Is Executive Compensation Aligned with Company Strategic Goals?

The off-the-shelf approach for executive compensation doesn’t work: every business has a unique culture, performance drivers and regulatory environment, therefore a need for a tailored compensation strategy to match.

Most companies try to keep up with what their peers are offering. There is the belief that the market determines executive compensation levels, but there are complex nuances to setting compensation. The challenges are in finding suitable companies to use as benchmarks and in ensuring that the selection isn’t created to achieve a certain outcome. In some cases, the benchmarking creates a “race to the top”, since when all companies want to be just above the midpoint then the midpoint keeps moving.

Compensation systems can generally be analysed along four dimensions: fixed versus variable, short-term versus long-term, cash versus equity, and individual versus the group. The factors that drive choices include the firm’s strategic objectives, ability to attract and retain talent, ownership structure, culture, corporate governance, and cash flow.

1 - Fixed versus variable - Total direct compensation is made up of a base salary, and short-term and long-term incentives. Both incentives are variable or at-risk elements and may be contingent on the achievement of certain organizational or individual goals. Awards can be based on an established formula or at the discretion of management or the board’s compensation committee. The mix of fixed and variable components is usually driven primarily by company size and industry, and to some extent, company-specific factors like culture and risk appetite. Variable pay is an important component of executive compensation. A large part of executive compensation should be variable and based on results, to ensure focus on performance.

2 - Short versus long-term - A second dimension is the extent to which variable compensation is paid out in the year it is awarded or deferred and paid over some future period. This applies to awards where the amount (specified cash payment or a fixed number of shares) is established upfront and based on meeting specified future targets. Short-term variable compensation generally takes the form of cash; long-term generally is delivered in equity, through instruments such as stock options, restricted stock, and performance shares. Long-term compensation generally involves multiple overlapping cycles. Companies undergoing a transformation usually emphasize short-term rather than long-term compensation to encourage fast change. Companies with less cash may focus on long-term compensation.

3 - Cash versus equity - The mix is often determined by business maturity. Young companies tend to rely a lot on equity to attract and retain key employees if cash is scarce. However, the percentage of equity compensation is higher for large companies than for small companies. Equity compensation encourages executives to think like owners, having the main objective to grow the value of the business and the value of the equity, while stock options are a flawed instrument because you want something that gives value if the company does better than its peers. For that reason, stock awards should be linked to outperforming comparable firms.

4 - Individual versus group – The firm’s culture and values will have an impact on the amounts tied to the two kinds of performance. “I” companies, in which there’s a high degree of personal accountability and individuals can influence results, tend to link more compensation to individual accomplishments (think of consulting firms, investment banking, and asset management firms, where partners are often valued for bringing in business). “We” companies tend to focus more on organizational results, typically financial goals or shareholder returns. In those companies, the performance is more stable and predictable.

A sound compensation system always begins with the organization’s strategic goals. If compensation is misaligned with them, trouble ensues. When the executive pay reflects the real roles and responsibilities of the leaders, as well as the strategic intent, you can attract the right talent and reward the right behaviours, in line with the purpose and goals. Decisions about executive pay can?have an?indelible impact on companies. When compensation is managed carefully, it aligns people’s behaviour with the company’s strategy and generates better performance. When it’s managed poorly, the effects can be devastating: the loss of key talent, demotivation, misaligned objectives, and poor shareholder returns. Given the high stakes, it’s critical for boards and management teams to get compensation right and stakeholders expect companies to focus on aligning pay to performance.

Here below two classic scenarios and how companies can use the four dimensions:

Profitable Growth - To achieve this goal, companies may adopt a plan with both short-term and long-term incentives. It rewards annual sales and gross margin increases and ties equity awards to the achievement of economic profit and long-term stock appreciation. Given that the goal is to generate sustainable growth over time, long-term incentives are the largest component of compensation, and profit is the most significant metric in determining it.

Turnaround - In a turnaround situation, the company’s strategic focus may shifts from growth to survival, which requires cash generation until the business’s environment or operations improve. In this context, the annual incentive plan would shift its emphasis from revenue and net income growth to free cash flow generation and expense management. Similarly, the long-term incentive plan should replace annual awards of restricted stock with a front-loaded grant of options vesting over a certain number of years. The stock option plan helps to retain and engage employees in a difficult business environment. In certain turnaround scenarios, when conditions are highly volatile it may make sense to move to semi-annual and quarterly goals, to align incentives with critical short-term objectives.

SALVATORE ARICO’

CEO PartnerWise Boardroom

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Salvatore Arico’ is the CEO of PW Boardroom, a brand subsidiary of PartnerWise and focuses on delivering global executive search and talent advisory solutions for C-Suite and Operating Boards for brands, retail and private equity.

Prior to taking the helm at PW Boardroom, he was the Chief Global Organization and Transformation Officer at Dufry?& Board member at Hellenic Duty Free Shops?and previously held positions at L'Oréal and Unilever.