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Heads We Win, Tails You Lose

Thursday, August 27th, 2009

Heads We Win, Tails You Lose

Originally published at Board Member magazine.
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It is not surprising the public perceives that executive compensation is a “heads we win, tails you lose” proposition. For the past three decades, executive pay plans have grown like kudzu in a muddy Georgia field. In an attempt to balance performance, competitiveness, risk and rewards we have also increased the complexity of pay. Given our lack of success to date, it may be time we fundamentally rethought this process.

Each year, compensation committees spend a great deal of time determining appropriate levels and establishing incentives to provide executives wealth consistent with expected future investor gains. But the reality is that much of the eventual executive gain is determined by business cycles and the timing of option exercises and stock sales — items essentially independent of the long-term investors’ gains.

Recently, there has been a movement to reduce the impact of the timing of sales on executive pay by requiring that executives hold stock received until retirement. This is a powerful tool for aligning executive and shareholder interests, but it only solves part of the problem. In too many cases, the size of annual awards is largely driven by competitive considerations where a specific dollar amount of expected value is used to determine the number of shares or options granted annually. This produces the nonsensical result of increasing the number of shares granted when stock prices decline or decreasing them in response to superior performance.

A better and simpler approach would follow the lead of private equity and venture capital firms, where executive compensation is largely dictated by individuals with substantial personal capital at risk. In this approach executives would receive a one-time competitively sized grant of full-value shares when hired or promoted. This grant would vest over a long-period of time like a typical career (10 years) or until retirement – based on time vesting and/or by achieving performance goals. No further grants would be contemplated unless a promotion or significant business combination occurred. Thus, we introduce two concepts not frequently used by most companies: 1) one-time grant of full-value shares based on a percent of the outstanding shares of the company (rather than projected value), and 2) long term vesting and holding requirements that ensure management has an ongoing stake in the company.

This one-time grant approach to equity compensation, by definition, has a perfect correlation with shareholder wealth over the same period. In contrast, the competitive annual award process mutes the relationship by annually adjusting poor performers up and strong performers down. For example, looking back at the 10-year performance of companies that are currently still in the S&P 500, we find that a one-time grant would produce total wealth for executives in companies that perform at the 75th percentile that is about 3x that earned by the 25th percentile. With competitive annual awards, that ratio is about two times.

This one-time grant of full value shares approach has a number of other advantages:

  • Executive would have an appropriate level of “skin in the game” from day one instead of waiting 5-10 years until cumulative equity awards provided adequate net shares.
  • Illiquid full value shares balance risk and reward consistent with long-term investor, TARP and emerging Obama administration pay objectives. Options and other leveraged grants don’t have the same element of “loss” to balance risk-taking.
  • It would eliminate the need to provide severance if terminated without cause or following a change in control. Contractual vesting of a portion of the shares would provide executives with adequate security in a more shareholder friendly manner.
  • When tough economic conditions occur (like we are currently experiencing) reported compensation would be limited to base salary and bonus earned (if any). This would likely show a much clearer link between pay for executives and employees – particularly if companies annually reported the change in the market value of executive holdings.

By eliminating the concept of an annual “competitive” equity award, we will take an important step in changing the public perception that executive pay is a “heads we win, tails you lose” proposition. We believe that by isolating the ownership interest of management as a discrete, contractual incentive, boards of directors can better manage the cash incentives and salary of executives, providing a more coherent and transparent oversight process. If we want executive management to think and act like owners, we should pay them like owners – long-term owners.

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Executive Transitions: Treacherous Waters That Don’t Have to Be

Tuesday, June 16th, 2009

Executive Transitions: Treacherous Waters That Don’t Have to Be

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Executive transitions into new roles continue to be one of the greatest challenges organizations face. Regardless of the reason for the transition or the source of the executive, executive transitions fail at an alarming rate, and always at a high cost to organizations. To fully discharge their duty to attract, motivate and retain management, Boards of Directors need to pay more attention to how critical changes in leadership are effected.

The dollar impact of failed transitions is relatively easy to calculate. The primary areas for such dollar impact estimates includes the cost to hire (e.g., search/placement fees, relocation, etc.), total compensation for said executive for the duration of employment, “maintenance” expenses such as administrative support and overhead, severance costs, and impact of mistakes and/or missed opportunities. The total of these costs typically total 10 to 15 times salary for a senior executive and can easily cost a company several million dollars. String together a few of these, and even a sizable organization can be crippled.

Recent executive transition research I led through Alexcel Group and the Institute for Executive Development, using an online survey of more than 150 practitioners in more than 140 different companies, showed that for external hires, 30% don’t meet expectations in the first two (2) years. While slightly better, 21% of internal placements don’t meet expectations in the first two (2) years. These “failure rates” may seem unacceptably high, yet other research in recent years shows failure rates of executive transitions can be upwards of 60% or even more.

When asked to characterize the level of support their organization provides to transitioning executives, 19% of respondents said they provided high support for external hires while 81% said they provided no to moderate support. For internal moves, 15% said high support was provided and 85% said no to moderate support was provided. One surprising result came for the question: What level of involvement does your Board play with executives who are changing roles? Only 1% of respondents said it was high, and 36% said none whatsoever. This contrasts with institutional investors’ interest in executive succession, where a poll of public pension funds indicated they held boards responsible for planning and executing executive succession.

When asked about the reasons for failed transitions, the most frequent response (68%) was due to lack of interpersonal skills, and the second most frequent response (46%) was lack of personal skills. The least-frequently chosen reason for failure at 15% was insufficient technical skills. So while candidates seem to have the functional proficiencies, they most often fail due to the softer leadership competencies. These findings suggest that there are significant gaps in hiring processes, where attention is paid to technical skills at the expense of softer skills that can just as easily derail an executive that otherwise “looks good on paper.”

So what are practitioners doing to assist with executives in transition, and how well is it working? For both external and internal hires, the most common practice (49%) is Mentoring and “Buddy Systems”, but the effectiveness of that practice was judged best for external hires where that was rated the most effective process. For internal moves, Executive Coaching was seen as most effective. While frequently used, the least effective process for both types of candidates was Orientations.

In our opinion, the key take-aways from this and other research include the following:

  • organizations don’t provide executive transition support that is commensurate with the importance of that event;
  • the best onboarding practices in the world will be of little value if companies don’t get the hiring right in the first place;
  • even with accurate hiring, executives can fail if they aren’t given needed support;
  • the type of support being provided often isn’t what will best facilitate executive success.

So what is a company to do?

  • First, make it a priority and invest resources accordingly, starting with Board oversight of the whole process, from methods used to hire and onboard candidates in general, to what is being done to ensure a new executive’s success in particular.
  • Second and related, make sure the hiring process is comprehensive and accurately gets at ALL competencies, not just technical proficiency and experience.
  • Third and also related, ditch the traditional Orientation material for onboarding, and instead use more hands-on approaches such as Mentoring, Executive Coaching, and/or other assimilation practices that are personalized and get better traction.

Executive transitions fail frequently at high corporate cost, andthey simply don’t need to. We’re convinced that if Boards adhere to the above three recommendations, their companies will immediately realize a distinct competitive advantage.

- Kevin R. Hummel, Ph.D.

Kevin Hummel works with a number of Board Advisory clients, across a variety of industries, on executive coaching and leadership development issues. You can view Dr. Hummel’s bio here. If you have any question or comments on this article, or want to speak with Kevin about any executive coaching, performance, or succession issue, he can be reached at khummel@board-advisory.com, or at (954) 783-2585.

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Aligning Tax Policy with Sound Executive Compensation Practices

Tuesday, May 26th, 2009

Aligning Tax Policy with Sound Executive Compensation Practices

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If we want executives to act and be rewarded like investors, we should tax them like investors.

As the chorus of public outrage over executive compensation rises to a new crescendo, it is understandable why the populist approach to “solve” executive pay is through regulatory pay limits. However, executive compensation experts and investor representatives alike agree that rather than limiting pay, the best thinking on the subject is focused on creating plans where executive wealth is tied to that of long-term investors – where they are unable to profit (or limit losses) from short-term changes in company performance or company stock price. There is much agreement that this linkage is best accomplished through executive equity arrangements with provisions such as “hold-till-retirement” requirements. However, in implementing these provisions boards of directors are now finding that federal tax policy is not aligned with what is arguably in the best interest of the public, not to mention shareholders.

We believe that minor changes to the tax code could facilitate these ownership provisions, thus providing greater alignment of executive pay with public interests. Further, these changes will also increase federal revenues by increasing the effective tax on executive pay without the adverse economic effect of broad rate increases. Simply put, we recommend that the tax code cease treating certain long-term executive equity incentives as annual “compensation”, and instead treat it like an investment.

Current Tax Law Rewards an Early Exit

The table below shows the current taxation of various popular executive equity compensation vehicles:

Vehicle Form of Income Timing
Restricted Stock or Performance Shares Full value is Compensation Vesting
Nonqualified Stock Option (NQSO) Gain is Compensation Exercise
Incentive Stock Option (ISO) Gain is Capital Gains Sale of shares

Any compensation value from an executive equity grant is also deductible to the employer (subject to the limits and performance rules of section 162(m)) and is subject to Medicare taxes (1.45% rate) from both the executive and the employer.

The net effect of this approach is that today’s executives have a powerful incentive to exercise stock options during favorable market cycles, then liquidate their positions to provide cash flow to execute the exercise, including withholding taxes. Since there is no further tax liability and typically little obligation beyond perhaps modest stock holding requirements, a rational executive/investor would clearly sell their ownership position and interests to diversify their overall portfolio. The existing tax treatment does not encourage long-term executive ownership nor penalize sale of stock during the executive’s career.

Alternative Tax Approach Creates Value from Holding to Retirement

An alternative approach is to treat executive equity awards as a sale of company stock on the date of grant, similar to any other investor purchasing shares for cash. Where there is a discount element (e.g., restricted stock or performance shares), the discount at grant would be treated as compensation to the executive and deductible to the company (subject to 162(m)). However, the tax on this compensation would not be due until it was both vested and sold. Thus a company could create a very favorable tax situation for its executives (and an incentive benefiting investors and the public alike) by requiring that they hold the stock until after they leave the company. Like other investors, any post-grant gain (or loss) would be taxed as a capital gain at the time of sale. Similarly, any dividends paid would be taxed at the 15% rate (under current law).

Vehicle Form of Income Timing
Restricted Stock or Performance Shares Value at grant is Compensation, any post-grant change is Capital Gain (Loss) Sale of Shares
Stock Options [1] Gain is Capital Gains Sale of shares

These proposed tax rules create a strong incentive for executives and Boards to design equity plans utilizing hold–till-retirement provisions. For example, without a hold-till-retirement provision a performance share grant would trigger immediate taxation for the full value at vesting. The executive would typically then sell shares to satisfy the withholding tax. With the benefit of a hold-till-retirement provision, the executive would not be liable for any tax until the shares were sold – at some point after retirement. This will result in more net shares remaining in the hands of executives, presumably providing a more significant incentive for delivering long-term results for investors and the public at large.

Curiously, although the executive would receive favorable tax treatment, the tax revenue gains to the government would be significant. Currently, the executive’s ordinary income tax and the corporate deduction largely offset each other. As a result, the executive’s basis in the stock is stepped up to the price at the date of vesting (for full value shares) or exercise (in the case of an option). Thus the net tax received by the federal government is limited to the capital gains tax calculated on any stock appreciation subsequent to vesting/exercise – and there is little incentive for executives to hold shares after vesting/exercise.

Under the proposed approach, the executive’s capital gains would be measured from the grant date price – as is the case with an investor purchase – with no offsetting tax deduction by the corporation. While this results in a lower tax rate for the executive, the effective taxation is increased by eliminating the employer’s tax deduction. Furthermore, the combination of hold-till-retirement covenants and supporting tax policy better aligns the executive performance incentive with the interests of investors and the public over time, rather than allowing an executive group to be rewarded for short term results. With a broad definition of equity incentive plans (i.e., including non-public company equity and equity-like vehicles), this approach can successfully apply regardless of company size or ownership structure (e.g., small businesses, joint ventures, subsidiaries, private equity and start-ups).

We believe this is an easily achievable first step toward aligning federal tax policy with public policy interests regarding executive compensation and corporation accountability. If we want executives to act and be rewarded like investors, we should tax them like investors.

- Paul McConnell

Paul McConnell works with a number of Board Advisory clients within the banking and related financial services arena on executive pay alignment, performance measurement, and executive performance issues. You can view Mr. McConnell’s bio here. If you have any question or comments on this article, or want to speak with Paul about any executive rewards, performance, or succession issue, he can be reached at pmcconnell@board-advisory.com, or at (407)876-7249.

[1] The tax code changes proposed in this article could be achieved by simply modifying existing ISO provisions in IRC sections 421 through 424, to reflect contemporary executive pay programs and hold-till-retirement obligations.

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Reconsidering Executive Equity: Separating Equity from Annual Compensation

Sunday, April 26th, 2009

Reconsidering Executive Equity: Separating Equity from Annual Compensation

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For the past three decades CEOs, Boards of Directors and compensation committees have allocated stock options and numerous other equity-based incentive arrangements based primarily on the annual competitive practice of peer companies.  In an effort to ensure equity was appropriately appreciated by the executives, companies went to great efforts to communicate the value of their annual equity award in present value terms, as part of a total annual pay package.  By treating equity as annual compensation, however, companies have created three significant disconnects between investor and executive interests.
First, when boards adopt a policy of providing competitive annual equity grants based solely upon the present value of the equity, they create the perverse phenomenon where stock price decreases (investor losses) result in granting more shares to management to maintain “competitive pay.”  When the stock price appreciates, the opposite result is found, as fewer shares are necessary to create the same “competitive” annual award value.  This contributed to the prevalent perception of a reward for failure, particularly evident in 2009.   Due to depressed equity values, boards were faced with the prospect of granting 60%-70% more shares just to maintain comparable equity “values” to 2008 [1].

Second, most compensation policies strive to provide competitive equity awards in terms of annual equity grants, but not in terms of aggregate equity ownership.  Thus, a new CEO and a very senior CEO, all other things being equal, would be provided comparable equity awards.  As a result, we find ourselves in the somewhat irrational position of delaying 5-7 years before a significant level of cumulative incentive is delivered to the executive.  Keep in mind the median tenure of a CEO today is 5.5 years.

Lastly, executive stock holding guidelines typically allow the executive to sell vested shares to the extent the executives’ holdings exceed a nominal ownership requirement.  This reduces the executive’s wealth ratio (the ratio between a change in company value and the change in the executive’s total wealth), diminishing the overall strength of the incentive and diminishing the alignment with investors.  Perhaps more importantly, the ability to sell shares allows the executive to effectively time the markets, potentially capitalizing on excessive risk taking and minimizing losses.  In addition, by allowing executives to divest shares prior to retirement, companies reduce or eliminate the shared interest in the orderly succession of management within the company.

One solution for resolving these disconnects can be found by changing our fundamental view of long-term incentives.  As an alternative to treating equity as part of a competitive annual reward package, companies can treat equity as a distinct, non-compensation investment incentive.  In this sense, annual compensation (salary and annual cash bonuses) is liquid and driven by individual skills and responsibilities and annual results achieved.  It is generally managed within the range of easily-established competitive practice at peer firms.  In contrast, executive equity is a career-based investment made on behalf of investors for the benefit of the executive, to align executives’ wealth creation goals with the long-term interest of the investor and payable only when investors realize their investment objectives.  To distinguish equity from annual compensation companies can:

  • Manage cash compensation (base salary, annual incentives and other annual cash value) consistent with the practices of peer companies, adjusted for individual performance.  This takes advantage of excellent peer data that is easily compared on the basis of company size, complexity and performance.
  • Establish a competitive ownership percentage for each key executive officer position based upon the percentage of beneficial ownership attributable to fully tenured peer executives at similar companies, balancing the level of incentive needed to achieve performance with the additional performance burden caused by the incremental dilution.  Define ownership percentages in terms of percent of total shares outstanding rather than specific present value, which is prone to dramatic short-term fluctuations.
  • Create a substantial equity position for executive officers early in their tenure through aggressive grants, but set actual vesting based upon performance outcomes realized by investors.   Suspend or limit awards once the competitive ownership/incentive level is achieved.
  • Treat long-term equity as a career investment on behalf of the executive, no longer subject to liquidation in order to buy the vacation home.  Specifically, limit the transferability of all equity granted until two years following retirement, eliminating any appearance of market timing and require the executive to also have a shared interest in the near-term success of the succession program [2].

This alternative approach to executive pay can correct for the misalignment of actual equity grant practices with investor outcomes – eliminating what is perceived by some as a reward for failure. While this approach may be too aggressive for many organizations, it rightfully places the focus of boards and compensation committees’ attention on determining the appropriate level or strength of incentive necessary to achieve objectives rather than focusing on simply emulating peer behavior.   Lastly, by separating equity from the annual “competitive” compensation program, boards can take an important step in changing the public perception that executive pay is a “heads we win, tails you lose” proposition.

- Jeff McCutcheon

Jeff McCutcheon works with a number of public and private Board Advisory clients on executive compensation, succession and performance issues.  You can view Mr. McCutcheon’s bio here.  If you have any question or comments on this article, or want to speak with Jeff about any executive rewards, performance, or succession issue, he can be reached at jmccutcheon@board-advisory.com, or at (904) 306-0907.

[1] Based upon a 40% reduction in equity values of 40% across the S&P 500, companies had to grant 67% more shares to maintain the same grant value as the prior year.
[2] See Board Advisory, LLC website for “Current Issues for Compensation Committees” for an analysis of proposed tax policy changes in support of “hold-till-retirement” equity programs.

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Will Executive Incentives Keep the “Bailout” from Working?

Wednesday, January 28th, 2009

Will Executive Incentives Keep the “Bailout” from Working?

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The infusion of hundreds of billions of dollars of taxpayer funds into the domestic financial system has created a fundamental change in the ownership structure of most banks.  By establishing the US government as the largest single shareholder in many of the TARP-participating banks, there is a divergence in shareholder objectives.   The government as an investor has provided cheap, patient capital in the form of preferred stock that only requires a 5% annual dividend and no price appreciation.  The Government has invested in these banks with the intention that these investments would stabilize the financial industry and get credit flowing again to the broader economy.  It wants financial recovery, job creation and economic growth.  However, historic financial industry practices and the incentive arrangements offered to executives at these institutions may be working directly against the government’s public objectives.

The traditional investor objectives of maximizing economic value through growth in earnings and increased rate of return on capital employed, and the incentives that reward these results, are the heart of the conflict.  When faced with difficult economic times such as we are currently seeing, the natural reaction (as motivated by these incentive plans) is to avoid the loss of capital, cut off lenders that don’t meet high credit standards and generally batten down the hatches.  It is no surprise that bankers are acting consistent with their objectives and their financial interests.

Alternative Approach
If the “bailout” is to succeed, we need to find some way to reconcile these divergent interests.  It wouldn’t make sense to change the incentives for the bank as a whole; The Government’s investment is big, but it is only 10-20% of the total equity in these banks.  The other shareholder’s interests must be respected as well.  But to clarify objectives and maintain accountability for results within the institutions, one possibility is to build a new organization within the banks that is focused on the needs of this new, unique shareholder.  This “Rescue Bank” can be a separate legal corporation or an autonomous division, but it needs special staffing, leadership, and incentives that are attuned to the unique goals of its shareholder.  It is likely that the strongest economic impact will come from the small to medium sized businesses that have historically been the engine of job creation.  A large number of these are suffering from overextension, shortage of capital and customers that cannot buy their products due to lack of financing.  These accounts could be transferred to the Rescue Bank, along with appropriate loss reserves that will create a level playing field.  Then the Rescue Bank could help these companies by utilizing flexible credit standards, refinancing, pools of investment capital and inexpensive financing facilities for their customers.
The Rescue Bank would need to be staffed by seasoned commercial bankers that have been through economic downturns and who are experienced in lending to troubled companies and by investment bankers that can help restructure balance sheets and provide creative secured lending.  The management group would comprise leaders that see beyond the bank’s balance sheet to its obligation of providing access to capital and general financial liquidity to the public.

Aligned Incentives
We know from experience that employee and management incentives do motivate the behavior that is asked for.  But if plans are built around net income and financial returns, we will not get the kind of actions that this situation or this shareholder requires.  Instead, a very significant portion of the staff’s annual compensation should be tied to such metrics as: client revenue growth; job creation or saves; GDP growth within the market area; business startups; and public approval.
We don’t want these bankers to totally ignore the concept of profits, after all the Government money does need to be repaid.  Long-term incentives could be designed to balance the annual goals by investing a slice of the parent’s capital along with the government’s money (e.g., $1 for every $5 of TARP dollars).  This “common stock” would be credited with any Recovery Bank financial returns in excess of the 5% required on the preferred stock.  Grants of book value phantom shares (with conversion rights to the parent common stock) that vest when the TARP money is repaid would provide a powerful leverage to get this troubled economy up and running again.  If the Rescue Bank’s annual return on total equity only reaches 7%, these awards would grow by 17% that year – plus any kick from the recovery the parent’s stock price.
Incentives do work.  If we create the right ones for this situation, we as a country can more quickly work our way out of this difficult financial situation.

- Paul McConnell

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