November 14, 2011 Articles

Elements of a Competitive Corporate Compensation Package

Attorneys moving in-house must understand the different elements that make up a competitive compensation package for corporate executives.

By Kandice K. Bridges

Attorneys who are preparing to make the move to an in-house counsel position, particularly a general counsel or other C-suite level position, need to be aware of the different elements that make up a competitive compensation package for corporate executives. A competitive compensation package in a corporate context is different from one in a law-firm context.

A comprehensive compensation package can include base salary, benefits, short-term incentives, long-term incentives, non-qualified deferred compensation, termination protection, perquisites, and fringe benefits.

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Base Salary and Benefits The most basic elements of a compensation package are base salary and benefits. Base salary is the building block of an individual’s compensation arrangement and is paid in cash consistent with the company’s payroll practices. Base salary is included in the employee’s income in the year in which it is paid and is subject to federal income tax and employment tax withholding.

Additionally, executives should be eligible for the benefits offered by the company to all employees. These benefits may include qualified retirement plans (e.g., 401(k) plans); medical, dental, and vision benefits; and life, disability, and accidental death and dismemberment insurance. Some employers also offer flexible spending accounts, dependent care reimbursement accounts, and pretax parking. These benefits may be made available to employees on a pretax basis.

Short-Term Incentive Compensation Short-term incentives are a critical part of any compensation package. As such, most companies have implemented annual bonus arrangements based on the achievement of specified performance measures. Eligibility for and performance criteria required to receive an annual bonus should be clearly defined. Performance criteria may vary by industry and can include one or more measures, including individual performance. For example, in the oil and gas industry, the most prevalent performance measures include finding and development costs, EBITDA, production, reserves, stock price performance, net income, and cash flow. Companies typically set expectations for the amount of the annual bonus to be paid upon achievement of the performance criteria by utilizing the concept of a target bonus, which can be expressed as a percentage of base salary.

Sign-on bonuses can also be a part of an executive’s compensation package, generally where the executive is walking away from a bonus or other compensation payable by the current employer. The sign-on bonus operates as an inducement to leave one position for another and can serve to make an executive whole. Sometimes these bonuses can be subject to repayment if the executive does not remain employed for a specified period of time (typically one year).

Sign-on bonuses and annual bonuses are included in an executive’s income and are subject to federal income tax and employment tax withholding.

Long-Term Incentive Compensation The most common form of long-term incentive is equity-based compensation. Stock options, stock appreciation rights, restricted stock, and restricted stock units are the most common forms of equity-based compensation.

Stock Options There are two different types of stock options—incentive stock options (also known as statutory stock options) and nonqualified stock options (also known as nonstatutory stock options)—each of which is subject to different tax treatment. Stock options allow the executive to buy stock at a specified price (generally the fair market value of a share of stock on the date of grant) for a given period of time.

Restricted Stock Restricted stock is the outright grant of shares to executives subject to restrictions as to the sale, transfer, and pledging of the stock. Restrictions typically lapse over time or upon the achievement of performance criteria as described below.

Restricted Stock Units Restricted stock units (RSUs) are an instrument whereby an executive is promised the right to receive the value of a specified number of shares after a specified period of time. RSUs are a promise to receive stock or cash in the future, as opposed to the outright grant of shares that are subject to transfer restrictions, like restricted stock.

Stock Appreciation Rights Stock appreciation rights (SARs) are the right for a participant to receive the excess of the stock’s value over the exercise price (generally the fair market value of a share of stock) set on the date of grant. SARs can be settled in shares of stock or in cash.

Long-term incentives are typically subjected to a vesting schedule, which requires that the executive earn his or her award over a period of time. Vesting can be based on time or performance. If vesting provisions are time-based, the executive will earn the award at future dates following the date of grant. The most common vesting schedules are three- and four-year graded schedules.

For example, assume an executive is granted 300,000 shares of restricted stock subject to a three-year graded time-based vesting schedule. If the executive remains employed, she would receive 100,000 shares on each of the first, second, and third anniversaries of the date of grant.

Performance-based vesting requires the achievement of pre-established performance criteria over a set performance period for the executive to become entitled to the award. The performance criteria should be documented in the applicable award agreement or plan document.

Another type of long-term incentive is a cash award payable in the future. For example, an individual could be awarded the right to receive $50,000 in cash on a specified date in the future (January 1, 2020) if at such time certain performance criteria are achieved. It could also be structured such that on January 1, 2012, the individual is awarded the right to receive $50,000 in cash on January 1, 2020, if certain performance criteria are achieved during a performance period that expires December 31, 2015.

Under certain circumstances, vesting of a long-term incentive may be accelerated, such as upon a change in control of the company or certain terminations of employment within a certain period of time following a change in control.

Typically, the executive recognizes income related to the transfer of property (such as restricted stock) when it is transferable and no longer subject to a substantial risk of forfeiture; however, a comprehensive discussion of the tax treatment applicable to each different type of equity instrument is outside the scope of this article. The executive would include the long-term cash award in income when paid.

Non-Qualified Deferred Compensation Non-qualified deferred compensation is generally any arrangement—whether written or unwritten, formal or informal—that allows for the deferral of compensation. An arrangement allows for the deferral of compensation if the person providing the services has a legally binding right during a taxable year to compensation that, pursuant to the arrangement, is or may be payable to the service provider in a later taxable year. An employment agreement could provide for the deferral of compensation.

Non-qualified deferred compensation arrangements can be beneficial to executives if they are structured properly, because they allow the service provider to defer income recognition until the amounts are paid at a future date. However, if such arrangements are not structured in a way that complies with Internal Revenue Code section 409A, including very specific terms related to deferral elections and when distributions can be made, the executive, not the company, could be subject to a 20 percent federal excise tax and interest.

Because the penalty is assessed on the employee and not the company, it is in the executive’s best interest to consult a tax advisor to ensure that there are no inadvertent 409A violations.

Termination Protection Executives should also negotiate key terms for employment, severance, and change in control agreements, including conditions that will trigger payments. Be aware, however, that not all companies utilize individual agreements and may, instead, adopt broader policies.

Employment Terms Key terms to be negotiated in an employment agreement include employment term, base salary, bonus, equity-based compensation, vacation days, business expense reimbursement, non-qualified deferred compensation, perquisites, benefits, and expectations regarding travel. Terms regarding any relocation benefits should also be spelled out in the employment agreement.

Severance Severance upon different types of termination should also be negotiated. These could include severance payable upon termination with cause, termination without cause, an executive’s resignation for good reason (including the definition of good reason), death, and disability.

Change in Control Different provisions are typically applicable when there is a termination in connection with a change in control of the company. The typical severance protection for named executive officers (other than the CEO) who suffer a termination of employment without cause or resign for good reason in connection with a change in control is two times the base salary or the sum of the base salary and annual bonus. It is also critical to be aware that in a change in control situation, if an executive is considered a disqualified individual for purposes of Code section 280G and receives certain payments in excess of safe harbor limits, she may be subject to the so-called golden parachute excise tax. When the parachute payments equal or exceed the safe harbor limit, a 20 percent excise tax is imposed on the executive. In the past, some companies have grossed up their executives for this excise tax, but the 280G gross-up has become a poor pay practice according to certain shareholder advisory groups. However, even if the company is unwilling to provide a 280G excise tax gross-up, there are still strategies that can be employed to minimize the exposure to the executive without costing the company.

It is important to note that compensation payable upon termination must be disclosed for the CEO and other named executive officers in the company’s proxy if it is publicly traded. Whether a general counsel will be a named executive officer depends on whether he or she is one of the top three highest compensated officers in the company.

Perquisites and Fringe Benefits Another category of compensation includes perquisites and fringe benefits. Perks and fringe benefits can include personal aircraft usage, tax planning, outplacement assistance, the payment of country club dues and initiation fees, personal security services, relocation benefits, car allowances or personal use of a car service, spousal travel benefits, and tax gross-ups. Some fringe benefits are excludable from income, such as tuition assistance up to certain amounts, de minimis fringe benefits, and certain employee discounts. However, the fair market value of taxable benefits must be included in income in the year the benefit is received.

Executive Stock Ownership and Holding Requirements Individuals getting ready to accept a position within a company should also be aware that they may be subject to stock ownership and holding requirements. Ownership guidelines typically dictate how much stock an executive must acquire within a specified period of time (usually three to five years). These guidelines are generally defined as a multiple of annual base salary or the ownership of a fixed number of shares. Holding requirements require executives to retain a certain percentage of shares acquired through the exercise or vesting of stock options, restricted stock, and other equity awards. These guidelines help align shareholder and executive interests.

From the Company’s Perspective It’s also helpful to understand from where the company is coming with respect to executive compensation packages. A company has an interest in determining what levels and types of compensation are going to be competitive so that its compensation structure does what it is supposed to do: incentivize and retain key performers while at the same time maximizing shareholder value. Publicly traded companies must also contend with institutional shareholder advisory groups that continue to influence executive compensation trends by annually defining best practices. Hot button issues right now involve the use of perquisites and tax gross-ups.

In benchmarking compensation, companies generally consider how their peers compensate their executives. A peer group is set by looking at other similar companies based on industry, market capitalization, revenue, total assets, and/or employee head count. Most companies develop a philosophy regarding how they want to compensate their executives relative to market. Many companies may choose to target the 50th percentile, whereas others may target higher levels.

Competitive levels of compensation are typically set by analyzing the compensation information for peer companies and aligning recommended levels with the company’s compensation philosophy. Compensation levels are traditionally set for base salary, target bonus, equity or long-term incentive awards, perquisites, and other benefits. Total compensation may be considered, including all different types of compensation, when measuring against the peer group.

When you receive the call that you are the candidate of choice for an in-house counsel position, consult with your advisor to make sure you receive the most competitive compensation package possible.

Keywords: compensation, in-house counsel, compensation package, benefits, stock ownership, termination, severance, base salary