Board Member

Annual Executive Compensation Levels: Where We Veered Off the Road

Posted by Paul McConnell on August 30, 2013  /   Posted in Compensation Committees

[Originally published in Board Member Magazine 2013 Q3.]

VeerIn our last article, we noted that somewhere along the way, executive compensation veered off the road.  Executive compensation plans became too complex, isolated from true performance and downside risk, and in many cases, total compensation was just too high.  While there is no shortage of blame to go around, we find one obvious flaw is the prevailing practice of treating executive equity as annual compensation.

Assume that you had money to invest in a business and I was going to run it for you.  I’d get a salary and bonus for my labor.  You might also give me shares of the company to align our interests and ensure I was fully “bought in” to the venture. It would be clear between us that the stock was my “share of the deal” and would remain invested with the company until we parted ways.

As an unintended consequence of the thirty-year effort by the SEC to improve the oversight of executive pay, we have effectively created a bias against the “share of the deal” approach to equity.  To provide greater transparency and comparability, the SEC requires companies to report all remuneration in annual terms – even if it is not an annual event.  Consequently, we stopped thinking about executive equity as a “share of the deal” and we fell into the mindset that it was all annual compensation.

Obviously, equity awards have a compensatory effect, and are a key part of an executive’s total pay.  The best talent will seek opportunities where they can share in the value they help create.  However, by seeing executive equity as a piecemeal annual reward rather than as one’s share of the deal we have created the perception that the equity is indeed a cash equivalent, to be exchanged for cash when needed.

From an owner’s perspective, the critical issue should not be the annual increment of equity, but the total equity commitment necessary for each key executive role to achieve the following investor objectives:

•        Providing an attractive package to recruit and retain the management talent needed;

•        Matching executive performance and wealth more closely to the company risk horizon; and,

•        Aligning executive wealth proportional to investor gains or losses.

Unfortunately, in the current “tail wagging the dog” scenario, we find companies think about equity in annual terms because we report it and compare it on annual terms.  This has the perverse impact of:

•        delaying the formation of a substantial equity position for several years in order to comply with annual compensation practices;

•        rewarding volatility by granting more equity (as a percent of outstanding stock) when the company does poorly and fewer shares when the company is highly successful; and,

•        thinking of equity as a cash equivalent that can be sold during the term of employment.

It makes far more sense to manage equity decisions using established target equity levels for each of the key executive roles.  Achieving the target ownership may be accomplished in one step (e.g., in a turnaround), or parsed out over time.  The key difference, however, is that executives and investors know the annual grant is not a bottomless pit of investor dilution.  Periodic grants would represent the execution of a strategy rather than an attempt to chase some market median practice.

With this approach companies, executives, and investors benefit three key ways:

•        We answer the question “how much is enough?” — the elephant in the room nobody currently wants to talk about;

•        We simplify pay by distinguishing an illiquid career investment from annual cash pay.  This change in perspective removes much of the concern driving the Dodd-Frank pay-ratio debate; and,

•        We assure all parties that executive management is a long-term investor in the company, with upside and downside risk, and full accountability for the economic consequences of risks through a sizeable stake held throughout their career.

It is time we begin to think and act like owners and treat equity as if we were making partners out of management – by granting them a piece of the enhanced value of the business over time, not doling out shares simply to reach a “competitive” amount of annual compensation.

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Are Relative Total Shareholder Return (TSR) Plans “The Answer”?

Posted by Paul McConnell on May 06, 2013  /   Posted in Compensation Committees

[Originally published in Board Member Magazine 2013 Q1.]

stockThere has been a great deal of recent interest in performance share plans that use Total Shareholder Return (TSR) relative to a peer group as a measure of performance.  Clearly, these plans usually look good in a pay for performance comparison and can help secure favorable say-on-pay votes, but the additional questions Compensation Committees should be asking are:

  • Do they motivate executive performance?
  • Are they right for this particular company?
  • Does TSR reflect true executive performance?
  • Is this the only performance-linked program we should use?

Any discussion of total shareholder return must start with the understanding that TSR is a result of good management performance, not the performance itself.  The desired management performance is the production of great products/services, properly priced for consumer value, that deliver consistent financial returns commensurate with the riskiness of the required investment.  If the market sees this performance, share prices are bid up relative to peer companies and positive relative TSR results, assuming of course, other, exogenous events do not occur.

From a motivational perspective, the strongest incentives are those where a clear line of sight exists between the desired behaviors (performance) and the reward.  TSR plans may not provide as clear a linkage as plans tied to measures of operating performance.  Even though it may be very hard to do, executives know what it takes to raise net income by 10%; it is less clear what it takes to raise the stock price by 10%.  And the market is not necessarily rational, certainly not in the short term but also seemingly for the long term as well.  Thus plans tied to operating metrics more clearly convey performance expectations and behaviors.  However, executive pay is not just about incentives and motivation.  It’s also about sharing the risk and reward of ownership.  What then are the situations where risk sharing is more important than communicating performance expectations?  Although the following list is not exhaustive, it shows the areas where we think these plans have value.

Shareholder Relations Issues:  In cases where there have been historical issues with the pay for performance relationships, relative TSR plans alleviate that problem – in fact, better than outright share ownership.  By definition, the change in the value of executive shares owned has a 1 for 1 alignment with TSR.  TSR performance plans have a more exaggerated relationship, due to the fact that the value of the shares awarded as well as the number of shares themselves vary with TSR.  The value of these shares typically climbs faster and drops more quickly than total shareholder return itself does.

Change in Strategy/Turnarounds:  In these situations, it is difficult to set reasonable performance goals.  Success will likely be much different than current expectations.  But a successful turnaround will likely have a dramatic impact on TSR, as the market builds new expectations into the market price.  These kinds of awards are also useful in justifying the kind of above market grants that are typically required to attract new management required to effect the change in strategy/performance.

Technology/Life Sciences:  These industries are known for high risk/high reward – particularly in the pre-IPO stage, where large equity grants are the rule.  These grants are either very valuable or worthless.  (Executives that have worked in these industries often have enough worthless stock option certificates to wallpaper their office.)  Relative TSR plans can replicate this highly leveraged reward practice in the public company stage.  Very successful strategies produce high relative TSR, which these plans magnify into even larger reward.

In Conjunction with Other Plans:  When other long-term plans are in place that use other metrics, a TSR plan can be good for balancing the total plan so that a company doesn’t create negative perceptions that management gets very generously rewarded when shareholders don’t.

Are relative TSR plans “the answer”?  No, they are “an answer” that can be very appropriate in the right situations.

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CEO and Executive Pay Plans: Help for a Broken System

Posted by Paul McConnell on May 06, 2013  /   Posted in Compensation Committees

[Originally published in Board Member Magazine 2013 Q2.]

Broken Somewhere along the way, executive compensation veered off the road.  It became too complex, isolated from true performance and downside risk, and in many cases, too high.  The original idea of executive compensation was to pay an adequate and fair wage and good benefits.  Any additional pay was intended to place executives in the same position as owners.  However, with high base salaries, equally powerful short-term incentives, long-term incentives that are treated as income rather than investment and often protect against downside risk, and the potential for golden parachute payments that reward executives when they fail, something went wrong.  The good news is that it can be fixed.  The bad news is that it will require some bold new thinking on the part of boards and management.

Performance.  Before discussing pay, let’s examine performance.

  • More often than not we reward CEOs for luck and good timing rather than for leadership, stewardship and good strategy.  Research has shown that as much as 80% of total return may be based on macro-economic factors and industry trends unrelated to company behavior.
  • Performance against internally-developed goals is important, but may be unrelated to actions that build long-term value for investors.  If a CEO is truly operating at a strategic level, the real impact of their leadership may not be evident for 5-10 years, and in some industries with long development or capital cycles, perhaps 15 years.  Yet for the most part we define CEO performance in terms of annual financial results rather than on more broad indicators of long-term value creation.
  • Current year plan-based targets, ROIC (return on invested capital) and share price are all great dashboard measures, indicating directional progress, but these measures should not be confused with actual success of a strategy or long-term value creation within an organization.  Boards need to think long and broad when it comes to assessing performance.

If we are to improve the pay model, we must first be willing to commit to a longer-term view of performance and articulate exactly what success looks like.

Pay.  Much of the current executive compensation thinking is a product of the 1980’s and 1990’s.  Many of today’s practices are influenced by the SEC efforts to standardize disclosure in an effort to bring more transparency and comparability to executive pay.  Unfortunately, as with many things, there were unintended consequences.

  • We think about and communicate pay in annual terms rather than in long-term outcomes.  If in doubt, read the “compensation philosophy” section of the typical CD&A.
  • We emphasize annual bonuses that pit CEO’s self-interest against investors when negotiating performance targets.
  • We claim that equity is an incentive to create alignment and balance risk, but we allocate it on the basis of “competitive pay” like cash; we too rarely acknowledge an intended career allocation or a targeted ownership objective.
  • We rationalize equity programs as putting executives in the same position as owners, but, in our experience executives rarely lose money. Annual equity awards are typically based on dollar-denominated “target values”, protecting executives from stock price changes, and executive stock holdings are often sold to the extent they exceed minimal ownership requirements.
  • We use “competitive practice” as a synonym for minimum requirement, whether dealing with salary and incentives, terms of employment, or severance.  As a board we seldom exercise leadership in crafting employment arrangements directly supportive of the company’s mission.

To say that executive pay is “broken” may seem overly harsh, but we should at least acknowledge that executive pay often falls far short of delivering on its objective of rewarding executives for long-term value creation.  The first step in the cure is admitting you have a problem.

In later articles, we will examine several solutions to these problems.

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Board of Director Compensation Trends: “Follow That Bandwagon”

Posted by Paul McConnell on October 19, 2012  /   Posted in Compensation Committees

Originally published in Board Member Magazine (2012 Q4).

bandwagonBoard Director compensation continues to evolve. We have seen director pension arrangements arrive and depart (1980s), board compensation using stock options have had their time in the spotlight (1990s through the mid-2000s), and now board meeting fees are waning. The clear trend and dictate of proxy advisory firms is to eliminate board meeting fees, set board pay at median, and pay at least 50% of the total in the form of shares held until retirement from the board. However, before we jump onto that bandwagon headed down the path of least resistance, perhaps we should consider for a moment reasons for paying directors in a specific form or amount.

Annual comparisons of director pay levels have led to a focus on an elusive “median director compensation level.” As one-half of companies find they are below median, they increase director pay and find a corresponding increase in the new average pay level. Unlike the fictional Lake Wobegon, we can’t all be above average. Rather, since the required level of reputation risk, personal energy, and talent commitment varies dramatically between boards, so too should remuneration.

The trend in form of pay, from options (incentive) to shares (investment), is easily understood in the context of the director’s role. An unintended consequence of options is that they can pit directors against all other investors with respect to the timing of exercise. While options may reward equity growth, they are inherently biased against dividends and can, under certain circumstances, provide an imbalanced reward for risk since the investment downside is limited to any embedded gains. More important, as a reward for price appreciation, the concept of any incentive may work directly against the director’s role—to provide risk oversight on behalf of investors.

Executive management is tasked with developing long-term strategies, executing those strategies, and managing the day-to-day enterprise. With the separation of capital and management inherent in our modern capitalist environment, the role of the board should be focused on ensuring the risks taken and strategies employed by management are reasonable, that controls are in place to avoid misuse of investors’ assets, and that the best executive talent is in place to lead the effort.

By establishing incentives for directors, we are distorting the balance in their assessment of risks by encouraging results without a corresponding risk offset. Incenting directors to improve performance may also unintentionally encourage boards to interject themselves into areas rightfully in management’s domain, at the expense of the board fulfilling its core responsibilities. On another front, what most analyses of director pay seem to avoid is any consideration of a director’s role in light of the value proposition companies communicate to their investors. Clearly, the board of a company held by a private equity fund will have a different role than a board of a company held primarily by retail investors. Similarly, an investor in early-stage pharma will have dramatically different expectations of the board than the same investor viewing a commercial real estate REIT investment. Just as the role of the board member should reflect these investor expectations, so should the pay.

Without belaboring the point any further, we have to ask, “How should directors be paid in the modern environment?” Clearly, each board is unique and must refine its objectives and define its role vis-à-vis investors and management. The role of a board of an immature, fast-growing company will clearly be different than that of a mature company. Chances are that the management team and the investors will look quite different as well. However, the concept of how to pay the board remains unchanged.

In summary, we believe boards should:

1. Pay an amount that reflects the board’s talent needs, as well as the level of reputation risk and commitment asked of the directors; this may involve paying well above or below industry standards when appropriate.

2. Pay in a form that reflects the board’s mission and does not create an imbalance with respect to risk oversight.

3. Implement ownership and shareholding guidelines that are consistent with the company’s message to investors.

This simply suggests the use of common sense, taking a fresh look at intent prior to racing to the trend. After all, it was Albert Einstein who observed, “The man who follows the crowd will normally go no further than the crowd.”

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© 2012 Board Advisory.
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