Originally published in American City Business Journals

By Joe Rankin

Chief executives of Fortune 500 companies receiving lavish pay, including significant stock options and other forms of deferred compensation, have become commonplace. But now, with the U.S. labor market tighter than it has been in years, these incentives are being considered more frequently at middle-market companies and smaller firms across America trying to attract key staff by matching incentives at larger, public companies.

I hear a growing number of owners of middle market firms say that key staff are now requesting an ownership share in exchange for a commitment to stay at the firm. In one recent case, a CEO was approached by his chief financial officer seeking equity in the company, valued at $2.5 million — 10 times the CFO’s annual salary.

The question for any CEO is whether that’s reasonable.

The answer is informed by the U.S. labor market, where it is increasingly difficult to find and retain talent.

Unemployment fell as low as 4.4 percent in April, and CEO pay was up 6.8 percent last year on the back of higher profits. The labor market is so tight that the Federal Reserve Bank of San Francisco noted in a recent report: “The expectation that the (unemployment) rate will fall even further raises the possibility that the labor market will exceed the Federal Reserve’s goal of maximum employment and could push up wages and prices substantially.”

It’s little wonder then that chief executives are scared they might lose their best talent.

To retain top performers, especially if they are key to succession planning, compensation packages have to be meaningful to the employee while not giving away the farm. That is not easy to do, but here are six things to consider to get that balance right:

1. What is being paid elsewhere?A good place to start assessing whether any demand is reasonable is to find out how competitors are dealing with compensation. A specialist executive recruiter will know what market conditions are sustaining. More detailed information is available in the annual reports of public companies, and private firms such as Compdata have detailed information on executive compensation at the industry and regional level. That research may reveal creative alternatives that do not involve giving away partial ownership of the company.
2. Is the employee worth it?If the compensation is in line with market conditions, the next consideration is to discern whether there will be a likely return on investment. For example, if a CFO charged with growing corporate earnings is seeking 2.5 percent ownership and already has a strong track record in that regard, a case can be made to the compensation committee that giving the executive equity will benefit all shareholders.
3. Link compensation to targets.Once a company gives extra compensation to executives, it should be tied to specific targets that are relevant to the role and business. For example, if you ask an executive to grow revenue but that growth is done through acquisitions funded by debt, there may be no immediate return on investment. Specific, meaningful goals are more suitable. For a CFO at a mature firm, that could be maintaining year-over-year sales from existing clients or reducing costs by a certain amount. At a start-up, a CFO could be rewarded for increasing venture capital funding. Payouts should be split between company goals, team goals and individual goals so that even if the firm struggles, the executive is still incentivized to work hard.
4. Think about timing.Employers must balance the desire to reward the employee now with securing their retirement. Packages might also contain a mix of certain and variable rewards. For example, a key executive could receive an annual bonus in cash (paid out in a range tied to performance), a “bond” that pays out as a fixed annuity in cash after an initial vesting period of several years, as well as stock options or grants that could add variable value over the longer term.
5. Explore a supplementary retirement plan.If your CFO is asking for better compensation, other top executives might not be far behind. Adding a supplementary retirement plan to give key staff a set payout upon retirement — such as two or three times final-year salary — is an effective tool to lock in talent.

6. Add a claw-back clause.Even with the best will in the world, things go wrong, so plan for all eventualities. Adding a clause in compensation contracts that claws back deferred compensation when executives are fired for cause removes a crucial risk. In April, Wells Fargodid just that, taking back an additional $75 million in pay and stock grants from two executives at the center of a scandal over fraudulent accounts, the largest claw back in banking history.

Adding improved deferred compensation plans for key executives will be a pressing issue for as long as the labor market remains hot. It’s a seller’s market for top talent. The companies that win the bidding war will come up with creative solutions for employees while also figuring out how to fund such arrangements in a way that makes economic sense. It’s a lot of work — but, when done right, key executives are happier and the company ensures an easier time with succession planning.

Joe Rankin leads the employee benefits consulting practice at Plante Moran.