The Expert CEO

Economic conditions are grim, with no end in sight; recriminations surrounding overpaid executives continue to make headlines, especially throughout the financial industry. At the top of the list is the 3.6 billion in bonuses paid to Merrill Lynch executives after the firm lost 15.8 billion in Q4 2008 (see WSJ article).

The vast majority of the members of ExpertCEO are in a different category – mostly small to mid-sized businesses, roughly 2/3 of whom are in the technology industry. Nevertheless, the issues involving CEO compensation in small and mid-size companies are just as real and potentially just as complex.

ExpertCEO recently conducted a compensation survey among its members, and not surprisingly, we had a record response – this is a topic near and dear to most everyone. One of the interesting results from the survey was that, while only 35% of our members received bonuses in 2008, 56% expect to receive one in 2009. The average salary for 2009 was projected to be level with the average for 2008, at just over $200,000. It will be interesting to see the results of a follow-up survey later this year to see how those expectations are changing. The complete survey results, including information sorted by company size and industry, are available to members of our site; CEOs and COOs interested in seeing the survey data are invited to apply for complimentary membership. To register, go here.

Regardless of company size, the central issue is pay-for-performance. ExpertCEO members typically have three components to their compensation – a base salary, a bonus and an equity stake in their company. In fact, 95% of our members who responded owned equity, with a mean stake of 8.5%.

With respect to bonus awards, the tricky question is how to measure performance. A recent posting on our site indicated that one member CEO’s board wanted to establish a bonus plan that triggered payments for the CEO and everyone else in the company based on a year-end cash balance target. And the pay formula was binary – pay 100% if the target is met and zero if it is not met. A number of comments on this approach agreed with the concept of targeting cash balance as the primary performance criteria during these difficult times. However, the “all or nothing” approach is unusual and will over-emphasize small accounting and reporting nuances at the end of the year. A more realistic approach might be a decelerating formula (e.g. pay 80% of the bonus if the target is 90% of the goal) and a threshold of a zero payment at, say 75% of target.

Other members described incentive compensation plans that substitute equity, in the form of options, for cash payments – another mechanism to conserve cash, and a very reasonable concept when cash is king. Simple in concept, BUT incredibly difficult in execution, when the liquidation preferences of many venture-backed companies are far higher than the value of the company, and the value of the options is questionable.

When a company is sold, liquidation preferences entitle certain (typically preferred) shareholders to receive fixed dollar returns before other (usually common) shareholders receive any payment; if the invested capital exceeds the purchase price, common stock and options turn out to be worthless securities. If the recession continues for a long period of time, these challenges will be increasingly relevant, as cash runs low and M&A exits are either infeasible or completed at valuations very low relative to the equity preferences in the company.

Executive compensation is always a delicate matter, but rarely more so than it is likely to be until economic conditions begin to turn around. CEOs need to feel comfortable their salaries and bonus targets are ‘in the zone’; calculating equitable and ‘market’ pay packages for their executive staff is another challenge ExpertCEO members are talking about. In response to numerous requests, we will be conducting a similar survey by VP function/company size/industry, to gather and share data members have told us they’d find useful. If you’re a CEO but not yet a member and want to participate, apply for membership today and help spread the word to other corporate leaders you believe would benefit from participation in this unique forum.

I’ve known George Von Gehr for more than 30 years.  A few weeks ago, I ran into him and learned  about his new book, “The Effective Entrepreneur: Fifty-nine rules to Create Value Throughout the Life Cycle of Your Company”.  George was kind enough to permit us to reprise some of the highlights here; the book is available on Amazon.com.

George, to quote from his book, “is a proven counselor to entrepreneurs and their advisors.  He had front-line experience as an entrepreneur before starting, growing and selling his successful boutique technology investment-banking firm.  His background includes degrees in engineering, law and business from Princeton and Stanford, as well as consulting with McKinsey & Company, Inc.

I selected as the first post excerpts from Rule #9 – Keep Capital Structure Simple — because I suspect that capital structures will be a major topic of discussion among investors and entrepreneurs as they struggle to refinance their companies during this economic crisis.

“In an ideal world, young companies would have only common stock and therefore simple capital structures.  All shareholders would be treated equally, regardless of whether they contributed cash or “sweat equity.”  This approach would require that boards and managements use considerable restraint in granting options, founders’ shares, warrants, or other equity based incentives.  As an alternative to policing the issuance of common stock, investors have gravitated toward preferred stock, a class of stock that gives cash investors first right to sale proceeds and various other protective and preferred rights, including special voting privileges.

Complicated capital structures cost money to track and maintain.  Thus, each new financing requires a review of all the elements of the complicated capital structure, may delay the process, and often leads new investors to ask for more strength in completing a difficult financing.  Multiple classes of stock also cause investor and board tension and possibly confusion over which class receives proceeds in what order and which class has special voting rights.  This class vote can, in fact, control some aspects of major decision- making for the company.

Creativity can be wonderful in financing and often is the only way to raise money.  Many venture capitalists love to brag about the clever financings they have done.  But the more clever the financing, the more damage it may eventually do to the capital structure.  Although the cash may arrive at the closing, the impact of the creative part of the financing may be felt for years and may ultimately make subsequent financings more expensive and difficult.”

George’s wisdom is a worthy caution as you consider the most suitable capital structure for your business, whether it’s an initial or follow-on round of financing.  Careful planning can protect ALL the stakeholders—those who took the earliest risks, as well as those who’ve invested at the highest valuations.  In the best of circumstances, you won’t have to worry about esoteric funding mechanisms.  If you do find yourself contemplating these more complicated alternatives, an experienced attorney specializing in early-stage financings is an invaluable asset as you evaluate the impact under various scenarios on founders, employees, and outside investors.