By: James F. Reda, Kimberly A. Glass, and James A. Rice, Ph.D.,FACHE
Our previous Consultant’s Corner column1 set out to determine trends in director compensation programs among publicly traded companies. This column was based on findings from our firm’s study of over 1,800 public companies in the Russell 3000 (“Russell 3000 Study”). We noted that this large sample size set our study apart from the numerous other published survey sources available. The important point here is that there is a wealth of information on how directors at publicly held companies are paid. Disclosure rules, combined with heightened outside scrutiny and competition for director talent, have created the need for publicly traded companies to evaluate director pay on a regular basis against market practice. With the help of outside consultants that rely on peer data and published survey sources, the appropriate market data is readily available.
But what about companies that aren’t publicly traded? For example, how are directors of privately-held companies compensated compared to their peers that serve on public company boards? What about family-owned companies, private equity-owned companies, or even non-profit organizations?
The unfortunate truth is that there is a dearth of helpful benchmarks to guide the discussion on director pay for companies that are not publicly traded. Unlike publicly traded companies, where detailed information about director compensation at any organization can be gleaned from an annual proxy statement, understanding compensation at private boards requires further research and analysis.
In this column, we will compare and contrast, based on our experience, the differences in director compensation programs among the following company categories:
- Publicly Traded Companies
- Private Companies
- Private Equity- Owned (“PEOwned”)
- Non-Profit Organizations
Figure 1 describes the differences in ownership among these company categories.
To the extent possible, our conclusions are backed by data-driven evidence. However, given the limitations of broad data availability for nonpublic companies, we also rely on our experience from working with boards of non-public companies.
UNIFYING DIRECTOR PAY PRACTICES
Despite the differences in director pay practices that will be discussed in this article, most boards of directors have similar overall objectives, regardless of company type. While the role of a board will evolve as a company grows and matures, the underlying principles remain consistent. The oversight duty, the decision-making authority, and the fiduciary responsibilities of a board are comparable, regardless of ownership, industry, size, complexity, or location within the U.S. For organizations of all kinds, good governance starts with the board of directors.
This confluence of director service has made pay practices of private companies more competitive, particularly as public and private companies compete for the same director talent. It is therefore appropriate for a private company to assume some leading practices of public companies with regard to board pay. In fact, we find that cash compensation paid to directors of public and private companies is fairly similar in terms of both value and structure. Cash retainer values are consistent among both types of companies, and increase with company size. Like public companies, many private companies pay additional cash retainers to committee chairs and members, and provide some type of incremental cash award to the lead director or non-executive chair. Private companies are also following the public company trend of eliminating board and committee meeting fees, and making up for this with a corresponding increase in board and/or committee member retainers. Despite the implementation of cash-based director compensation plans that mirror public companies, private companies do not generally award equity and usually do not make up this value in higher cash pay. Since equity makes up a large portion of total pay for public company directors (generally over 50 percent), total director compensation levels at private companies are significantly lower than at public companies.
This same director talent pool may also extend to nonprofit organizations, though these positions are largely unpaid. Some experts recommend that those seeking to become an independent corporate director of a private or public company should first join the board of a non-profit organization to gain a better understanding of the governance process.
PAY PRACTICES FOR EMPLOYEE DIRECTORS VS. INDEPENDENT DIRECTORS
“Independent” or “outside” directors that are not otherwise employed by or affiliated with the company (or related persons) are necessary and valuable resources, regardless of public or private company status. These directors are typically free from conflict of interest and often provide a big picture view that is different from “inside directors” or “employee directors.” For this reason, today’s corporate governance standards for public companies require that outside directors make up the majority of a board of directors. While private companies are normally free from such restrictions, most have adopted this best practice of including outside directors on the board. Outside directors add credibility for private companies, sending a message to investors that the company takes professional guidance seriously, which is particularly important in liquidity event situations.
The most notable unified or standardized practice when it comes to compensating directors is the exclusion of employee directors from the director pay program. Among all companies, it is really only the outside directors that receive payment for board service.
Accordingly, CEOs of a public company will not receive any payment for their duties as director, even if they serve as the board chair. Other members of the C-Suite that serve as a board director will not receive additional compensation either. This same practice applies at most private companies. Even in the case of a family-run business, a family member that is already an employee and sits on the board will not be compensated for these additional board duties. The basis for this rule is two-fold: 1) serving on the board is typically part of the employee’s duties and therefore covered under the compensation received for the employee role, and 2) receiving pay from the board and the company will further blur director independence.
There are two unique private company situations where board members that are not technically employees, but are also not true “outside” directors, might receive director compensation, both of which are discussed in more detail later in this article:
- Non-Employee-Family Directors or “NEFDs”: These board members sit on the board of a family-owned private company. While they are not employees of the company, they are members of the family that owns the company. These directors either receive no pay or are paid at a discounted rate compared to outside directors.
- Private Equity Firm Representatives or “PEPrincipals”: This type of board membership occurs in private equity-owned companies where the private equity controlling owner will have representatives on the board of directors. These directors either receive no pay or are paid at the same rate as outside directors. In either situation, they are paid separately by the PE firm.
At non-profit organizations, the best practice is to keep executives separated from the board completely. Even an executive director (comparable to a CEO of a public company) will typically not have a seat on a non-profit board. As discussed in greater detail later in this article, most non-profit organizations do not pay outside directors, which in the non-profit world are referred to as “trustees.” An exception would be larger hospitals, which sometimes pay small annual amounts to their directors.
The next sections describe typical director pay practices among each company category.
For publicly held companies, many of the board’s responsibilities are defined by regulatory bodies and are more rigorous and complex than for privately held companies where there is a substantial amount of discretion as to the role a board will play within an organization.
While it has always been desirable to have a healthy complement of outside directors on the board, corporate governance rules adopted by the New York Stock Exchange (NYSE) and the NASDAQ Stock Market (NASDAQ) in 2003 require that a majority of a listed company’s board consist of independent directors, and with limited exceptions, that such board appoint independent compensation, audit and nominating/corporate governance committees.
In addition, compensation arrangements for outside directors of public companies must be disclosed. This disclosure typically is found in a company’s annual proxy statement and/or Form 10-K. The Securities and Exchange Commission’s (“SEC”) executive compensation disclosure rules issued in 2006 require a Director Compensation Table that must include annual compensation paid to each director who is not a “named executive officer.” In addition, companies are encouraged to provide additional narrative disclosure of material features of the compensation program. For this reason, it has become relatively easy to identify and understand trends and levels of director pay at listed companies.
After significant growth in the early 2000s, increases in public company director pay levels have now stabilized. Heightened scrutiny from shareholders and a series of high-profile lawsuits in recent years have resulted in a standardization of pay levels between companies of similar size and industry. Companies are reviewing their plans more frequently than ever before and, subsequently, are making smaller changes.
Among the 1,813 companies in our Russell 3000 Study, median 2015 total director compensation was $191,043.2 The median revenue of these companies was $1.2 billion. Total compensation increased with company size, as shown in Figure 3.
Most public company directors receive a combination of cash and equity compensation, with equity compensation making up at least half of total compensation regardless of company size or industry. The median pay mix of companies studied was 58 percent equity and 42 percent cash.
Director pay is continuing to be simplified as companies eliminate board and committee meeting fees, and make up for this with a corresponding increase in board and/or committee member retainers. Of all companies in our study, the average cash compensation program was comprised mostly of board retainer (78 percent), with small percentages allocated towards board meeting fees (6 percent), committee member retainers (10 percent), and committee member meeting fees (6 percent).
The median annual board cash retainer was $55,000. Annual board cash retainers are correlated with company size, increasing from a median of $40,000 to $100,000 by ascending revenue size.
The trend away from meeting fees is evident in our sample. Among all companies studied, only 28 percent still provide board meeting fees, and 29 percent provide committee meeting fees. In general, smaller companies are more likely to pay meeting fees than larger companies.
Additional compensation is almost always paid for serving as a committee chair, lead director, or non-executive chair (“Leadership Premium”). Increasingly, these Leadership Premiums are the only additional amounts beyond the board and committee retainers and equity awards paid in these more streamlined director pay programs.
Almost all companies (94 percent)3 provided committee chair retainers, consistent with the general industry market practice of providing premium pay to the directors with the most responsibility. Just under half of all companies (47 percent) 4 provided committee member retainers.
Of all companies in our study, 41 percent reported a non-executive chair (“NEC”). Most of the companies with a NEC (91 percent) provided additional compensation, with the median incremental fee for this leadership position being $65,000. Fifty-three (53) percent of all companies reported a lead director. Of these companies, 79 percent provided additional compensation, with a median incremental fee of $25,000 (almost entirely paid in cash). Unlike the NEC role, the difference in incremental compensation for this role did not vary significantly by company size or industry.
For annual equity awards, which typically make up at least half of total pay, the market trend over the last decade has been away from stock options and toward full value shares (restricted stock, deferred stock or outright stock). The prevalence of stock options continues to decline, and when companies do grant options, they often grant options along with full value shares.
Some companies (23 percent) provide an additional award upon initial election to the board; however, this pay component continues to decrease in prevalence as annual awards have become a large and important part of director pay programs.
Nearly all companies studied provided an equity award (97 percent). Seventy-seven (77) percent granted full value shares only, compared to just 8 percent granting stock options only. Twelve (12) percent of companies granted a mix of full value shares and stock options, and the remaining 3 percent of companies granted no equity awards at all. The median total equity award value for the entire study sample was $112,000.
In recent years, the bar has been raised with respect to private company governance, despite the fact that requirements (Sarbanes-Oxley, Dodd- Frank, etc.) imposed by various governing bodies (SEC, stock exchanges) apply only to public companies. In today’s business environment, the talent pool is becoming more homogeneous as executives and directors move freely between organizations that are small and large, and public and private. No longer able to afford the informal corporate governance practices of the past, private companies are under increasing pressure to implement or improve board oversight. These companies are embracing public company governance style, including formation of boards that include outside directors and standard committees. This movement has also affected family businesses, particularly as shareholders of family-run companies have become less concentrated with each passing generation.
However, the task of understanding and adopting best practices for compensating outside directors of private companies remains challenging for the following reasons:
- The variety of private companies that exist (small, large, family owned, private equity owned, etc.); and,
- The lack of available market data, as most companies do not disclose many details related to director oversight, including pay.
With little hard data on private company director pay available, it is difficult to uncover the extent of the difference in total compensation levels between public and private companies. The biggest difference in director pay at private versus public companies is equity. Private companies do not generally use equity as a key element of their compensation programs. This lack of equity awards, which make up over half of total compensation for public company directors, results in lower total compensation at private companies.
We have estimated total director pay levels for private companies of various sizes, based on our consulting experience as well as our Russell 3000 study of director pay programs at publicly traded companies. As shown previously in Figure 1, total director pay at these public companies increased with revenue.
Among all revenue categories, more than 50 percent of total pay was made up of equity. Using this data as a guide, we have estimated the total pay range for similarly sized private companies, as follows.
For example, Table A of Figure 4 below shows that among all Russell 3000 companies, total pay is $191,043, made up of 42 percent cash and 58 percent equity. Table B shows that among similarly sized private companies, total compensation will range from $80,708 (the 42 percent cash portion of $191,043) to $113,809 (the 42 percent cash portion of $191,043 plus 30 percent of the remaining equity portion). Table C shows that the resulting private company pay range is equal to 42 percent to 60 percent of public company pay for similarly sized companies. We have followed the same methodology to estimate total pay levels among private companies within each revenue category.
Based on our experience working with private companies, we believe that the ranges in Figure 4 are a sound benchmark for how private companies of various sizes compensate directors. In general, these companies pay cash to the same extent as public companies of similar size, and in some cases pay more cash to make up for the lack of equity awards (though still at a reduced rate resulting in lower total pay).
In general, private company director compensation programs lack equity awards to the same extent that private company executive pay programs lack equity awards. Most public companies have some kind of executive equity program in place,5 and equity typically represents 50 percent to 75 percent of net total compensation for a senior executive of a public company. While more and more private companies are adopting long-term cash incentive plans, real equity awards (e.g. stock options or restricted stock) are used by a minority of private companies. The arguments against implementing an equity-based incentive program in a private company generally fall into four categories:
- The owners do not want to dilute their voting control;
- The owners are concerned about opening up the primary shareholders to potential legal actions with dissatisfied minority shareholders (e.g. the employees who received stock awards);
- The executives and directors— and in some cases, the business owners— don’t want the risk and complications associated with illiquid, non-publicly traded stock; and,
- Equity is more complex that cash. Considerations such as number of shareholders, form of ownership (such as IRS Subchapter S incorporation or a limited liability partnership) and other related issues make it more difficult to institute a program.
A private company that does not grant equity awards to executives is, therefore, unlikely to include any sort of equity in its director pay program. However, as a general rule of thumb, we find that if a private company does have an executive equity program in place, they are much more likely to offer equity to their directors. And at these companies, the same type of equity vehicle offered to the executives is usually offered to directors. For example, we have worked with a privately held client that offered stock appreciation rights (“SARs”) to both executives and directors.
Overall, we estimate that less than 10 percent of private companies provide director equity awards, compared to 97 percent of public companies as mentioned previously. An exception to this is PE-Owned companies. Many PE-owned companies pay directors solely in equity, which we discuss later in this article.
Most family-owned businesses benefit from a board that includes not only family members but also well informed, seasoned, outside directors. These independent advisors are particularly important for the following reasons:
- Outside knowledge: While any organization will benefit from the different and diverse perspectives that outsiders can offer, this is particularly true for family-owned entities run mostly by family members who may not have much experience outside the organization.
- Succession planning: in a family-owned business, management is often hesitant to address the issue of succession planning due to complications surrounding the family dynamic. A board that consists of outside advisors can work around those concerns, helping ensure that a successor is selected based on merit and appropriate fit rather than nepotism.
- Accountability: Having an outside board to report to on a regular basis ensures that family members are applying best business practices.
As with public companies and non-family-owned private companies, employees of a family-owned company will not receive any additional compensation for board service, whether they are a family member or not. But what about non-employee family directors (which we refer to as “NEFDs”)? These cases are a little more complicated.
In 2016, Gallagher’s research team set out to understand exactly how much both NEFDs and outside directors of family-owned companies arepaid by conducting phone and electronic mail inquiries to a number of large family held business. The outreach was successful, with nineteen companies responding. These companies spanned various industries, including retail, food processing, consumer products and general manufacturing. The median revenue of these nineteen companies was $6.9 billion.
Twelve of the nineteen companies (63 percent) had family members serving on the board that were also senior members of the management team. In line with common practices for all types of companies, these family members received no compensation for board service.
Six of the nineteen companies (32 percent) had family members who were not employed by the company serving on the board. In speaking with these companies, it was evident that many business owners believe it is the duty of an NEFD to serve the company without compensation. In other words, the NEFD should have an inherent, vested interest in the outcome of the company, and compensation for board service is neither appropriate nor necessary. Accordingly, four of these six companies paid no compensation to the NEFDs.
However, two of these companies paid NEFDs at a discounted rate from what they paid outside directors. In one case, the payment was on a meeting basis, and in the other case, the payment was on a retainer basis. In both examples, the discount compared to outside director pay was significant. As described below, the average discount for NEFD pay compared to outside director pay was a steep 72 percent.
- Example 1: Outside director is paid annual cash retainer of approximately $15,000 plus $2,000 per meeting; NEFD received $1,000 per meeting only, without any retainer. Based on eight annual meetings, the outside director received a total of $31,000 and the NEFD received $8,000 (a 74 percent discount).
- Example 2: Outside director is paid a $126,000 annual cash retainer and the NEFD is paid a $40,000 annual cash retainer (a 68 percent discount).
- For these two companies, the average discount is 72 percent.
Our discussions with these companies uncovered that owners generally agreed upon the following considerations with regard to the NEFD role:
- All NEFDs should be paid the same—either no payment or payment at the same discounted rate compared to outside directors.
- There is no basis in making a distinction between third and fourth generation, ownership positions, or dividend rights.
- It is possible to distinguish board pay based on contributions to the board such as committee work or even leadership positions. However, the general practice is to not assign NEFDs to a board committee, which is typically organized according to experience, knowledge and overall contributions that lead to increased company value.
We found that outside directors of family-owned companies are paid similarly to directors of other private companies, with a focus on cash and little to no equity awards. Some key findings were as follows:
- The median annual cash retainer was $75,000.
- Median annual total compensation was $100,250.6
- Only 11 percent of companies used equity as part of their director compensation package.
- 42 percent of companies paid a lead director premium.
- 47 percent of companies paid their committee chairs a leadership premium.
- 42 percent of companies paid board meeting fees with a range of $1,958 to $2,650 per meeting (25th and 75th percentiles).
- 32 percent of companies pay committee meeting fees with a range of $1,531 to $2,294 per committee meeting (25th and 75th percentiles).
Like non-family-owned private companies, cash levels are similar to what we would expect to see among public companies. In fact, our Russell 3000 Study found that public companies with revenues ranging from $3 to $9.9 billion also had a median cash retainer of $75,000.
Consistent with expectations, the lack of equity awards (present at only 11 percent of our family-owned company sample) creates a large disparity in total compensation levels compared to the same group of Russell 3000 companies. Median total compensation among these public companies was $227,005 (consisting of 57 percent equity and 43 percent cash). This is 126 percent higher than median total compensation of $100,250 among the family-owned sample. This difference is due to the equity award; if we were to extricate only the 43 percent cash portion of $227,005, the resulting $98,000 (inclusive of cash retainer and committee member fees) is right in line with total compensation of $100,250 at family-owned companies. As discussed previously, this is one way that private companies, family-owned or not, set director pay by stripping out the equity portion of comparable public company total director pay.
Private Equity Owned Companies
PE-Owned companies invest in strong board governance early on in pursuit of significant growth. A top-down agenda set by the private equity fund generally drives the board’s focus, with an overall goal of progress toward a liquidity event, such as an initial public offering (“IPO”) or M&A event. The directors of PE-Owned companies are mainly focused on strategies to increase shareholder value with a much shorter time horizon than directors of other private companies or public companies. Accordingly, these PE-Owned boards are more deeply entrenched with company management and in most cases meet on a more frequent basis than other company boards.
As with other types of companies, employee directors of PE-Owned firms, such as the CEO, are unpaid. Beyond employee directors, there are two types of directors that will typically serve on these boards: 1) outside directors and 2) employees of the private equity firm, which we refer to as “PEPrincipals.” See Figure 5 for a comparison.
The board of directors (frequently referred to as “trustees”) serves as the governing body of the non-profit organization. In this capacity, the trustees are legally accountable to the organization’s supporters and the greater public. Different from a public or private for profit organization, the non-profit board is generally responsible for determining, maintaining, and furthering the organization’s mission and purpose. Trustees are charged with ensuring the organization abides by ethical and legal standards in making its vision a reality.
While there is no federal law prohibiting non-profit organizations from compensating trustees, it is common practice to consider non-profit board service a volunteer act. Most boards do not provide regular compensation for their members. In fact, a common practice by trustees is not only uncompensated service, but annual financial contributions from trustees to the organization.
While the general belief is that trustees should not receive any board compensation, it is also widely held that they should not be expected to pay expenses above and beyond their personal donations. Accordingly, many non-profit organizations do adopt travel reimbursement policies for board members, including reimbursement for various service-related expenses such as car, travel, meals, and sometimes even entertainment.
The table below estimates the percentage of non-profit organizations that pay their board members. Overall, only a small percentage of nonprofit organizations pay any board compensation (2.8 percent). Among the specific groupings (Arts, Education, Health, etc.), this percentage generally ranges from 2 percent to 4 percent, with an exception for large hospitals. Large hospitals are more likely than any other non-profit organization to compensate board members, with 15 percent of them providing some type of director pay. However, when these large hospitals do provide board pay, it is generally a nominal annual amount of less than $5,000.
Despite the long-standing practice of not paying nonprofit board members, increasing concerns regarding the effectiveness of non-profit boards has caused some experts to call for overall improvement in board organization and knowledge among these entities. As such, there may be some growth in the reliance on pay as a means to encourage enhanced engagement, quality of decision-making, and diverse experiences among nonprofit board members.
Figure 7 details some reasons why most organizations currently do not pay board members, as well as some reasons why organizations may consider adopting board pay programs in the future.
The organization’s culture, funds, members, donor expectations, and the image it wishes to portray will all factor into the decision whether to compensate board members. Like for profit companies, non-profit organizations that are considering adopting a board pay program should consider the following best practices:
- Establish policies with clear objectives, and indicate how compensating the board of directors will benefit the organization.
- Determine what amount of compensation is considered reasonable, and review the compensation regularly.
- Determine which board members will be compensated (the chair, board officers, or all board members), how much each board member will be compensated, and whether the chair will be paid more than others. E Determine how the compensation will be structured (e.g., flat fee, retainer, per diem, formula), how it will be distributed, and the tax implications.
SUMMARY AND CONCLUSION:
Figure 8 summarizes the differences in director pay programs as detailed in this article.
Similar to executive pay trends, director pay trends continue to “trickle down” from public companies to private companies, finally reaching non-profit organizations.
With evolving standards and further integration of the director talent pool, we expect that private companies will continue adopting the cash-based pay practices of public companies. In order to remain competitive and ensure good governance, we will likely see an increase in the number of non-profit organizations that pay directors (though the total pay amounts will be nominal compared to for profit companies). For all companies, governance improvement actions are focused on strengthening the role and responsibilities of the board of directors, and an appropriate director compensation plan is a key factor to consider.
1) “The Evolution of Director Compensation” appeared in the May/June 2017 issue of The Journal of Compensation & Benefits.
2) In this study, total director compensation excludes leadership premiums (committee chair retainers as well as lead director and/or non-executive chair incremental retainers) and represents the average paid for committee member service assuming membership on two of three main committees (audit, compensation, and nominating & governance).
3) 94 percent of all companies studied provided a committee chair retainer to at least one committee chair.
4) 47 percent of all companies studied provided a committee member retainer to members of at least one committee.
5) Based on our firm’s review, 84 percent of Russell 3000 companies granted equity awards to the CEO in FY 2015.
6) Total Compensation includes annual cash retainer, equity award, and board and committee meeting fees. For example, if the annual retainer is $75,000 in cash, the board meeting and compensation committee meeting fees are $2,000 per meeting, the board and each of the three committees meet five times per year, and each independent director sits on two committees, the total compensation will be $105,000 ($75,000 plus 5 times $2,000 plus 10 times $2,000).
7) Data Sources for this figure include: 1. “What is Reasonable for Nonprofit Board Pay” Economic Research Institute. 2011 (by Linda M. Lampkin and Christopher S. Chasteen, PhD) http:// downloads.erieri.com/pdf/what_is_rea sonable_nonprofit_board_pay.pdf.2. “Is it Time to Pay Hospital Board Members?” Becker’s Hospital Review. 2013 (by Molly Gamble) http:// www.beckershospitalreview.com/co mpensation-issues/is-it-time-to-payhospital- board-members.html.