1. What do we know about executive compensation at privately held firms? Rebel A. Cole DePaul University Hamid Mehran Federal Reserve Bank of New York

2. © 2009 Rebel Cole and Hamid Mehran Summary We examine CEO compensation at privately held U.S. firms. We examine CEO compensation at privately held U.S. firms. We find: We find: Pay is higher at larger firms and varies widely by industry, consistent with stylized facts about pay at public companies.Pay is higher at larger firms and varies widely by industry, consistent with stylized facts about pay at public companies. Inflation-adjusted pay has fallen at private companies, in contrast with the widely documented run-up in pay at large public companies.Inflation-adjusted pay has fallen at private companies, in contrast with the widely documented run-up in pay at large public companies. The pay-size elasticity is much larger for private than for public companies.The pay-size elasticity is much larger for private than for public companies. Pay is higher at C-corporations than at S-corporationsPay is higher at C-corporations than at S-corporations Pay is higher at more complex organizations.Pay is higher at more complex organizations. Pay is inversely related to CEO ownership and firm risk.Pay is inversely related to CEO ownership and firm risk. Pay is a function of CEO age, education and gender.Pay is a function of CEO age, education and gender. Pay decreases with age and increases with education. Pay decreases with age and increases with education. Pay is lower for female executives. Pay is lower for female executives.

3. © 2009 Rebel Cole and Hamid Mehran Background: Why do we look at privately held firms? The existing literature on executive pay (and corporate finance, in general) has focuses almost exclusively on large, publicly traded corporations. The existing literature on executive pay (and corporate finance, in general) has focuses almost exclusively on large, publicly traded corporations. Why? Data are relatively easy to obtain. Why? Data are relatively easy to obtain. CRSP, COMPUSTAT, EXECUCOMP, ETC.CRSP, COMPUSTAT, EXECUCOMP, ETC. In the U.S., there are more than 30 million predominately small, privately held firms, but only about 10,000 firms with publicly traded securities. In the U.S., there are more than 30 million predominately small, privately held firms, but only about 10,000 firms with publicly traded securities. There are a number of reasons to think that determinants of executive compensation differ at large public and small private firms. There are a number of reasons to think that determinants of executive compensation differ at large public and small private firms.

4. © 2009 Rebel Cole and Hamid Mehran Who sets CEO Pay? The board of directors Public: Public: Board of Directors typically has 5 – 20 members.Board of Directors typically has 5 – 20 members. At larger public firms, such as those covered by ExecuComp, a compensation committee sets CEO pay, usually using pay at comparably sized firms as a guide.At larger public firms, such as those covered by ExecuComp, a compensation committee sets CEO pay, usually using pay at comparably sized firms as a guide. Private: Private: Board of Directors is usually of size one--the CEO.Board of Directors is usually of size one--the CEO. If the Board is larger, it usually consists of the CEO’s family members.If the Board is larger, it usually consists of the CEO’s family members. => The CEO essentially sets his or her own pay.=> The CEO essentially sets his or her own pay. CEO characteristics should be important determinants of CEO pay (age, education, gender). CEO characteristics should be important determinants of CEO pay (age, education, gender).

5. © 2009 Rebel Cole and Hamid Mehran Who does the Board of Directors represent? Public: Public: (Supposedly) represents dispersed shareholders(Supposedly) represents dispersed shareholders Median CEO ownership 0.25%Median CEO ownership 0.25% Private: Private: (Primarily) represents the controlling shareholder or family.(Primarily) represents the controlling shareholder or family. Median CEO ownership is 50%; average is 70%; but range is very wide—from 1%-100%.Median CEO ownership is 50%; average is 70%; but range is very wide—from 1%-100%. Most other shareholders are family or founding partners.Most other shareholders are family or founding partners. => CEO pay should be inversely related to CEO ownership, as there is decreasing incentive to take distributions as pay as ownership increases.

6. © 2009 Rebel Cole and Hamid Mehran Who monitors the firm? Public: Public: Regulators, the media, and large block holders (both debt and equity).Regulators, the media, and large block holders (both debt and equity). Private: Private: Largely unregulated and ignored by the media,Largely unregulated and ignored by the media, Primary monitor is a bank who lends money to the firm.Primary monitor is a bank who lends money to the firm. Banks often impose loan covenants mandating minimum financial ratios, limits on CEO pay.Banks often impose loan covenants mandating minimum financial ratios, limits on CEO pay. Leverage should be an important determinant of CEO pay, with an inverse relationship: lower leverage =>higher pay.

7. © 2009 Rebel Cole and Hamid Mehran Who expropriates minority shareholder wealth? Public: Public: Managers with little equity ownership expropriate wealth of dispersed minority shareholders.Managers with little equity ownership expropriate wealth of dispersed minority shareholders. Private: Private: CEO is the controlling block holder with large equity ownership who expropriates wealth from minority shareholders, who also are often smaller block holders.CEO is the controlling block holder with large equity ownership who expropriates wealth from minority shareholders, who also are often smaller block holders. However, large equity holdings limit gains.However, large equity holdings limit gains. Strong personal relationships between CEO and minority shareholders also limit expropriation.Strong personal relationships between CEO and minority shareholders also limit expropriation.

8. © 2009 Rebel Cole and Hamid Mehran Who pays taxes? The role of organizational form Public: Public: All U.S. public firms are C-corporations, paying taxes at both corporate and personal level. (No dividend imputation in the U.S. Highest effective tax rates exceed 70%!)All U.S. public firms are C-corporations, paying taxes at both corporate and personal level. (No dividend imputation in the U.S. Highest effective tax rates exceed 70%!) Private: Private: Mix of C-corporations and S-corporations, which “pass through” income to shareholders and avoid tax at the corporate level.Mix of C-corporations and S-corporations, which “pass through” income to shareholders and avoid tax at the corporate level. => CEOs at C-corps should earn higher pay, as they take distributions as tax-deductible salary expense. => CEO Pay should be higher at C-corporations.

9. © 2009 Rebel Cole and Hamid Mehran Background: Who pays taxes? $1.00 Distribution S-CorpC-Corp 100% Ownership Dividends$1.00(1-Tp)$1.00(1-Tc)(1-Tp) Salary$1.00(1-Tp) 50% Ownership Dividends$0.50(1-Tp)$0.50(1-Tc)(1-Tp) Salary$1.00(1-Tp)

10. © 2009 Rebel Cole and Hamid Mehran Background: Who pays taxes? $1.00 Distribution, Tc = Tp = 30% S-CorpC-Corp 100% Ownership Dividends $1.00(1-Tp)=$0.70$1.00(1-Tc)(1-Tp)=$.049 Salary $1.00(1-Tp)=$0.70 50% Ownership Dividends $0.50(1-Tp)=$0.35$0.50(1-Tc)(1-Tp)=$0.245 Salary $1.00(1-Tp)=$0.70

11. © 2009 Rebel Cole and Hamid Mehran Why do we look at privately held firms? For all of these reasons, it is likely that the determinants of executive compensation differ at large public and small private firms. For all of these reasons, it is likely that the determinants of executive compensation differ at large public and small private firms. => What we know about executive pay at public firms is unlikely to hold true at privately held firms, yet there has been almost no research on the determinants of executive pay at privately held firms. => What we know about executive pay at public firms is unlikely to hold true at privately held firms, yet there has been almost no research on the determinants of executive pay at privately held firms. In this study, we attempt to establish some stylized facts about executive pay at privately held firms. In this study, we attempt to establish some stylized facts about executive pay at privately held firms.

12. © 2009 Rebel Cole and Hamid Mehran Hypothesis: Pay-Size Elasticity Public: Public: Board uses pay at comparably sized firms to set CEO pay, leading to the “best documented empirical regularity” regarding CEO pay, a pay-size elasticity of 0.3.Board uses pay at comparably sized firms to set CEO pay, leading to the “best documented empirical regularity” regarding CEO pay, a pay-size elasticity of 0.3. Private: Private: Board is usually the CEO, who does not use comparables to determine her compensation.Board is usually the CEO, who does not use comparables to determine her compensation. => pay-size elasticity at small firms will not conform to “best documented empirical regularity.”=> pay-size elasticity at small firms will not conform to “best documented empirical regularity.”

13. © 2009 Rebel Cole and Hamid Mehran Hypotheses: Organizational Form C-Corps: C-Corps: corporate income distributed as dividends is taxed twice, once at corporate level and once at personal level.corporate income distributed as dividends is taxed twice, once at corporate level and once at personal level. Corporate income distributed as compensation is taxed only at the personal levelCorporate income distributed as compensation is taxed only at the personal level S-Corps: S-Corps: no double taxation.no double taxation. Hypothesis: CEOs at C-corps prefer to take corporate income out as salary rather than dividends, so they should be paid more than CEOs at S-corps. Hypothesis: CEOs at C-corps prefer to take corporate income out as salary rather than dividends, so they should be paid more than CEOs at S-corps.

14. © 2009 Rebel Cole and Hamid Mehran Hypotheses: Ownership Share Corporate income distributed as dividends must be shared on a pro rata basis with other owners while CEO pay goes only to the CEO. Corporate income distributed as dividends must be shared on a pro rata basis with other owners while CEO pay goes only to the CEO. Hypothesis: CEO pay should be an inverse function of CEO ownership. Hypothesis: CEO pay should be an inverse function of CEO ownership.

15. © 2009 Rebel Cole and Hamid Mehran Hypotheses: Leverage Numerous studies suggest that CEOs make corporate decisions to reduce the probability of financial distress, thus improving job security. Numerous studies suggest that CEOs make corporate decisions to reduce the probability of financial distress, thus improving job security. Also, loan covenants often limit CEO pay or mandate maintenance of minimum debt coverage ratios. Also, loan covenants often limit CEO pay or mandate maintenance of minimum debt coverage ratios. Hypothesis: CEOs adjust their pay to reduce likelihood of financial distress so CEO pay should be an inverse function of firm financial risk. Hypothesis: CEOs adjust their pay to reduce likelihood of financial distress so CEO pay should be an inverse function of firm financial risk.

16. © 2009 Rebel Cole and Hamid Mehran Hypotheses: Educational Attainment There is a broad literature documenting the relationship between salary and educational attainment. There is a broad literature documenting the relationship between salary and educational attainment. However, there is little evidence on how education affects CEO pay at privately held firms. However, there is little evidence on how education affects CEO pay at privately held firms. Hypothesis: We expect better educated CEOs to receive higher pay than less educated CEOs. Hypothesis: We expect better educated CEOs to receive higher pay than less educated CEOs. May be more productive.May be more productive. May “think” more of themselves.May “think” more of themselves.

17. © 2009 Rebel Cole and Hamid Mehran Hypotheses: CEO Age There also is a broad literature documenting the relationship between salary and worker age. There also is a broad literature documenting the relationship between salary and worker age. However, again there is little evidence on how age affects CEO pay at privately held firms. However, again there is little evidence on how age affects CEO pay at privately held firms. We expect pay to increase with age up to a point. We expect pay to increase with age up to a point. At some point, CEOs may prefer to “leave” earnings in the firm At some point, CEOs may prefer to “leave” earnings in the firm Hypothesis: We expect a quadratic relationship between CEO age and compensation, rising to a maximum and then falling for older workers. Hypothesis: We expect a quadratic relationship between CEO age and compensation, rising to a maximum and then falling for older workers.

18. © 2009 Rebel Cole and Hamid Mehran Hypotheses: Gender Numerous studies have found that women are paid less than men, even senior corporate executives. (Note that there are not enough female CEOs at public U.S. firms to do a study.) Numerous studies have found that women are paid less than men, even senior corporate executives. (Note that there are not enough female CEOs at public U.S. firms to do a study.) CEOs at privately held firms have extraordinary input into their own pay so discrimination should not play a role in the pay of female CEOs. CEOs at privately held firms have extraordinary input into their own pay so discrimination should not play a role in the pay of female CEOs. However, relative risk aversion can play a role; if female CEOs are more risk averse, then we expect to find that female CEOs of privately held firms earn less than males. By leaving pay in the firm as equity, they reduce financial risk. However, relative risk aversion can play a role; if female CEOs are more risk averse, then we expect to find that female CEOs of privately held firms earn less than males. By leaving pay in the firm as equity, they reduce financial risk.

19. © 2009 Rebel Cole and Hamid Mehran Data: What is a “small firm?” U.S. Tax Returns: 20 million Schedule C filers U.S. Tax Returns: 20 million Schedule C filers Dun & Bradstreet: 10 million small firms Dun & Bradstreet: 10 million small firms Collected from “yellow-page” phone books, records of creditors including suppliers of trade credit.Collected from “yellow-page” phone books, records of creditors including suppliers of trade credit. Verified by phone, so all have a telephone.Verified by phone, so all have a telephone. Compare to approximately 10,000 U.S. firms with publicly listed debt or equity securities, per CompuStat or CRSP. Compare to approximately 10,000 U.S. firms with publicly listed debt or equity securities, per CompuStat or CRSP. Fewer than one out of 2,000 U.S. firms is public.Fewer than one out of 2,000 U.S. firms is public.

20. © 2009 Rebel Cole and Hamid Mehran Data: Survey of Small Business Finances (SSBF) Primary data source: Survey of Small Business Finances, jointly sponsored by the U.S. Federal Reserve Board and Small-Business Administration, conducted by major survey research firms. Primary data source: Survey of Small Business Finances, jointly sponsored by the U.S. Federal Reserve Board and Small-Business Administration, conducted by major survey research firms. Four iterations: 1987, 1993, 1998, 2003Four iterations: 1987, 1993, 1998, 2003 Only 1993 and 2003 iterations collected information on executive pay.Only 1993 and 2003 iterations collected information on executive pay. Two surveys, conducted a decade apart, should enable us to identify empirical regularities in CEO pay at private firms.Two surveys, conducted a decade apart, should enable us to identify empirical regularities in CEO pay at private firms.

21. © 2009 Rebel Cole and Hamid Mehran Data: Survey of Small Business Finances (SSBF) 1993 SSBF is a sample of 4,356 firms. 1993 SSBF is a sample of 4,356 firms. 2003 SSBF is a sample of 4,240 firms. 2003 SSBF is a sample of 4,240 firms. Each sample is a stratified random sample that, when properly weighted, is representative of privately held U.S. firms with 500 or fewer employees (~5 million for-profit, non-farm, non- financial firms). Each sample is a stratified random sample that, when properly weighted, is representative of privately held U.S. firms with 500 or fewer employees (~5 million for-profit, non-farm, non- financial firms). SSBF provides data on owner characteristics, firm characteristics and firm financial statements. SSBF provides data on owner characteristics, firm characteristics and firm financial statements.

22. © 2009 Rebel Cole and Hamid Mehran Data: SSBF To facilitate comparisons with CEO pay at public firms, we look only at corporations, excluding proprietorships and partnerships, which account for about half of each sample. To facilitate comparisons with CEO pay at public firms, we look only at corporations, excluding proprietorships and partnerships, which account for about half of each sample. We exclude firms that did not know or refused to provide their CEO pay. We exclude firms that did not know or refused to provide their CEO pay. We exclude firms reporting that the primary owner is not the day-to-day manager of the firm because we do not have information on the characteristics of these managers. We exclude firms reporting that the primary owner is not the day-to-day manager of the firm because we do not have information on the characteristics of these managers. We exclude a handful of public firms that qualified for and are included in the SSBF. We exclude a handful of public firms that qualified for and are included in the SSBF.

23. © 2009 Rebel Cole and Hamid Mehran Data: SSBF This leaves us with a final sample of: This leaves us with a final sample of: For 1993: For 1993: 1,630 firms; of which 1,009 are C-corps and 621 are S-corps.1,630 firms; of which 1,009 are C-corps and 621 are S-corps. For 2003: For 2003: 1,668 firms; of which 601 are C-corps and 1,067 are S-corps.1,668 firms; of which 601 are C-corps and 1,067 are S-corps. Note: the legal limitations on the number of shareholders at S-corporations was increased from 35 in 1993 to 75 in 1996 and 100 in 2004. Note: the legal limitations on the number of shareholders at S-corporations was increased from 35 in 1993 to 75 in 1996 and 100 in 2004.

24. © 2009 Rebel Cole and Hamid Mehran Data: ExecuComp Data on CEO salary plus bonus for S&P500, Mid- Cap 400 and Small-Cap 600. Data on CEO salary plus bonus for S&P500, Mid- Cap 400 and Small-Cap 600. Enables us to extend previous work on the pay- size elasticity. Enables us to extend previous work on the pay- size elasticity. Data are from 1992-2004, producing 19,113 firm-year observations. Data are from 1992-2004, producing 19,113 firm-year observations. We also analyze 1992-1994 and 2002-2004 separately for better comparability with the SSBF data, but this limits our ability to slice the data. We also analyze 1992-1994 and 2002-2004 separately for better comparability with the SSBF data, but this limits our ability to slice the data.

25. © 2009 Rebel Cole and Hamid Mehran Data: SEC Proxy Statements Data on CEO salary plus bonus for Compustat firms smaller than $250 million in total assets, the largest size firm in the SSBF. Data on CEO salary plus bonus for Compustat firms smaller than $250 million in total assets, the largest size firm in the SSBF. Enables us to disentangle public/private from large/small. Enables us to disentangle public/private from large/small.

26. © 2009 Rebel Cole and Hamid Mehran Executive Pay: By Size and Organizational Form

27. © 2009 Rebel Cole and Hamid Mehran Executive Pay: By Industry

28. © 2009 Rebel Cole and Hamid Mehran Descriptive Statistics

29. © 2009 Rebel Cole and Hamid Mehran Descriptive Statistics (cont.)

30. © 2009 Rebel Cole and Hamid Mehran Pay-Sales Elasticities ExecuComp SEC Proxy 1993 SSBF 2003 SSBF ALL.289.304.569.457 By Quartile IV (Largest).307.253.664.336 III.269.289.421.306 II.392.449.858.402 I (Smallest).100.183.653.280

31. © 2009 Rebel Cole and Hamid Mehran OLS Regression Results: Dependent Variable is Ln (CEO Pay)

32. © 2009 Rebel Cole and Hamid Mehran OLS Regression Results: Dependent Variable is Ln (CEO Pay)

33. © 2009 Rebel Cole and Hamid Mehran Summary and Conclusions We extend the literature on executive compensation by analyzing CEO pay at small privately held U.S. corporations. We extend the literature on executive compensation by analyzing CEO pay at small privately held U.S. corporations. Differences in ownership and governance structures of small and large firms suggest that determinants of CEO pay also should differ. Differences in ownership and governance structures of small and large firms suggest that determinants of CEO pay also should differ.

34. © 2009 Rebel Cole and Hamid Mehran Summary and Conclusions First, we test whether “stylized facts” about executive pay at large public firms also hold true for small private firms. First, we test whether “stylized facts” about executive pay at large public firms also hold true for small private firms. We find that pay is higher at larger firms and varies widely by industry, consistent with stylized facts about pay at public companies.We find that pay is higher at larger firms and varies widely by industry, consistent with stylized facts about pay at public companies. However, we also find that inflation-adjusted pay has fallen at private companies, in contrast with the widely documented run-up in pay at large public companies.However, we also find that inflation-adjusted pay has fallen at private companies, in contrast with the widely documented run-up in pay at large public companies. We also find a much higher pay-size elasticity at privately held companies.We also find a much higher pay-size elasticity at privately held companies.

35. © 2009 Rebel Cole and Hamid Mehran Summary and Conclusions Second, we find that CEOs of C-corps are paid significantly more than those of S-corps. Second, we find that CEOs of C-corps are paid significantly more than those of S-corps. This finding supports our hypothesis that CEO pay at C-corps enables CEOs to avoid the double taxation of corporate income distributed as dividends. This finding supports our hypothesis that CEO pay at C-corps enables CEOs to avoid the double taxation of corporate income distributed as dividends.

36. © 2009 Rebel Cole and Hamid Mehran Summary and Conclusions Third, we find that CEO pay is a decreasing function of ownership. Third, we find that CEO pay is a decreasing function of ownership. This supports our hypothesis that it is cheaper to distribution corporate income to CEOs via compensation than dividends. This supports our hypothesis that it is cheaper to distribution corporate income to CEOs via compensation than dividends. Moreover, this relationship is stronger at C-corps than at S-corps as the penalty is larger for C- corps because of double taxation. Moreover, this relationship is stronger at C-corps than at S-corps as the penalty is larger for C- corps because of double taxation.

37. © 2009 Rebel Cole and Hamid Mehran Summary and Conclusions Fourth, we find that CEO pay is inversely related to firm financial risk as measured by the ratio of debt to assets or the D&B Credit Score. Fourth, we find that CEO pay is inversely related to firm financial risk as measured by the ratio of debt to assets or the D&B Credit Score. This suggests that CEOs adjust their compensation so as to reduce the probability of financial default. This suggests that CEOs adjust their compensation so as to reduce the probability of financial default.

38. © 2009 Rebel Cole and Hamid Mehran Summary and Conclusions Finally, we find that CEO pay is a function of CEO characteristics. Finally, we find that CEO pay is a function of CEO characteristics. CEO pay is a quadratic function of age, first increasing to a maximum and then falling. CEO pay is a quadratic function of age, first increasing to a maximum and then falling. CEO pay increases with education. CEO pay increases with education. CEO pay is lower for females. In a companion paper, we are exploring how relative risk aversion might explain this result. CEO pay is lower for females. In a companion paper, we are exploring how relative risk aversion might explain this result.