Growth Strategies

Picture Improves for Private-company Pay

As public companies cut back on stock options, private businesses are more evenly matched when competing for executive talent.
Lisa YoonJuly 26, 2005

Small private companies have long faced a David-and-Goliath battle with their larger public counterparts in the competition for senior executive talent, at least when it comes to compensation. But now that some public issuers are scaling back on offering stock options — in large part because of FAS 123R, the new Financial Accounting Standards Board requirement that they treat options as an expense — private businesses are sizing up better, experts say.

To be sure, Rich Mahfouz, chief financial officer of Carlsbad, California-based telecom Nobel Ltd. Co. echoes many of his small-company peers when he says, “It’s a challenge putting together [executive compensation] plans that are comparable to public companies’.” With much broader access to the capital markets, public companies have been to hire top executives more easily by offering attractive compensation packages — including stock options that, before FAS 123R, were free of balance-sheet expenses as of the option-grant date.

Private companies can offer equity compensation, too, but the process is more complicated. Lacking a public market to help them value the underlying stock price — a necessity for an options-pricing model such as Black-Scholes — private companies must rely on independent appraisals that drive up accounting and consulting costs.

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Another difficulty is that, with no public market, stock options can hurt a small company’s cash flow because “the company is essentially buying back the equity” when it grants options, explains Barry Buck, a partner in the Boston office of Mercer HR Consulting.

That may be why stock options aren’t a big part of the pay package at companies like Nobel, which had revenues of $28.9 million in 2003. Instead, Mahfouz says, “we very effectively use [cash] incentive compensation plans.” Based on the company’s regular performance reviews, an executive’s cash bonus can be as much as 20 percent of his salary, he adds.

Yet compare that with Covad Communications, a San Jose, California-based telecom that that now trades over-the-counter for about $1.30 a share after being delisted from Nasdaq in 2001, and that recorded $429 million in revenues in 2004. A glimpse of the company’s compensation picture reveals that CFO Mark Richman, for example, received a 2003 cash bonus of $164,310 — almost 69 percent of his $239,231 salary. No wonder that smaller private companies like Nobel see a challenge in luring executives from their bigger public rivals.

But with the implementation of FAS 123R, which began to require the expensing of options for public companies for the first reporting period starting after June 15, “the competition gap is closing,” says Bruce Clouser, a partner at PricewaterhouseCoopers Human Resource Consulting.

The Allure of Cash Flow

One reason is that the reality of expensing options is a bit further off for private companies, which will be required to do that six months later than public companies. Even then, says David Broman, chief executive officer of compensation consultancy Syzygy Consulting, expenses aren’t as important a measure of the financial shape of private companies, where investors — usually venture-capital firms — are more interested in positive cash flow.

In its latest survey of pre-IPO and private-company total compensation released in April, in fact, Syzygy reports that in anticipation of FAS 123R implementation, private companies are boosting stock compensation for executives. Overall, the 122 companies (with a median valuation of $140 million in net worth in 2004) offered 3.7 percent more equity pay than in the previous year’s survey. At the same time, the consultancy observes, public companies are doing the opposite. In fact, Broman believes, “the tables have turned for good” in terms of increased competitive advantage for small private companies.

Of course, at many private technology companies seeking to change their status via an IPO or sale of the company, stock options have historically been the bread and butter of their compensation packages. That’s true of the executive-compensation plans of Vesta Corp., a prepaid-card services provider, according to CFO Sanjay Khare. “We don’t have huge pools of cash unless the company has a good year,” he says, “so we focus the senior management team on execution [of company performance goals].” Although Khare declined to detail what his executives receive, he says about 20 percent of total compensation at the Portland, Oregon-based company is in stock options.

At Vesta, with 2003 revenues of $469 million, base salaries are “at or very slightly below” the levels at a similar public company, he says. But executives at the growing company believe its upside potential is expansive enough that the stock-option offerings take total executive compensation above that of its competitors. “True wealth creation is in stock options,” adds Khare.

Indeed, the opportunity for wealth creation at young, growing companies has long made the competition for talented executives easier for Skip Smith, CFO of Mill Valley, California-based BondDesk Group LLC, which took in $20.2 million in 2003. During his entire career, which has been spent with Silicon Valley tech firms, “I’ve never lost anyone to public companies for talent,” he maintains.

Besides attracting adept executives, another benefit of options at private companies is the ability to retain talent, says Khare. “The difference at private companies is, unless or until the company goes public or gets acquired, there’s no way to realize the value [of stock options]. In that sense, options are a great way to retain people” — at least until the company goes public.

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