While most public companies have formal subcommittees of their boards of directors, we find that many private companies do not. To be fair, public companies are required to have committees such as audit committees in order to ensure compliance with SEC rules, while private companies generally are not subject to similar requirements. That being said, private companies can benefit from boards in a variety of ways, particularly by ensuring that executive compensation plans are not misaligned with long-term shareholder objectives—a problem we frequently encounter.
For example, aside from ordinary perks, executive compensation at private companies is often limited to base salary and an annual cash bonus, which presents at least two possible problems. To start, if annual cash bonuses are too small in proportion to total compensation, those bonuses may not serve as an effective incentive to achieve near-term objectives. Additionally, if compensation plans consist only of variable components that are tied to short-term results, management may not be motivated to take action necessary to increase shareholder value over the long-term—or worse, may take actions that increase short-term results but actually decrease long-term shareholder value. This can be particularly true when members of senior management have no ownership interest in the company, a situation that is fairly common in private companies. These are just two simple examples of how flaws in the design of compensation plans can introduce risk, but there are many more.
The good news is that mitigating this risk doesn’t have to be a daunting exercise. Many private companies have board members who are seasoned professionals with vast experience at a wide range of companies. By leveraging their experience along with readily-available third party resources such as industry benchmarking and best practices, companies can proactively identify risks in existing compensation plans as well as opportunities to better align those plans with shareholder objectives. While introducing new compensation elements may increase long-term cash payouts, I haven’t met many business owners who wouldn’t be happy to pay executives more if those executives generated overall increases in both cash flow and shareholder value.
So if you have a board, consider creating a compensation committee to engage in discussions about plan design, leveraging outside experts when necessary. And if you don’t yet have a board, you may want to consider establishing one…
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