Executive Compensation

John J. McFadden · 2005

A comprehensive guide for designing and implementing various executive compensation packages, covering cash, bonuses, deferred compensation, and stock, with a heavy emphasis on tax and regulatory considerations.

Executive Compensation is an essential toolkit for business owners, compensation planners, and financial professionals tasked with attracting, retaining, and rewarding key talent. This comprehensive guide navigates the complex landscape of executive pay, from determining reasonable cash compensation and designing effective bonus plans to structuring sophisticated nonqualified deferred compensation, restricted stock, and stock option arrangements. It provides detailed analysis of the critical tax, securities, and regulatory (ERISA) implications of each strategy, offering practical insights and sample agreements to help you design plans that align executive incentives with corporate goals while minimizing tax burdens and ensuring legal compliance. Whether for a closely-held business or a public corporation, this book equips you with the knowledge to create competitive and justifiable compensation packages that drive performance and secure your company's future leadership.

The model it argues

This model outlines how the design of executive compensation packages (design levers) influences executives' psychological and behavioral states, ultimately impacting key organizational and individual outcomes such as performance, retention, and tax efficiency. The model is inferred from the principles and practices detailed throughout the book.

Key ideas

Compensation Reasonableness: The degree to which total executive pay is justifiable and defensible against challenges from the IRS or shareholders. It is determined by comparing pay to market rates for comparable positions, and considering the executive's qualifications, the nature of the work, and the company's size, performance, and dividend policy.
Incentive Plan Design: The structure and mechanics of performance-based compensation, particularly short-term cash bonuses. This includes whether rewards are tied to specific formulas (e.g., percentage of profits), pre-defined targets (target bonuses), or are awarded on a discretionary basis.
Deferred Compensation Design: The architectural choices in a nonqualified deferred compensation plan, such as whether it is a 'salary reduction' (employee's own money) or 'salary continuation' (employer money) plan, the terms of vesting and forfeiture ('golden handcuffs'), and the mechanisms for payout.
Benefit Security Design: The methods used to secure an employer's promise for future payments under a nonqualified plan. This ranges from an unfunded, unsecured promise (subject to creditor risk) to more secure arrangements like Rabbi trusts, which segregate assets but are still subject to creditor claims in insolvency.
Equity-Based Compensation Design: The use and structure of compensation methods that grant executives an ownership interest or a stake in the appreciation of the company's equity. This includes nonstatutory stock options, incentive stock options (ISOs), and restricted stock grants, each with different tax and accounting treatments.
Perceived Alignment of Interests: An executive's subjective belief that their personal financial incentives are directly and meaningfully linked to the financial success of the company and its shareholders, encouraging them to act as an owner.
Retention Motivation: The motivational force encouraging an executive to remain with the company, created by compensation elements that have increasing value over time or would be forfeited upon premature departure, such as vesting schedules on stock options or deferred compensation.
Performance Motivation: An executive's drive to achieve specific, measurable business goals (e.g., profit targets, sales growth) that are directly linked to receiving incentive-based compensation like cash bonuses or performance shares.