Designing an executive compensation program: Five best practices for private companies

Creating an executive compensation program is one of the most important steps a company can take — and it is far from the simplest. The best programs are often the result of years of collaboration between the management team, board, and shareholders. Critically, an effective pay plan can help attract and retain top talent, motivate senior leaders to achieve defined business objectives, align their interests with shareholder outcomes, and improve the company’s overall financial performance. 

Conversely, a poor compensation plan may have the opposite effect, leading to misaligned management incentives and underperformance. These could, in turn, generate negative press, votes against the board, and shareholder activism.

Private companies nearing a potential IPO generally have a narrow window of opportunity to establish a top-notch pay program without the scrutiny, expectations, and distractions of the public market. Developing a program while still private may also help companies save time and money after an IPO. 

Developing your executive compensation program 

Each company’s circumstances are unique, so there is no “one-size-fits-all” executive pay program. Ask 10 investors how they think about assessing executive compensation and you will probably get 10 slightly different answers. That said, we believe these five high-level best practices can help you start building a program that can evolve as your company grows. 

1. Know where you stand
Getting your compensation plan right often involves understanding where you are relative to the market. Benchmarking can help you see how your key executives’ pay compares to that of public market peers, both in terms of the amount they are paid (quantum) and how they are paid (structure), including award types, timing, and criteria. The goal is not necessarily to be fully aligned with your public market peers at this stage. Instead, the goal is to first assess whether and to what degree your pay practices might be outside the norm for your industry.

Importantly, a benchmarking exercise does not need to be expensive or complex. A prudent approach is to identify a small group of three to five industry peers against which you can realistically compare your pay program. It is advisable to consult with both your internal team as well as outside investors, whose views on which public companies most appropriately reflect your business may differ. 

2. Set a compensation philosophy 
Compensation philosophies reflect a company’s guiding principles for setting pay. While the specifics of executives’ pay quantum and structure may change annually, effective compensation philosophies aim to establish consistency and discipline around those changes. 

Without a philosophy, an organization might struggle to answer common investor questions like: 

• Do you aim to pay top executives at, above, or below market levels? 
• What behavior does your program most seek to incentivize? 

Here again, peer benchmarking can be helpful. For example, if your current total executive pay is well below your peers’, a philosophy with a stated aim of above-market compensation would warrant closer consideration. As your pay program matures, benchmarking can function as a regular health checkup for your philosophy, helping to confirm that you are on track or allowing you to adapt to any surprises along the way. 

3. Stick to it
Even the best compensation philosophy can be meaningless without follow through. True, you may occasionally need to deviate from your philosophy, and it will likely evolve over time. But frequent variance (either real or perceived) from your philosophy — especially when combined with unclear rationale for those divergences — may damage your relationship with two key stakeholders: your management team and your investors. 

Consistent adherence to your philosophy can help establish the foundation of a pay-for-performance culture and help manage executives’ pay expectations. If your philosophy is inconsistently applied, top managers may come to see performance objectives as negotiable or expect to be “made whole” despite a performance miss. For your investors, frequent adjustments to a compensation philosophy can erode trust, particularly if you are perceived as attempting to increase pay during periods of underperformance. This behavior can lead to heightened pay scrutiny, even in periods of outperformance. 

4. Get your board on board
Your board of directors, specifically the compensation committee, will be responsible for setting and overseeing executive compensation once you enter the public markets. This is because the US Securities and Exchange Commission (SEC), Nasdaq, and the New York Stock Exchange all require public companies to have a compensation committee. Notably, the SEC requires public compensation committees to have at least three directors, two of whom are independent, though most institutional investors prefer compensation committees to have 100% independence. Developing a committee that understands and supports your compensation philosophy while you are still private can help ensure a smooth transition to being public.

If you are approaching an IPO and your board lacks a compensation committee, we believe you should start creating one as soon as possible. Ideally, you want a functioning compensation committee in place at least 12 to 18 months prior to an IPO. This window gives directors enough time to gel as a committee and see a complete business cycle for your company. If you are closer to IPO than that window, even three to six months can give a committee time to get minimally up to speed. 

5. Embrace transparency: Do the work now and save headaches later
Many private companies may assume that the first few years as a public entity are a honeymoon period with lower scrutiny on pay practices. But in fact, all public companies are required to file compensation disclosures. Some companies are even required to file detailed disclosures and hold “say-on-pay” votes as soon as one year after their IPOs. 

SEC requirements on pay disclosure and shareholder votes depend on a company’s status as an Emerging Growth Company (EGC) or Smaller Reporting Company (SRC). Companies are required to increase pay disclosure and begin holding say-on-pay votes within one to three years of losing EGC status (assuming they don’t qualify as an SRC). A company loses EGC status when it clears defined revenue, equity float, or debt thresholds, or is public for five years. Importantly, SEC disclosure and vote requirements can go into effect immediately for companies who aren’t an EGC at IPO. More detailed discussion of EGCs and SRCs can be found here. 

Notably, public companies are still required to provide compensation disclosure even before losing EGC status. Though “scaled” for their smaller status, these disclosures can nevertheless attract investor and proxy adviser scrutiny. For example, the proxy advisers Glass Lewis and ISS may recommend votes against compensation committee members for companies where they believe pay disclosure and/or practices are lacking.

Rather than assume you will have ample time to meet enhanced public market disclosure requirements, we recommend doing the work now to save time and headaches later. Once you are public, every detail of every dollar that you pay executives will need to be publicly disclosed and explained to investors. In our view, it is crucial to keep this in mind as you establish your compensation philosophy and program. Entering the public markets with a transparent, intentional, and straightforward pay program will help you build rapport for long-term success with shareholders.

Compensation best practices for private companies

These best practices are a starting point as you build out a bespoke executive compensation program for your company. In our view, it is essential for private companies to understand how the public markets assess executive compensation and to start developing a strong program while they are still private.