Small companies may claim they treat their people better, but when it comes to designing compensation packages, the real story this year is one missed opportunity after another

All too many of the companies that participated in this year's executive-compensation survey are competing in the job market with executive-compensation packages that are pale imitations of those offered by large corporations. It's a real problem. Those companies, which have sales averaging about $5.2 million and are otherwise quite shrewd when it comes to such financial matters as building sales or boosting profit margins, are passing up fabulous compensation alternatives, many of them subsidized by Uncle Sam in the form of valuable tax deductions. Fifty-six percent of respondents reported that their payroll costs had placed an increasingly large burden on operating expenses during the past two years. But instead of looking for ways to reduce that burden through noncash compensation and tax-advantage benefits, they continued to focus on salary and bonus as the keys to recruiting executives. That's a dangerous game, since it pits fast-growing companies that are often strapped for capital against larger, better-heeled competitors. A quick look at the survey results shows an unfortunate tendency toward quick-gratification, cash-intensive benefits. Sixty-one percent of the survey respondents gave their chief manufacturing officers a company car -- and even more did likewise for their chief operating officers and chief sales officers. But only 19% gave their manufacturing executives the opportunity to delay taxes and save for retirement through any form of deferred compensation. And a paltry 5% opted for such incentives as phantom stock or restricted stock for their executives.

And the beat goes on. Seventy-nine percent or more relied on cash bonuses to retain top operating, manufacturing, financial, sales, and marketing executives, despite the fact that bonuses drain working capital and as outright gifts do nothing to tie valuable people to companies over the long term. Meanwhile, just 35% used profit-sharing plans, which can be combined with vesting programs to reduce executives' tax bills and virtually guarantee executive longevity.

What's the problem? In large part it's that many compensation and benefits strategies are simply more complex than straight cash rewards are. Anita Carlson, president and CEO of Five-O Advertising Inc., a $1-million Portland, Ore., business, is a good example of a company owner who is frustrated by the difficulties involved in setting up a creative benefits program. She plans to retire in eight years and has been trying to figure out a way to prepare her executives to buy out the business then, perhaps through an employee stock purchase plan (a benefit offered by only 6% of the companies surveyed). So far she hasn't been able to settle on a strategy that will meet her needs. "I've been reading books and talking to consultants, but everything's geared to large corporations," says Carlson. "Nothing really seems right for our size company at our stage of development."

Many complain about bad experiences with overpriced, underproductive consultants. "We paid a consultant $24,000 to do a compensation study and wound up learning less than we already knew from reading the want ads in our Sunday newspaper," says George Hatfield, CEO of $35-million Hatfield & Co., of Mesquite, Tex., which distributes instrumentation, piping specialties, and filtration systems.

No wonder so many owner-managers of growing companies believe they must develop their own executive-compensation strategies. William Reidy is chairman and CEO of Fine Organics Corp., an $8.2-million specialty-chemical manufacturer located in Lodi, N.J., one of the 2% of businesses surveyed that offer phantom stock to executives. (Phantom stock is a contractual promise to pay key employees a sum equal to the rise in value of a hypothetical amount of company stock, usually over a specified time period.) "We had to reinvent the wheel when we set it up," he recalls. "We had a plan from a consultant that was so convoluted we wound up taking the concept and developing our own simplified version."

The trouble is that if entrepreneurs are forced to come up with their own executive-compensation strategies, they often wind up drawing on what they already know -- rather than using some of the state-of-the-art strategies that can actually be tailored to their own particular needs. Sometimes that can produce exciting results, but more often than not CEOs remain either dissatisfied with what they've done or uncertain about what to try next.

"I wanted to treat my employees like owners and have them make decisions as if this were their own company, so I set up a phantom stock program," confides Larry Baum, president and chief executive of $2-million Computing Center, of Ithaca, N.Y. "But every member of my experimental group left, including the chief operating officer and the vice-president of sales. Maybe it was the wrong idea. Maybe it was the wrong people. I'm back to square one."

George Hatfield's greatest frustration is the tremendous limits he sees in finding ways to keep himself, his partner, and other key executives happy on the compensation front. "The federal government has eliminated everything besides the 401(k) plan, and look how much they've cut back on that," he complains. "Being able to put away $7,000 or so a year in retirement savings just doesn't add up to much for me or my executives. And there simply aren't any other options."

The good news is, Hatfield is wrong. There are plenty of cost-effective ways to keep executives loyal and productive over the long term -- in many cases while producing bottom-line benefits. (See "The Executive-Compensation Strategist," below.)

The bad news is, it takes some self-education, on the part of CEOs and their management teams, to learn about the universe of compensation options. But with 75% of the companies surveyed this year confident that their sales will rise during the course of the year -- and nearly as many (66%) projecting that their profits will increase -- there has never been a better time to start.

-- Research assistance was provided by Anne Murphy.


Six opportunities you may be missing out on

There are plenty of cost-effective ways to keep executives loyal and productive over the long term. Some you should consider:

* 401(k)s. These plans allow employees to defer part of their salaries and make withdrawals at age 59/ without penalty, thereby earning current tax deductions and tax-deferred interest on retirement savings. There are ways to enhance 401(k) options: Robert Funk of Express Services Temporary & Permanent Personnel, in Oklahoma City, set up a two-tier 401(k) plan that's open to all employees but provides corporate matching funds to department managers and directors at a higher percentage.

* Phantom stock. For owners who want to share the rewards of their companies' growth without creating a class of minority shareholders, here's an alternative. Phantom stock mimics the performance of real stock, since there is a contractual agreement for the company to pay key employees at specified intervals for any increases in the company's market value. Employees often prefer this to outright stock gifts, because there's no income-tax liability when the phantom stock contract is signed. Employees are taxed only when payments occur.

* Restricted stock awards. If your executives want to own stock, this is a way to minimize your company's risks. Restricted stock awards come with plenty of strings attached. Executives gain full ownership after a vesting period and can sell their shares back to the company only at specified intervals.

* Incentive stock options. Under the right conditions -- such as in a company that plans to go public -- ISOs are a good incentive. They give executives the right to buy stock at a discounted price at some specified future date. The executives expect that ultimately they will be able to sell their shares at a profit.

* Secular trusts. A secular trust provides one way to hold payments in a deferred-compensation plan. Companies can use secular trusts to set aside large sums for their executives' future needs and ideally tie executives to them over the long term. The trusts provide companies with an immediate tax deduction, but executives must pay current taxes on the money that goes into the trusts, which is certainly a disadvantage from their standpoint. But for people working for cash-strapped businesses, there's an advantage: since secular trust funds are segregated from working capital, employees' deferred compensation is secure.

* Rabbi trusts. If your company doesn't need an immediate tax deduction, these provide a vehicle for setting deferred-compensation funds aside so executives pay taxes only when funds are distributed -- at which point the company finally gets to record its tax deduction.