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What do we know about executive compensation at small privately held firms?

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Abstract

We examine executive compensation using data from two nationally representative samples of small privately held US corporations conducted 10 years apart—in 1993 and 2003. We find that executive pay at small privately held firms increases with firm size and varies widely by industry, consistent with stylized facts about executive pay at public companies. From 1993 to 2003, inflation-adjusted executive pay declined at small privately held companies, in contrast to the run-up in executive pay at large public companies over the same period. Executive pay is higher at more complex organizations, is inversely related to CEO ownership and financial risk and is related to CEO age, education and gender.

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Notes

  1. See Frequently Asked Questions posted on the US Small Business Administration’s Web site at: https://www.sba.gov/sites/default/files/advocacy/FAQ_March_2014_0.pdf.

  2. An S-corporation is similar to a C-corporation in that its shareholders enjoy limited liability, but is different in that it is exempt from corporate taxation and, at the time of the survey, had to have less than a certain number of shareholders (35 at the time of the 1993 survey; 75 at the time of the 2003 survey), only one class of stock and no foreign or corporate shareholders. See Internet Appendix I in “Electronic Supplementary Material” for more information on how the limitation on the number of shareholders has changed over time.

  3. See Blau and Kahn (2006) for a survey of the literature on gender and pay.

  4. Huberman and Wei (2006) find that women make significantly larger contributions to their 401 K plans, suggesting greater risk aversion. Greater relative risk aversion also could explain the lower CEO compensation we find in our analysis.

  5. There also are 1987 and 1998 versions of the SSBF, but neither of these versions provides information about executive pay.

  6. See Rosen (1982) for an early discussion. A survey article by Murphy (1999) is generally regarded as the definitive work in this area of the literature, providing references to more than 200 academic articles published up through 1998. Hallock and Murphy (1999) reprint 45 of the most influential of these manuscripts.

  7. Of course, the most prominent advantage of the corporate form of organization over partnerships and proprietorships is limited liability, whereas investors’ liability is limited to the amount of their equity investment. Owners of partnerships and proprietorships face unlimited liability. There are other organizational forms which enable shareholders to avoid taxes (see chapter 4 of Scholes and Wolfson 1992).

  8. Mehran and Suher examined a large sample of converted banks post-1997 when banks were allowed for the first time to organize themselves as an S-corporation and document that they pay more dividends post-conversation relative to control groups.

  9. The median CEO pay for S-corporations in our 1993 (2003) sample is $38,000 ($50,000), so the majority of our S-corporation CEOs would have incentive to favor dividends over salary.

  10. While many states conform to federal treatment, some do not follow the federal treatment of S-corporations, with some applying a tax surcharge to burden S-corporations at a corporate rate when the individual rates are substantially lower. Moreover, if a company has any significant foreign operations, other nations may not recognize the pass-through status of S-corporations. For a number of non-tax reasons, S-corporations are unusual in the international arena.

  11. At α = 100 %, one dollar of salary would be exactly equivalent to one dollar of dividends for the shareholder-manager of an S-corporation, ignoring the effect of the payroll tax. At compensation levels below the IRS maximum level of income subject to the Social Security portion of the payroll tax ($60,600 in 1993, $87,000 in 2003), CEOs of S-corporations should favor dividends over salary because dividend distributions are not subject to the 12.4 % payroll deduction.

  12. In our 1993 (2003) sample, the median firm has CEO pay of $45,000 ($53,000), but profits of only $20,000 ($37,000). Median CEO ownership is 60 % (95 %).

  13. Several studies, including Henderson and Fredrickson (1996) and Sanders and Carpenter (1998), have shown that CEO pay is related to organizational complexity. Bushman et al. (2004) find that directors’ equity-based incentives vary with organizational complexity.

  14. Murphy (1999) and others have documented that CEOs of large publicly traded firms have significant discretion in the level and form of their pay, even when CEO ownership is quite small. Therefore, it is reasonable to assume that the CEOs of our small firms, who typically own a controlling stake in their firms, have far more discretion in setting their own pay.

  15. Internet Appendix II in “Electronic Supplementary Material” provides more details about the 1993 and 2003 SSBFs. Similar surveys were conducted for 1987 and 1998, but neither of those two surveys collected information on CEO pay. The survey questionnaire and methodology reports are available, along with other information, at the Federal Reserve Board’s Survey of Small Business Finances Web site: http://www.federalreserve.gov/pubs/oss/oss3/nssbftoc.htm. Also see Cole and Wolken (1995) for a descriptive study of the 1993 SSBF and Mach and Wolken (2006) for a descriptive study of the 2003 SSBF.

  16. Some variations of partnerships offer some, but not all, of the advantages of the corporation. For example, the limited partners in a limited partnership enjoy limited liability, although the general partner does not, and partners in a master limited partnership can readily transfer ownership interests.

  17. For the population of US firms that were publicly traded during 1994, we examined the proxy statement of each firm. We found that no firm with less than $10 million in total assets issued stock options and only one percent of firms with assets between $10 million and $100 million issued stock options.

  18. We split wholesale and retail firms—SIC codes 50–51 and 52–59, respectively—into two separate categories.

  19. In the 1993 SSBF, question P10 asks “During (YEAR), what was the amount of officers’ compensation?” In the 2003 SSBF, question P5.5 asks “For the fiscal year ending (DATE), what was the total amount of officers’ compensation?”

  20. The D&B credit score is not available from the 1993 SSBF. When the credit score is omitted from this specification using the 2003 sample, the leverage ratio becomes negative and statistically significant at the 0.01 level, consistent with our finding for the 1993 sample.

  21. The coefficients from this regression correspond to a quadratic equation. Taking the first derivative and setting it equal to zero, we solve for the implied maximum value of age.

  22. We also tested specifications including CEO experience in place of and in addition to CEO age. The results are not qualitatively affected. Experience is not significant when added to age and is significant with the same qualitative values when in place of age and age squared.

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Acknowledgments

We acknowledge the helpful comments or discussions of Anup Agrawal, Tim Burley, Kathleen Farrell, Rachel Hayes, Claudio Loderer, Kevin Murphy, Todd Pulvino, Scott Schaefer, James Vickery and participants at the Conference on Corporate Governance at Family/Unlisted Firms held June 15–17, 2006, in Thün, Switzerland; the CESifo workshop on Executive Compensation held July 16–17, 2008, in Venice, Italy; and the Fourth BI-CEPR Conference on Money, Banking and Finance held October 2–3, 2009, in Rome, Italy. The views expressed in this paper are those of the authors and do not necessarily represent the views of the Federal Reserve Bank of New York or the Federal Reserve System.

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  1. Driehaus College of Commerce, DePaul University, Chicago, IL, 60604, USA

    Rebel A. Cole

  2. Research and Statistics Group, Federal Reserve Bank of New York, New York, NY, USA

    Hamid Mehran

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  1. Rebel A. Cole
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Correspondence to Rebel A. Cole.

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Cole, R.A., Mehran, H. What do we know about executive compensation at small privately held firms?. Small Bus Econ 46, 215–237 (2016). https://doi.org/10.1007/s11187-015-9689-2

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