While the work of public company compensation committees is well understood and receives considerable investor attention, the same cannot be said for private company compensation committees. Most private company boards don’t use standing subcommittees, so the owners lack the point of view of public company directors experienced in this type of work.

For most private companies, setting executive compensation is an annual exercise that is less than optimized. Whether it is due to economic constraints or personal friendships, some important discussions just don’t happen often enough, if at all. If a private company board intends to start a formal compensation committee, here are some important questions to consider.

How do the base pay, annual bonus, and long-term incentives align with the company’s strategic plan and market realities? Most private companies have well-established routines for addressing compensation. Since leadership tends to be stable, the decision-making behaviors and unspoken metrics are known. During economic booms, compensation discussions tend to revolve around the question, “Are we at risk of losing executives?” During moderate times the question leans toward, “Is the pay fair for what the executives are doing?” In a downturn, the thinking is more, “How can we afford to compensate executives?”

Performance reviews at private companies are often summaries, not data-rich exercises. They are also likely to be siloed, and not viewed in terms of the overarching goals of the organization. My experience suggests that the board can improve these areas by asking the following questions:

How has the individual’s performance driven success to achieve strategic goals?
Is the individual a good fit for the role they are in both today and in the future?
How does the individual exemplify the values and culture we aspire to demonstrate?

Looking at this triad of criteria sets the stage for a better evaluation of how impactful the organization’s leaders are in achieving ownership objectives, and therefore how to compensate them for their impact.

Does the company have the right data for benchmarking? Most private companies have access to limited compensation data. Their trade associations often provide compensation data specific to their industry, but I have found such reports to have limitations. They are indicative but not sufficiently informative. Often, there are not enough data to have confidence in what the numbers are saying. When you ask about location adjustments or niche adjustments, there isn’t sufficient information and you need to interpolate to form an opinion. Public companies have an advantage in that their data are rich and plentiful in comparison.

Private companies may be reluctant to pay for something that is often seen as not having enough utility (“but we only use it once a year”), hindering access to higher-quality data insights. There are many high-quality compensation consultants who can help, but they are a greater expense than the data. So, owners do without it—at the expense of more appropriate and competitive executive compensation.

How does the company deal with underperformers that can’t be easily replaced? Private companies tend to have smaller and less well-developed management teams than public companies do. Executive turnover tends to be lower for many reasons. Personal loyalty and relationships tend to be stronger since there is no public market pressure for performance.

If a senior executive isn’t cutting it, but is not easily replaced, how much risk do you want to take in transitioning to a new player? What is the value of “the devil you know” versus going to the open market? While there is value in organizational stability, what is the cost of condoning unacceptable performance? If the problem includes objectionable behaviors, the cost could be more than you think. These types of concerns often prevent needed change.

How much should the company let loyalty overrule merit? As the saying goes, if you are making money, the bank is happy, and if you are paying your taxes, you can do what you want at a private company. If the management team has been together for a long time, personal friendships can get in the way of evaluating and acting upon poor performance. How are you going to balance the conflicts?

Instances of executive underperformance and excessive loyalty are typically well-known throughout the ranks of the business. A decision to accept these shortcomings tells the staff what the real culture is, what gets rewarded, and what negative behaviors are tolerated, at least for the lucky few.

How aggressively should the company set goals? Maybe more critically, should there be any leniency if the company doesn’t make the goals? For a private company, if the owners are happy with the business results, then they are good enough. If there is no outside pressure, then there tends to be incentive to reward people even when they don’t reach their goals (the “let’s be nice” syndrome).

This is where outside directors can help the owners and managers balance conflicts. The outsiders should not have these biases and know they have been engaged to provide clear-eyed perspectives on what is best for the business. The outsider directors, and the board as a whole, need to serve as a compass through these difficult decisions.

Performance and compensation are issues in every organization. As the business grows, the issues become more complicated and the risks of talent flight increase. While much of the work of a compensation committee is formulaic, the bigger issues require deeper consideration. The hardest part of this work is often the judgment to balance facts and figures against emotion, relationships, and the risks and rewards that are not measured in dollars and cents.

These are the quandaries that allow board members to earn their keep.

Bruce Werner is managing director of Kona Advisors, which advises private and family-owned businesses. He has served on the boards of nonprofit and private companies.

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