Financial crises have a way of spurring companies to refocus their long-term executive incentives (LTI) perhaps in recognition that the imperative is to retain talent to work through the reversal.
Coincident new regulatory initiatives often stimulate this interest for example in 2008 and more recently new SEC rules on disclosure of unvested award values. Many readers will be familiar with our LTI scenario process which has now been formalized in these regulations.
The traditional LTI plan awards time vesting share options or units that reward an increasing share price. A one-and-done approach that tends not to look at values again.
Reviewing periodic payout scenarios rather than just award values enables assessment of the impact of long-term compensation and leads to more homogenous payout scenarios that will improve retention and performance.
More compliance? Consultants will certainly see it as a new revenue stream but private companies and business owners, as well as public companies, will all benefit by adopting this practice. In fact, more than just shareholder disclosure we wonder whether the SEC had this in mind.
The key objectives in designing a long-term incentive are to:
- Set goals that align with strategy. “Increase the share price” just won’t do. What are the tasks and initiatives that the private or public markets will recognize as creating sustainable value? Is retention one of those goals?
- Create a real incentive. The amount of compensation at risk must be motivational. Too little will not promote innovation, whereas too much could lead to excessive risk-taking that could place the enterprise in jeopardy.
- Define success. Achievable goals that are defined both quantitatively and qualitatively with proportionate and minimum and maximum payout goals.
- Understand associated risk. The unintended consequences that could result from incentivizing certain behaviors. Develop governance guardrails.
- Maintain competitive discipline. Comparing the size of the task or stretch being set with that of competitors is next to impossible. Pay at risk is assumed to represent a reasonable proxy and while comparable, incentive design must always be customized to each business.
- Select the appropriate delivery. Options, Appreciation Rights, stock, cash, Performance, Deferred and Restricted Units plus their various sub-categories present a bewildering list but all serve a purpose. Selecting the right vehicle mix is as important as setting goals and helps channel effort.
- Consider the stage of evolution. A start-up is able to make significant leaps and take more risk than an established company scrapping for incremental advantage over evenly matched competitors.
A properly incentivized Top Team can significantly influence a company’s fortunes and care should be taken in the design and effectiveness of a long-term plan.
In the current environment your plan may need review if:
- Cash compensation is low and incentives high
- Awards are uncapped
- There are no multi-year goals
- Equity is a short-term incentive.
Several years of disrupted pay and high-inflaton will cause organizations to consider “catch-up” adjustments which would be better supported with a comprehensive review that includes future severance and change-in-control terms and their power to motivate behavior.
Photo by S Migaj: https://www.pexels.com/photo/road-near-trees-2272357/