CEO Compensation: The ABCs of Paying Yourself
What matters most, which mistakes to avoid, and where to turn for advice
H ow Do You Decide What's Important?
In a survey of past Inc . 500 companies we asked chief executives some specific questions about the considerations that went into their compensation decisions. (See chart, below.) CEOs also told us what their greatest concerns were as they contemplated how much money to take out of their companies this year. A founder of a high-tech start-up, for example, tosses and turns over "how much to allocate to research and development in relation to market saturation." Similarly, the captain of a cash-starved business is obsessed with "meeting debt-to-equity ratios and other financial tests used by lenders to extend credit." Some CEOs have precise formulas for calibrating salary increases ("one-half the increase in sales, plus 5% of pretax profits"); others are more scattershot ("what the company can afford and remain competitive").
Yet the primary concerns that creep into the decision-making process are universal. They have everything to do with "company needs," which boil down to cash flow and profitability -- present and future. "We focus on the profit-and-loss performance to improve the company's value," says one CEO, "and we need adequate cash to expand the executive management team to take us to the next tier." And still another says he leaves "a substantial cushion in case of a downturn."
So maybe we shouldn't be surprised that only 17% of those who responded to our survey indicated that lifestyle choices are very important to their pay decisions. What's good for the company is apparently good for the CEO. "As the company grows, my personal wealth grows faster than it would if I took money, paid taxes, and invested it elsewhere," explains one CEO. "Company stability is more important to me now than personal convenience or luxury. I can't talk to my people about keeping costs down to compete if I drive a BMW."
Take a look at the responses, below:* * *
What Influences CEOs' Compensation Decisions
To arrive at my total compensation, I am influenced by --
important Important important
Company's needs 80% 15% 1%
Increasing my net worth 33% 33% 20%
Lifestyle choices 17% 47% 29%
Employees' perceptions 13% 48% 30%
Industry norms 11% 34% 47%
If You Want Advice, Where Do You Go?
Half the CEOs we surveyed look only to themselves for guidance about how much to take out of and how much to leave in their companies. As for the sources tapped by the other half, boards, accountants, and published surveys rank highest, closely followed by trade-association data. As advice givers, spouses just beat out compensation experts.
CEOs we talked with also supplement national salary surveys conducted by accounting firms, trade associations, and compensation specialists with regional, state, and even city surveys conducted by departments of employment, private-industry groups, chambers of commerce, and associations of human-resources professionals. Following are some of the paths CEOs have taken to come up with their own compensation figures.
Targeted associations. If you're in a fast-growing, fragmented industry, finding accurate salary data that reflect the economic reality of your niche can be daunting. Such was the case for Julie Prafke, the president of Humanix Corp., a $10-million temporary-placement agency in Spokane, Wash. Because her primary trade association (the National Association of Personnel Consultants) includes many permanent-placement agencies, whose CEOs lie on a higher pay plane, Prafke had difficulty pinpointing where, exactly, she fit in. Networking led her to a professional association of independent temp agencies, which compiles compensation surveys. By participating in those surveys -- which takes her maybe an afternoon a year -- Prafke receives privileged, useful information for the price of her membership.
But to price yourself accurately, warns Harry Geller, you have to use survey results correctly. For instance, Geller, the CEO of $25-million Global Mail, in Sterling, Va., analyzes the annual compensation report published by his trade association, the Air Courier Conference of America. According to its executive summary, CEOs take out an average of about $600,000 -- an average, notes Geller, that could include the paychecks of Fred Smith of Federal Express and Kent Nelson of United Parcel Service. "Look more carefully at the medians and modes for the annual revenue range you fall into," Geller advises.
Executive-search firms. Don't cringe. Good headhunters publish their own salary surveys for internal use, know the cost of CEO talent in their market, and can provide you with hard-to-find surveys. "We're in retail, and 90% of key executives in specialty retail use one main recruiting firm in the area," says Orv Madden, CEO of Hot Topic, a $25-million specialty retailer of music-licensed fashions in Pomona, Calif. That made shopping for a search firm easier, Madden admits, but getting it to work with him on an ongoing basis meant forging relationships with two of the firm's principals. When he's recruiting, Madden rings up those inside contacts for other salary information as well. He also likes fresh retail-industry surveys, such as one published by the National Retail Federation, in Washington, D.C.
Chief executive Julie Wang went a step further and made her headhunter, who specializes in fast-growing public-relations companies, an informal adviser to her business, $5-million Wang Health Communications, in New York City. Wang's expertise has helped the headhunter develop his health-care niche, and in return he has found her five senior people, including the person who is now Wang's business partner -- who, it turns out, was making double Wang's salary. That forced Wang to focus on her own pay and on how to value her specific contributions as a leader and not just a founder. "In the end we negotiated a middle ground," she says.
CEO roundtables. From informal breakfasts to exclusive forums, peer exchanges are invaluable -- especially when groups are small and discussions are confidential and frequent. Marion McGovern, the president of M2 Inc., a consultant brokerage firm in San Francisco, prefers Young Entrepreneurs Organization forums, attended by company founders who have grossed $1 million in revenues by age 35. "We're all at the same point in our lives, and we have the same pressures," McGovern says. "You bare your soul -- covering everything from building your own incentives to getting employees to buy into them. You hear about what works, what doesn't, and why."
Advice from managers in different industries "challenges you to adapt it to your own situation," says Brian Collins, the CEO of Commonwealth Inc. Warehousing and Distribution, a $5-million company and a participant in roundtables sponsored by the Cincinnati Chamber of Commerce. The wild card in the compensation game, Collins has learned, is how you choose to define your company. "You'd be surprised at how many owners don't know what, exactly, they do," he says.
Your managers. Mike Watson, the president of Three Springs, in Huntsville, Ala., an $18-million provider of residential treatment programs for emotionally disturbed children, is a pushover for executive-compensation articles in trade magazines and business-management newsletters. Whatever he misses in the popular press is clipped and copied by his assistant (or a manager) and circulated to all managers and curious employees.
The most lasting bit of advice Watson has clipped: "It's all about evaluating yourself and your people equitably," he says. "The best evaluators are your customers, and my customers are my employees." That's why Three Springs' eight managers huddle every November to evaluate Watson's performance. The information helps the board set Watson's annual pay. "They have a bunch of criteria," says Watson, pointing to tangible personal goals such as entering a new market or forging a strategic alliance. "They know what I had planned to do, what I did, and what I didn't do."
Comparisons with public companies. Public information is at your fingertips. Raymond Smith, president of WinterBrook Beverage Group, a $25-million marketer and distributor of sparkling-water drinks in Bellevue, Wash., pores over the prospectuses and disclosure documents of a cross section of midsize beverage companies -- mostly those in the $15-million-to-$20-million range -- comparing the ownership stakes, salaries, and bonuses of profitable competitors. "I look at what they're trying to achieve," says Smith, referring to competitors' marketing and financial strategies and the timing of their product debuts, "and I compare those with what I'm trying to do." Studying the compensation of chief executives at Coca-Cola and Pepsi carries a psychological benefit: the six- and seven-figure sums inspire him to keep building value. "Knowing what the big guys make sets an upper limit," Smith reasons. "I already know how low I can go!"
Similarly, Hot Topics' Madden reviews every offering prospectus in his specialty retail niche, since there may be only 10 to 15 a year. "I check what they're paying, particularly in long-term compensation, in the event that we go public," he says. Meanwhile, Madden taps his venture partners for pay information on competitors. "If they've done lots of deals in your industry, have them do a portfolio search for you to let you know -- confidentially -- what specific CEOs make," he says.
Industry consultants. If you're short on time, consultants can be a breezy one-stop shop. Chief executives who tap them say the quality and thoroughness of their surveys make them reliable, if expensive. Art Allen, CEO and 100% owner of Allen Systems Group, a $23-million computer-software seller in Naples, Fla., uses Warren Culpepper and Associates, in Atlanta. "Its compensation resources are known throughout the software world," Allen says. "What's most helpful are the salary and bonus guidelines for every position in the company." Poll peers in your industry for the names of good consultants.
Compensation specialists. They're cheaper and more plentiful than ever. "When CEOs use accountants for salary issues, they're missing the boat," argues Joseph Shurance, the president of $3-million Executive Business Services, in San Diego. That, of course, is contrary to what many CEOs believe. Shurance by no means distrusts accountants -- he has two of them. But when it comes to pay issues, he wants someone who takes his personal financial interests to heart. "The goal of an accountant is to maximize the wealth of the company," he says, "while the goal of a specialist is to maximize owner wealth by looking at how compensation fits into the overall company-growing strategy."
When Shurance bought out his partner, last year, his compensation pro was with him every step of the way. "Our accountants couldn't have done an adequate job of attaching dollar values to people during the process," says Shurance.
Classified ads. Call him crazy, but when John Schirle Jr. wants to know the going rate for a CEO in his industry and geographic market, he leafs through newspaper ads. Schirle, the president of $22-million Plus Marketing, in Detroit, might even call the company and ask to speak with the current CEO. "Usually, we wind up talking about compensation -- or lack of it," he says.
American Compensation Association (ACA). This Phoenix-based clearinghouse of compensation and benefits information is geared to CEOs of public companies, but it also offers publications, article reprints, conferences, seminars on tape, and surveys that growing companies can can use. Contact the ACA (602-922-2020; fax, 602-483-8352) for a catalog.* * *
How Can You Trip Up?
You take out too much money, or you don't take out enough. You place the good of the company above your family, or vice versa. In talking with compensation experts and CEOs, we got an earful about mistakes of omission and mistakes of commission. Although we also heard about a number of technical issues to consider, especially from the experts, we put those aside, since your own advisers can give you advice for your particular situation. Here, then, are the five cardinal sins of CEO compensation:
1. Cheat yourself in the early going. Jeff Hirsch was one of those CEOs who for years put in sweat equity but didn't give himself a regular salary or set up a deferred-compensation program. But martyrdom came back to haunt him in 1992, when he hired a professional manager of operations to help grow his then three-year-old Los Angeles-based software company, Xymox Systems Inc. Somewhat grudgingly, Hirsch offered the manager an equity stake. "It was like taking in an investor -- except we had to pay this attractive salary, too," says Hirsch. "This manager walked into a significant position, a great situation -- one my partner and I had created and were still waiting to benefit from." Although he claims the exchange was "just another business transaction," Hirsch admits he was unhappy knowing that the modest amounts of cash he had earmarked for himself would land in another's pocket.
Of course, cheating yourself also cheats your family. John Greene, the president of Custom Transportation Service, in Braintree, Mass., knows the guilt of using family members' personal charge cards to cover payroll. But over the past year Greene's bonus (which is about 5% of pretax income) and his salary combined have grown by nearly 30%. His secret: "If you treat yourself as an employee, and pay yourself properly from the get-go, you can't go wrong."
2. Gouge the company. Sure, there are times when you take a little extra and then there's an unexpected decline in your business. That's only natural; no harm done. But when "lifestyle" issues -- or greed -- got the best of one of compensation consultant Ken Kulesza's former clients, Kulesza, the president of ExecuComp Systems Inc., in Norwell, Mass., witnessed the destruction firsthand. The client plundered his company coffers, which ruined the fiscal year, destroyed morale among the company's 100 employees, and put the CEO in the hot seat. "This guy was always defending his outrageous pay level," explains Kulesza, who adds that such behavior attracts the attention of the IRS. (See number 5, below.) Taking too much out can also put an end to any plans you might have for going public and for going to your banker for a loan or line of credit.
3. Base your compensation on bad numbers. "Last year we were doing great, and in May, suddenly, the business lost $30,000," says Jeff Hopmayer, the president of Original American Scones, an $8-million scone maker in Oak Park, Ill. The inventory count was wrong. Hopmayer gave up his expected raise. His advice to CEOs itching for a raise: "Four months of data don't dictate a pattern. Look at performance over the long haul, and don't be too anxious." Today Original American Scones enjoys 30% gross margins, which Hopmayer suspects will in time allow him guilt-free pay hikes.
Conversely, growth itself can trip up compensation plans. "When a CEO wears all the hats, he or she can watch only so many things at once," laments Bear Barnes, the president of Flying Colors Painting Inc., a $1.7-million company in Norwalk, Conn., that recruits and trains college students to paint houses. "Every six months something scary happens." Like the time Barnes applied for workers' compensation, which required giving his provider a payroll estimate for the year; that year he wound up with double the volume of business he expected, and he expanded his workforce. He had to pay his provider $15,000 for the difference between the payroll estimate and the real thing. That $15,000 had been targeted for his own pocket.
4. Get bogged down too soon with too many fancy benefits. "It's fine to look at what benefits other CEOs at your level provide for themselves and for their employees, but you don't necessarily want to be the market leader in that category," says Diane Posnak, a partner with executive-compensation consulting firm Pearl Meyer & Partners, in New York City. "It's difficult to take away defined benefits, which don't ebb and flow with business success. If you suffer a downturn, you're tied to a fixed cost that's viewed as a take-away." The guideline is affordability.
5. Think the IRS isn't watching. Heads of S corporations have nothing to fear, since profits go directly to the owners, but heads of C corporations may. Although there's no fixed salary- compensation level that will set off flashing lights at the IRS, Bernie Kent, a tax partner with Coopers & Lybrand in Detroit, figures anything above $500,000 is open to questions. "It's difficult for them to prove unreasonableness below that level," he explains.
Beyond that, Uncle Sam keeps an eye on entrepreneurs who take year-end bonuses that are fat compared with their salaries, as well as those who take all profits as a bonus. "Your best defense is to leave as much money as you can in the business," says Kent, who adds that a clear paper trail is a must in case you're audited.* *
How Much in Salary? How Much in Perks?
How will you structure your total compensation? How will you weigh the elements you choose? Salary. Performance bonus. Insurance. Cars. Laptops. There are plenty to choose from, but if you have limited resources, you'll want to invest in the portions that deliver the biggest bang for your buck. Which elements have the greatest impact on the business (and lifestyle) goals you've outlined for yourself? How do they change as your company moves from one stage to the next?
As a rule, CEOs of start-ups take a hefty portion -- nearly 80% -- of the total dollar value of their compensation in base salary. That's because they have few, if any, benefits or perquisites in place. "If you're the owner, you may pay yourself more than what company size would normally dictate, or whatever's in the till at the end of the month, as long as you're still in business," says Larry Wangler, a principal of Towers Perrin's executive-compensation consulting practice in Irvine, Calif. "But as you hit breakeven, you want market pay with a modest bonus. You start thinking about a company car, a club membership, profit sharing. You need competitive benefits to attract good people. By the time your company has reached maturity, when you are the head of a professionally managed company, your compensation is much more market driven. It has to be competitive."
Wangler's "best-guess" breakdown of how typical founders who are 100% owners weigh the compensation mix as their companies grow:* * *
CEO Compensation at Different Stages of Development
An estimate of how CEOs break it down:
Stage of Growth
Compensation Emerging Developing Mature
Base salary 78% 64% 50%
Annual bonus 10% 16% 25%
Benefits 8% 12% 14%
Perks 4% 8% 11%
Noncash Perks Favored by CEOs
In our survey we asked about the noncash perquisites CEOs gave themselves. The answers ranged from newspaper subscriptions to a corporate airplane. Here's a breakdown of some of the more common perks:
Deferred compensation 16%
Club membership 17%
Personal legal advice 18%
Personal financial advice 18%
Company car 31%
n* * *