162(m) - Created to Slow Public Companies, but a Real Accelerator for Start-ups

Twenty years ago, 162(m) was enacted by Congress. The purpose of this rule was to slow executive pay growth by capping the tax deductions on executive compensation at $1,000,000. There was an exemption for performance-based pay. The rule made it clear that typical stock options were among the compensation tools considered to be exempt from the cap. While 162(m) has been cited as a contributor to the growth we have seen in Fortune 500 executive pay, little is said about its impact on start-ups.

When viewing the world from the position of a cash-strapped start-up, high cash compensation creates an incredibly unfair playing field. Before 162(m), profitable companies could offer the most experienced and qualified candidates large amounts of low-risk cash compensation, while starts-ups could only offer high-risk equity compensation. It was difficult to convince a mid or high-level executive from a successful company to join a scrappy little private company with lots of ideas and potential, and far lower cash compensation.

In 1993, with the new tax deduction rules in place, many established companies moved to protect their tax deductions by moving more pay from guaranteed cash to at risk cash and equity. While this makes complete sense, it also provided a unique poaching opportunity for smaller firms with more leveraged upside. At the same time the stock market was 5 years into the most meteoric climb in its history.

The combination of moving cash to equity compensation and the incredible equity performance of start-ups (at the time mostly technology/semiconductor firms) provided a new form of pay comparison. Looking at base pay plus the gain from equity became a convincing story when recruiting. In many cases it provided the motivation for executives with established careers to take the plunge with small firms and amazing upside.

The law of unintended consequences was once again at work. 162(m) was designed to slow pay volatility by removing the tax incentive from high pay. It inadvertently helped fuel the growth in pay by making it easier for young companies to hire experienced leaders. These savvy professionals saw more potential in growing these companies into publicly traded players rather than aiming to be acquired and the relative pay safety that could once be found at larger firms.

Of course, 162(m) has not been fundamentally changed, nor the cap raised, in twenty years. This lack of keeping up with changes in pay level and compensation philosophy has blurred lines and continues to provide upside opportunities for those experienced professionals looking for a payoff rather than a multi-decade career. I would bet that changing the cap to $5 Million (along with a corresponding change in how stock options are treated) would likely slow executive pay increases while making it harder for start-ups to hire the talent they want and need as they grow. I would love to hear your thoughts on this perspective.

I want to make it clear that I am not personally advocating such a change. I think the boom in innovative start-ups is one the best things to happen in the U.S. over the past 50-60 years.

(Compensation data courtesy of Forbes. http://www.forbes.com/2008/04/30/ceo-pay-historic-lead-bestbosses08-cx_sd_0430flash.html)

Dan Walter is the President and CEO of Performensation an independent compensation consultant focused on the needs of small and mid-sized public and private companies. Dan’s unique perspective and expertise includes equity compensation, executive compensation, performance-based pay and talent management issues. Dan is a co-author of “The Decision Makers Guide to Equity Compensation”, “If I’d Only Know That”, “GEOnomics 2011” and “Equity Alternatives.” Dan is on the board of the National Center for Employee Ownership, a partner in the ShareComp virtual conferences and the founder of Equity Compensation Experts, a free networking group. Dan is frequently requested as a dynamic and humorous speaker covering compensation and motivation topics. Connect with him on LinkedIn or follow him on Twitter at @Performensation and @SayOnPay.

Comments

[E. James (Jim) Brennan]

The parasail in the graphic ought to be colored gold... or is it already platinum? Very few people understand what a tiny fraction of all top executives earn the hemongous sums that win headlines, disfavor, resentment and envy. Usually only NEOs of immensely profitable large organizations soar above the vast majority of small-company CEOs, start-up business founders, struggling sole proprietors and nominally-paid enterprise leaders who continue to reinvest every scarce dollar into meeting payrolls and keeping their outfits alive. The excesses of a few create a backlash against all.

[Dan Walter]

Thanks for the comment Jim. You are correct in the fact that the truly eye-popping executive compensation numbers are limited to a tiny percentage of companies. Sometimes it is hard to remember that when the media happily feeds us the pablum of excess.