So you’ve finally decided to add an outside, independent director to the board of your privately-held A/E firm. You’ve even identified several candidates. Now the question is what (if any) compensation to offer them. For an independent party to take on the time and responsibility of serving on your board, you expect some level of compensation is appropriate, but how much?
Before addressing that question, here are a few background statistics on board compositions in the A/E industry. According to a 2015 study on ownership and ownership transition conducted by ROG together with Practice Lab (Boston, MA), of the 57 A/E firms participating, the average board consisted of five directors with a lower quartile of three and an upper quartile of seven, and 25% of the surveyed firms reserved at least one board seat for an outside director.
Anecdotal observations suggest that the larger the firm and the more distributed and active its internal stock market, the more likely it is to have one or more outside directors. Additionally, firms that sponsor employee stock ownership plans (ESOPs), particularly 100% ESOP-owned firms, are more likely to have outside directors. In fact, we frequently see independent ESOP trustees insisting on outside directors when negotiating the terms of an ESOP transaction to ensure a higher level of corporate governance. A recent study conducted by the National Center for Employee Ownership (www.nceo.org) reported that approximately two-thirds of responding firms had at least one outside director.
This trend toward outside directors at ESOP-owned companies have been driven by a number of recent court cases and regulatory actions, according to David Solomon, an attorney at Levenfeld Pearlstein specializing corporate law. Solomon indicates that, “there is a strong trend for ESOP trustees to insist that the board of directors of an ESOP company include several outside, independent directors, and in many cases the trustees will ask for the board to consist of a majority of outside directors. The goal of this request is to both show that the ESOP trustee has some control over activities of the board, such as a decision to pay a control premium in a stock transaction, as well as to add a level of accountability and professionalism to the board room that is many times lacking in a closely-held, privately owned company. This level of oversight and implementation of professional governance practice has the effect of protecting the employees’ investment in the company through their ESOP participation which is a positive development.”
Having established the value of independent outside directors, the question of how to compensate them remains. The aforementioned NCEO study explored the subject of outside director compensation (note that this study includes firms outside the A/E industry). The study found that among the 241 respondents with outside directors, the median annual compensation was $12,000, with a fairly wide range from a lower (10th percentile) of $2,600 top a high (90th percentile) of $40,160. The most common form of payment for outside directors was a fee per meeting at 47%, with the median respondents holding four meetings per year. The second most common form was a fixed retainer at 37%.
In deciding what to offer your outside directors, consider the following:
This discussion of how much compensation to pay outside directors raises another interesting question. If you compensate outside directors, can and should you also pay additional compensation to internal (employee) directors? After all, a director’s role and responsibilities are distinct from their role and responsibilities as an employee or manager. While still uncommon, some firms provide additional compensation to internal directors. This can be a way to reinforce the distinction of the internal directors’ roles as a member of the board and their roles as employees.
In summary, outside directors can bring value to boards that internal directors often cannot. This value can include: Outside perspective uninhibited by internal politics; Expertise in subjects such as law, finance, human resource, etc.; The “been there, done that” experience of a retired industry executive, and much more. So what is that worth to your firm? Survey data above suggests a fairly wide range of compensation, but here, the old adage “you get what you pay for” rings very true.
Does your firm have an ownership strategy that clearly defines how you will be able to exit your firm? Are you relying on selling your firm to a third-party or the next generation of leaders? According to the Census Bureau and assuming age 67 for retirement, more than 9,000 people a day are hitting retirement age, and this is expected to increase to over 12,000 by 2028. During this same period, the gap between the number of buyers and sellers will likely narrow and, in some years, will be negative. This gap will not widen to significant levels until 2035. Over the next 15 years, transitioning ownership will be one of the biggest challenges for A/E firm leaders.
The chasm between buyers and sellers seem to be increasing, which is making ownership planning more challenging. Buyers – likely Millennials – have a different appreciation for risk/rewards trade-off, and many have higher student debt obligations than previous generations. Compounding this chasm are the sellers – likely to be Baby Boomers – who are reluctant to give up control and are not satisfied with their valuation because they’ve invested so much into their company, but have not been taking anything out. They are banking on the “End of the Rainbow” value.
Many firms elect an internal ownership transition plan because sustaining their business and ensuring the welfare of their employees is most important to them. While an internal transition plan is often the path that most firms choose, it doesn’t take the external ownership plan off the table. Many firms develop their internal transition plans with the desire to sell to a third party in the future. However, will the market be in their favor? If not, they still have the option of transferring internally.
The share repurchase obligation is one of the biggest risks of a closely held company. Since the redemption of shares is not a tax-deductible expense, for every $1.00 of stock value that is redeemed, a company needs to generate about $1.41 of cash flow. Managing this tax risk leads firms to seek alternative ways to improve liquidity for their shares by discounting their value, tying in equity-based deferred compensation plans, or sponsoring partial or 100% ESOP ownership plans.
Selling shareholders are finding it more difficult to get a fair value for their ownership interest in a closely held A/E firm. As a result, I am seeing more firms relying on discounted stock valuation and delivering high returns in the form of dividend payments to offset low stock appreciation. Also, more firms are sponsoring ESOP ownership plans to take advantage of their tax benefits – especially 100% S-Corp ESOP ownership plans – as these firms become tax-exempt entities. Over the past two years, I have rendered more fairness opinions for firms converting their ownership to 100% S-Corp ESOPs than the previous 15 years. Will this trend continue?
Learn more about the latest ownership and value-enhancing trends that are occurring in the architecture, engineering, environmental consulting industry at the ROG Growth & Ownership Strategies Conference in Naples, Florida, November 6 – 8. For more information feel free to contact Michael at firstname.lastname@example.org.