April 16, 2018 Executive Compensation Executive & Director Pay Design Articles

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Executive & Director Pay Design

Transform Your Pay Program to Transform Your Business

As the imperative for business transformation grows, so grows the need for redesigning executive pay.

In one interesting case, a global industrial manufacturer faced both types of transformation in a single decade. At the start of the decade, it faced severe financial losses, significant debt and languishing share prices. The new CEO, an outsider, crafted a vision to streamline operations by reducing the number of unique products and platforms globally. His work was a textbook case of re-focusing on core operations and competencies during a turnaround.

The board made sure the new pay plan focused on profit and cash flow, but it added non-financial metrics such as quality and a reduction in manufacturing costs that incentivized product and platform reduction around the world. Since the compensation plan paid on global results, it created an “all for one and one for all” mentality. This supported the CEO’s goal of promoting collaboration where prior pay programs focused on individual accountability by line of business.

Revamping pay to bolster change is an imperative because maintaining a “business as usual” pay program poses two risks:

  • Pay can be a distraction (or even a roadblock) to re-inventing the business.
  • Sending the wrong signals (internally and externally) about the company’s new direction and changing priorities.

Pay should, of course, be structured to encourage sustainable shareholder value creation, and transformations are no different. But, traditional approaches may sometimes fall short. In this regard, business transformations — like turnarounds and strategic reinventions — often provide license to break the mold and explore unconventional designs that will better support key priorities and drivers of long-term value creation.

If thoughtfully tailored to the shifting strategy, pay can also serve to reassure insiders and outsiders that the board is committed to taking the necessary steps to transformation.

A turnaround is usually characterized by a strategic or operational reset to spur profitable growth. That means the plan should allow for heavy investment that may depress near-term results and/or a shrinking of the business to rid the company of underperforming assets. Focus first on stabilizing near-term earnings or cash flows and make sure your design has elements to retain talent (and attract it, as needed). It’s critically important that the program (and underlying goals) align closely with the company’s messaging to shareholders about its roadmap to long-term value creation.

In a strategic reinvention, the focus is often on the creation of new technologies, processes or businesses. Pay designs should emphasize returns and measures of innovation or operational improvement, often over several years. You may also want your plan to appeal to executives who want to “build something out of nothing.” An entrepreneurial focus, often a magnet for star talent, can be an incentive in itself. However, if reinvention is limited to a single business unit, be mindful of the risk of creating a “haves versus have nots” compensation structure where pay for those leading the new venture is out of proportion to those working in the company’s core lines of business.

Ultimately, the new program at the industrial manufacturer mentioned earlier galvanized company leaders to realize the CEO’s centralized vision, which helped reposition the company for the future.

Increasing competition forced the company to undertake a strategic reinvention, repositioning itself to handle technological disruption. Knowing that quarterly earnings expectations could pose an obstacle to making “big bets,” compensation was used to promote long-term innovation.

To this end, the board designed a special incentive award for the CEO separate from the ongoing program. Roughly 20% of the CEO’s total opportunity then depended on a discretionary assessment of how well he shepherded the development of new and untested technologies and processes. Unlike in the turnaround, he would be rewarded for hitting key milestones driving long-term, top-line growth instead of short-term profitability.

If you face either situation — strategic reinvention or turnaround — remember to think outside the box with compensation design, just as executives do with strategy, business models and operations. Consider less traditional, sometimes more qualitative, metrics to serve as the best signals for achieving key milestones, but do so in balance with traditional financial metrics and share price performance.

That said, all transformations are not equal and compensation design needs tailoring to meet the specific strategic and talent needs of the organization.

View the full article as it was originally published.

Mark Emanuel

This article was originally published in Directors & Boards.

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