Long-term Incentives

“Pay For Performance” Made Simple

Posted by Paul McConnell on August 12, 2016  /   Posted in Compensation Committees

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.

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Are You Paying for Performance or Just Paying for Results?

Posted by Jeff McCutcheon on February 08, 2014  /   Posted in Compensation Committees

Performance reportPaying for performance is assumed to be the objective of most executive and employee pay plans. A quick read of a handful of proxy statements will likely find the phrase “pay for performance” prominently used. The Dodd-Frank Act expressly instructs the SEC to require companies to describe their pay-for-performance program. However, we find many of these programs simply pay for results.

Let us explain. Paying for performance infers that the reward is somehow  linked to actual contribution, whether as individuals or as a team. It requires some level of cause and effect. In the context of a management long-term incentive arrangement (LTI), this might be achieved by linking the number of shares vesting to achievement of a key strategic objective, like successful diversification into a new business or developing a pipeline of new products to sustain a higher gross margin.

Paying for results is simply managing incentive payments to an outcome, whether the direct result of performance or not. For example, a company’s stock may rise for many reasons, including factors well outside the impact of management. This approach is typical of many total shareholder return (TSR)–based long-term incentive plans. The plans are defensible on the basis of their alignment with shareholder returns over the same period of time. However, let’s not lose the distinction here—paying for results is not the same as paying for performance.

Investors support long-term incentives primarily because they believe the incentive will both reduce the risk inherent in strategy execution and decrease the eventual investor cost to realize the strategy. The LTI should reward successful strategy execution and serve to complement and, at times, counterbalancethe short-term nature of the annual incentive. It’s about providing a financial incentive to create future value through execution of a strategy, which may require an extended period of time to achieve.

For these reasons we argue that performance—causality to results—is critical to maximize the valueof the incentive investment. If you simply pay for market-based returns using absolute or relative  TSR, the LTI may serve more as a lottery ticket than an incentive. By this we mean actual payout is viewed  more as chance than contribution. This hardly serves to motivate any change in behavior on the part of the executive or help guide the executive team in navigating tactics and priorities. While such programs are often lauded, they may in fact diminish or delay accountability for a poor strategy by rewarding (or punishing) for events reflected in stock price that are unrelated to changes in long-term franchise value.

The LTI should address two equally important objectives—deliver the strategy (paying for performance) and create value for investors (paying for results). The former is an often difficult, uncertain, and time-consuming effort. Yet, achieved thoughtfully, it produces a resilient and successful organization. The LTI should also reflect performance risk. A business-as-usual strategy (or lack of strategy) should provide no more than “caretaker” rewards, even if shareholder returns are exceptional. Similarly, an exceptional strategy that does not produce above-market returns for investors cannot be granted superior rewards. However, the exceptional strategy that is duly rewarded over time by the market should deliver superior rewards to the management team

As we saw in 2013, institutional investors are beginning to migrate from simple, standardized, and often poorly conceived metrics dictated by the proxy advisers (e.g., ISS and Glass Lewis) to a more nuanced dialogue with managers and board members regarding pay. As institutional investors trade the “pass/fail” approach for dialogue, it is critically important for managers and boards to speak clearly to their shareholders about how the LTI is integrated with both successful strategy execution and rewards to shareholders. By clearly articulating the detailed link between enterprise strategy and executive rewards, companies will benefit from not only more effective executive efforts, but also greater investor support.

Are You Paying for Performance or Just Paying for Results? from BoardMember Magazine, Q1, 2014

Aligning Tax Policy with Sound Executive Compensation Practices

Posted by Paul McConnell on May 26, 2009  /   Posted in Compensation Committees

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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© 2009 Board Advisory.
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