Background
For a wide variety of purposes, including business valuation, assessing minority shareholder claims, and the assessment of payroll and income taxes, it is necessary to consider the reasonableness of executive compensation. This is particularly true when the executive is also the controlling person of the business paying the compensation. Valuation analysists do this as part of normalizing historical financial results for applying valuation multiples. Shareholder claims do this to address whether a company is over-(or under-) compensating executives. Tax professionals do this to assert that payments to executives characterized as compensation are not disguised dividends and payroll taxes are being fully paid.
Important considerations
The standard applied in tax cases, but which is also useful in other applications, is the Independent Investor Test. The basic premise is whether an independent owner would compensate the executive the same amount if they took over management of the firm. A hypothetical investor is assumed to insist on efficient management.
Role in the company: Especially with smaller businesses, executives tend to handle the responsibilities of what would be the responsibilities of several executives at a larger company. The importance of the executive in the success of the business needs to be assessed and documented. This includes the services performed by the executive’s experience, position, hours worked, duties performed, results achieved, and whether these factors are appropriate for the compensation received.
Character and condition of the company: This is generally a question of the size and complexity of the business. Executive compensation generally increases with larger companies. This is appropriate: management of companies that are otherwise identical would be more complicated for larger companies. Larger companies have more operations to oversee, more customers and vendors that affect the operations, more employees to manage, and more dynamic conditions that affect the company. However, that increase is generally thought to be logarithmic, not linear. As an example, assume the CEO of Company A is appropriately compensated $500,000. All of things being equal, Company B is ten-times larger than Company A. However, the CEO of Company B would not be appropriately paid $5 million, i.e., time times more than the CEO of Company A.
Non-cash compensation: There is more to an executive’s compensation than their base salary and year-end bonus. Long- and short-term incentives, benefits, and executive perks are also valuable.
How is executive compensation determined?: How the executive’s compensation is calculated is also a worthwhile indication whether executive compensation warrants adjustment. Executive compensation that is (i) formulaic, (ii) explicitly part of an executive’s employment agreement, and (iii) applied consistently across all executives indicates that compensation is handled appropriately. Executive compensation that is handled on an ad hoc basis, seemingly at the whims of whomever is in charge, deserve additional scrutiny.
Location and related cost of living: Executives at a company housed in major urban centers (e.g., New York, Chicago, San Francisco, Los Angeles) will necessarily be compensated more than an otherwise identical company located in a small city that has a lower cost of living.
Sources of Information
The performance of the company should be assessed and benchmarked against others in the same industry. Companies that are performing well can and should be willing and able to compensate the executive leadership that brings such results. As additional (or less) compensation is prospectively paid to the executive, the restated profit results of the employer are again compared to the results achieved by others in that industry. Although a modest base pay will need to be paid regardless of results, a large portion of many executive’s compensation is appropriately based on this type of contingent compensation analysis.
There are multiple data services that provide executive compensation survey data. However, caution is required because this data is based on survey results; there is a lot about the data that is held back or simply unknown. For example, are long-term incentives like stock options included in the compensation data? If so, are the stock options fully vested? How are they valued?
For assessments involving larger companies, publicly traded companies are required to disclose compensation of their top-paid executives. The aspect of comparability between these publicly traded companies and the subject company is paramount. Assuming suitable guideline companies can be found, executive compensation of publicly traded companies is a good source of information.
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