the interests of owners. These groups also know that this depth of understanding may require a significant amount of discussion and consensus building.

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