This document discusses executive compensation peer groups and appropriate methodologies for constructing them. It recommends that peer groups consist of companies similar in both industry and size to the client, as these are the biggest factors influencing pay levels and structures. Additionally, peer companies should have revenues and market capitalizations within 0.5-2.0 times of the client's, in order to provide an appropriate basis for compensation comparisons. The document cautions against using "aspirational" or "talent" peer groups that do not accurately reflect the client's current size and industry.

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Executive Compensation Peer Groups
Much has been written and discussed about executive compensation peer groups, including a
recent article in the March 12, 2012 issue of Agenda magazine, the publication for corporate Board
members. Peer groups are the named companies (in public company proxy statement filings) to which
companies compare their executive compensation. They have historically been groups of companies
similar in size and industry for most companies. However, there has been recent discussion to move in a
different direction by looking at competitors for talent, those organizations similar in business strategy,
etc. We feel this is an unwise and unwarranted change to the prevalent methodology. Peer groups are
composed of companies similar in both industry and size because those are the two biggest
determinants of pay levels and pay structure.
Historical Issues with Peer Group Development
Occasionally, companies have had “aspirational Peer Groups” – companies that they want to be
like “when they grow up” – and talent Peer Groups – who they lose and/or recruit executives to/from.
The former is a significant issue because the firm is comparing its compensation today against much
larger firms that it desires to be like sometime in the future. This is not a bad approach to look at as a
“roadmap” for the future. However, it should not be used to compare executive compensation against
in the present, for the simple reason that the firm may never get there. We had this issue with a client
back in the early 2000’s, a fast growing public company that wanted to compare itself to much larger
firms that it saw itself similar to 3-5 years down the road. Unfortunately, the firm never hit those
numbers, missed its Wall Street forecasts, the stock dropped, and it was bought by a much larger
company.
Using talent competitors is also inappropriate at the executive level. While perhaps useful at
the broader employee level, it is not at the executive level because of the disclosure and scrutiny of
public company executive compensation. It is important therefore to compare a company to firms that
they currently resemble. Take a $250M publically traded software company. It may compete for
engineers and technical talent against the likes of Microsoft, Google, and EMC – all much larger
companies – or against venture-funded pre-IPO firms. Nonetheless, it does not recruit similar executives
from those companies. The CEO, CFO or CTO of Microsoft, Google, or EMC would never leave to go to a
$250M public software firm. If the company hired talent at the executive level from those
organizations, it would likely bring in a Controller, a 2nd or 3rd level technical executive, or a business unit

2. executive. Similarly, it would also not likely hire its CEO or CFO from a venture-backed firm, unless that
individual had prior experience as a public-company CEO or CFO.
Constructing Appropriate Peer Groups
In order to construct appropriate Peer Groups for public company executive compensation
purposes, it is important to look at three things:
1. Industry or industry similarity
2. Revenues (0.5 to 2.0 times that of the client with the client ending up as near to the median
of the final sample as possible.)
3. Market capitalization (0.5 to 2.0 times that of the client with the client ending up as near to
the median of the final sample as possible.)
Industry similarity, often measure by GICS (General Industry Classification Standard) or SIC
(Standard Industry Classification) codes, is important because industry determines the skill sets
executives need, its profit margins, etc. This is not to say that organizations never hire outside of the
industry, as they do. However, that will generally lead to hiring someone from a company with very
different levels and structures of pay. For example, high technology firms are significant users of equity-
based long-term incentives in executive compensation, with more modest cash compensation. If a
software company chose to hire an executive from a more traditional industry, it would often find
higher cash compensation and lower equity-based compensation. The CEO of a $250M software
company might make a base salary of $500K per year, a target incentive of 80% or $400K, and LTI of
$1.2M, for a total on target comp package of $2.1M. The CEO of a $250M chemical company might
make a base of $650K, a target incentive of 90% or $585K, and LTI of $750K for a total target comp
package of $1.985M. In some cases, it is necessary to expand beyond a firms’ primary SIC or GIC code to
get enough of a sample in the Peer Group. When this occurs, it is important to get related codes or
industries. For example, while there may not be enough small semiconductor firms, a company could
compare itself against other hardware or firmware technology companies that have similar margins.
This is not ideal, but it will work.
When is it appropriate for a firm to go outside of its industry or related industry? When it is
unique enough to warrant such a deviation. Here is an example of this sort of situation. We recently
helped a client that sold a manufactured building product. Thus, it was natural to look at Construction,
Plastics, and Rubber companies of similar size. This yielded an acceptable sample, but the companies
were, on average, paying significantly lower than our client. When we asked why they paid higher, they
indicated that they had very strong brand recognition even though they were a commodity product, and
as a result they hired executives from companies with strong brands in order to help build their own
brand recognition. Accordingly, we expanded our search to include Durable Consumer Product
companies as those firms generally have strong brand recognition. This sector, even with companies of
comparable size, paid much higher, as the economics of the strong brands allowed them to make higher
profits and pay their executives more. In the end, we developed a blended Peer Group between the two
sectors that we examined and explained this in the proxy statement CD&A.

3. Revenue size is also critical because this and industry are the big predictors of cash
compensation (base and bonus). For example, the CEO of a $250M software company would be at
$500K base and $400K target bonus, whereas the CEO of a $1B software firm at a base of $900K and a
$900K target bonus at the median. If the $250M firm were to include numerous $1B firms in its Peer
Group, it would unnaturally inflate the median level of pay. We believe that a range around our clients’
revenues that allows for similar comparisons is 0.5 to 2.0x of their revenues.
Market capitalization is important because it, combined with industry, dictates the level of long-
term incentive compensation, particularly if the firms have approximately the same number of shares
outstanding. If two similar-sized companies in terms of revenue (say $500M) have dramatically
different market values (say $400M, with 40M shares outstanding and this a $20/share price and $2B
with 50M shares outstanding and thus a $40/share price), the $2B dollar firm will be able to deliver
much more value at the time of grant to its employees, expressed as a % of market cap. The smaller
market cap company would also require significantly more shares (if delivered in restricted shares or
units) to deliver the same $1M grant to its CEO – 50,000 vs. 25,000 for the larger market cap firm. This
is 0.125% dilution for the smaller market cap firm and 0.063% dilution for the larger market cap firm, or
double. We believe that a range around our clients’ market capitalizations that allows for similar
comparisons is 0.5x to 2.0x of their market cap.
We strive to get our clients approximately equal to both the median revenues and market
capitalization of a 16-18 firm Peer Group, the minimum size that we believe is statistically relevant. This
is often very difficult to do in industries and industry sub-segments that are not heavily populated, or
are dominated by very small or very large players. In these cases, we may expand the revenue and
market capitalization range to 0.33x to 3x that of our client or look at similar industries in order to get
enough firms for a more robust sample.
Jack Connell is Managing Director of Connell & Partners, Inc. (Woburn, MA) a firm that he
founded in 2005 and sold to Gallagher Benefits Services (GBS), which itself is a division of Arthur J.
Gallagher (NYSE:AJG) in 2011. The firm is a boutique executive compensation consulting firm that works
for many public and private Board Compensation Committees and Management teams. We construct
peer groups, analyze and structure executive and Board compensation programs, develop severance
and change-in-control provisions, conduct risk assessments, and provide litigation support services in
the executive compensation arena. Jack can be reached at 781-647-2739 or via email at
jack_connell@ajg.com.