When it comes to executive compensation and company performance, directors commonly go by the following “rule”: The goals for the coming year should exceed last year’s results. Some directors believe that, if performance goals decline, executives should not receive any bonus, even if the business environment won’t allow the company to exceed its prior performance record.
But the rule that requires companies to always set higher goals for top-line and bottom-line results should not be considered hard-and-fast. Even as companies aim for long-term, continuous improvement, there are legitimate cases when lowering the bar is acceptable.
Three situations show that circumstances occasionally dictate the need for lowering performance goals. The first situation is when a company is run by executives who consistently deliver outstanding performance, but in an economic downturn oversee a period of falling results that still top the industry. (This example holds true for virtually any company caught in a major economic downturn.) The second is when a company comes off several years of great results, but executives and the board decide to make major investments to enhance long-term competitiveness, lest competitors catch up. The third is a cyclical commodity-based company that, in spite of best-in-class operational efficiencies and rising sales, gets blindsided by volatile raw-material prices, boosting the costs of goods sold by a third or more.
Executives at these companies should not always be expected to demonstrate year-over-year improvement. Asking them to essentially juice results during a single year might even hurt the long-term success of the business. (Deferring an investment to meet current year profit goals may result in losing ground to competitors in the long term. Similarly, deferring maintenance to reduce current year costs can lead to increased downtime down the road.) That’s not to say directors should accept anything less than a long-term record of sustained, rising results, only that for temporary periods decline may fit within that record.
So what steps can a board take to ensure that year-over-year declines are truly exceptions? First, directors should begin every goal-setting cycle with the simple premise that year-over-year improvement is the standard. Second, if management contends that a decline is inevitable, directors should consider the steps management has been taking to anticipate and mitigate the decline. For example, are there valid strategic reasons for a decline, such as ramping up long-term investment? Can the board reasonably expect, based on management’s plans, that investments will lead to future performance that compensates for the decline?
If external forces are contributing to the decline, the board needs to consider whether management explored all reasonable alternatives to avert the decline. Key questions the board should raise include:
- If a demand slowdown was forecasted, did management adequately explore new market opportunities to offset declines via new channels, new geographies, or the use of new methods to reach customers (e.g., “big data”)?
- If raw material costs were forecasted to rise, did management consider hedging increases or consider alternative sources of supply?
- If competitors have breakthrough product launches planned, did management anticipate these launches, and where possible, accelerate its own development of potential competing products?
- If manufacturing costs were forecasted to rise, did management either consider reengineering current processes or explore potential cheaper outsourcing solutions?
- If disruptive technologies were likely to affect the industry, did management position the company to swiftly take advantage?
As part of examining the steps management is taking, the board should also look at its own actions. Key questions the board should ask itself include:
- Was the board involved fully in the development of this strategy, and did executives make short- versus long-term tradeoffs clear?
- Have directors demonstrated adequate goal-setting discipline themselves as evidenced by balance and symmetry in their decisions over time?
- Were unfavorable circumstances that resulted in more lenient goals balanced by favorable circumstances with more aggressive goals?
If the board is to make exceptions to an otherwise universal standard of continuous improvement, it needs to follow certain standards in adjusting goals. It may be that a board can become comfortable in setting lower goals at threshold and target, but maximum goals require truly superior performance.
Third, once the board makes an exception, it should balance the interests of the management team and shareholders. Shareholders deserve to know that directors have set adequate stretch goals to drive superior performance. Over time, goals should result in performance and payouts that meet four tests:
- They are sufficient to generate returns above the risk-adjusted cost of capital, and presumably in turn boost total shareholder return.
- They align relative pay and performance with peer companies.
- They represent a fair sharing between executives and shareholders of the value created.
- The rewards are sufficient to executives motivated and engaged.
No director takes the lowering of performance goals for granted. Management has the responsibility to develop, execute, and reformulate a strategy to deliver year-over-year improvements. But times come when exceptions are warranted for the long-term success of the company. The aim then is simply to create the most effective way to reward and motivate executives while ing performance at the necessary level for sustained success.
View the full article as it was originally published.