“Pay For Performance” Made Simple

“Pay For Performance” Made Simple

By Paul McConnell & Jeff McCutcheon

With the introduction of shareholder “Say on Pay” votes, an entire industry formed to demonstrate the degree of alignment between executive pay and corporate performance or to challenge the result (the underlying assumption being that the two should be directly, causally, related).  Few Compensation Committees, however, really consider the definitions of what constitutes “pay” and “performance”.

Moreover, even assuming a perfect linear relationship between, for instance, SEC-reported total pay and total shareholder return (TSR), where your company’s pay is dead-on with performance, you still don’t know if that pay is appropriate or if any causality exits.  At best, all you can say is that you are no worse than anyone else – which fails to inspire anyone.  What is missing in this analysis is whether shareholders are getting a fair return on the value of the equity that they have granted to employees.

Our analysis of Fortune 1500 companies indicates that salaries and “target” cash incentives are generally predictable based on company size. Level of salary is strongly linked to company size and the amount of the annual incentive (generally a percent of salary, with notable exceptions in certain industry sectors) is typically tied to annual financial performance.  In very basic terms, cash buys the talent.

Most of the disparity in the relationship between pay and performance arises from equity incentives.  Equity is powerful. It constitutes 60%-70% or more of the pay package in the largest companies. Because it takes many forms, it is difficult to compare many types of equity in terms of the value delivered to management and in terms of direct comparison to any “market” standard.  The matter is further complicated by governance programs and a regulatory/reporting framework that often considers peer practice comparisons more important than any judgement regarding reasonable sharing-of-value creation.

For Compensation Committees and executives, it is beneficial to stand back from the process and think in more broad terms about what incentive equity in executive compensation should achieve. In a start-up, equity incentives represents a trade-off for current compensation and a shared risk in the venture, with earlier employees (higher risk-takers) generally receiving the more lucrative terms.  As the existential threat of downside company risk declines, the relative ownership stake awarded to management as a percent of the company generally declines through successive funding rounds, IPO’s, etc.  In private equity situations (leveraged buyouts, going private), an up-front sharing of 10%-12% of the company in the form of an option is intended to align management to an expected time horizon (i.e. 4-6 years) and a new, focused strategy.  This dilution is explicitly built into investors’ expectations, and management’s potential gain is calculated based on the expected returns of the specific investment thesis.   However, in most public companies in corporate America, we see a different practice.  Executives are awarded “long-term” equity on an annual basis which is then valued, reported and viewed by executives as part of their annual compensation.  We effectively shift from a value-sharing arrangement to a competitive annual pay arrangement, where in most instances the competitive pay target is hypothetical and only loosely related to value sharing.

We think it is a better approach to think in terms of a competitive level of value to be shared with management based on the relative importance of capital and labor (knowledge) in the creation of that value.  Industries or situations where capital is the primary driver (e.g., utilities, heavy industry, etc.) require less value shared.  Industries where intellectual capital is paramount warrants proportionally larger ownership interest to attract the necessary talent.  Once a competitive ownership level is defined, Boards and their Compensation Committees should think about how quickly to allocate the equity.  If it is a potential breakthrough situation or a turnaround, a front-loaded award of equity makes sense.  If the strategy is more akin to hitting lots of singles and doubles (to use the baseball analogy), annual awards tied to incremental achievement might make more sense.  In either instance, the level of sharing is not in question, only the time required to realize the full allocation.

A shared-value approach to equity also addresses the “elephant in the room” – how much equity is enough?  By operating with a value sharing target, the conversation shifts to how quickly the target can be allocated.  Long-term vesting, distinct from the award, remains the key to retention and liquidity, and limits the company’s exposure from a premature executive exit.  More importantly, the value sharing approach automatically aligns executive and shareholder interests through shared expectations, without the need for elaborate charts and graphs.  At the end of the day it’s about value sharing – the more value you create, the more wealth you get.  Committees need to avoid distractions from excessive peer comparisons, proxy advisor edicts and SEC & accounting rules.  It is only through a shared, “mature” view of the executive relationship that we can quell the critics and clear the air on executive pay.

For more information about Pay for Performance compensation advice, visit us at Board Advisory.

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