Recently, the Wall St. Journal ran an article that provides insight into how a company can tailor executive compensation to better fit a "pay for performance" rewards architecture. I found myself agreeing with almost everything the author had to say, so determined I'd quote here from the piece by Alex Edmans and offer my commentary (in parenthesis following each excerpt) on the conclusions he draws.
"The secret to reforming compensation isn't so much looking at how much bosses get paid—but how they get paid.
"It's easy to understand why critics focus on the gaudy awards of cash and stock that executives take home. And, yes, it's hard to deny that some bosses get paid a lot more than they deserve. But the structure of compensation is ultimately a lot more important than its level, because it gets to the heart of how managers run companies and create value for shareholders."
(This has been a core tenet of VisionLink...well, forever. How you pay someone communicates what the company values and the outcomes that are most critical to the present and future success of the business. The structure used for compensation also gets to the heart of how company leaders create value for all stakeholders, not only shareholders. Even if the goal is to multiply wealth for all primary producers, a business must take a comprehensive approach to how growth is driven in the business AND how risk is mitigated when it creates rewards programs.)
"An effective way to deter executives from taking excessive risk is to compensate them with debt-based pay as well as equity. However, many compensation packages feature only cash and equity."
(There are many ways to do this. One way we recommend--and that the article goes on to suggest--is through deferred compensation. Such plans make participants general creditors of the company in the event of insolvency, forcing business leaders to be cautious about putting the organization at risk through overly ambitious transactions or strategies. It also encourages the development of "good profits" and discourages those that come at the long-term expense of both customers and shareholders.)
"Another critical change companies should implement is to lengthen the time that executives must wait before they can cash in their shares and options. All too often, stock and options have short vesting periods, sometimes as little as two to three years. This encourages managers to pump up the short-term stock price at the expense of long-run value, since they can sell their holdings before a decline occurs. A CEO can, for instance, write subprime loans to boost short-term revenue and leave before the loans become delinquent, or scrap investment in R&D. This is possible since, in many cases, stock and options immediately vest when the CEO leaves the company."
(A company doesn't have to be public for this to be an issue. Most of our work is done with privately held businesses and the focus there is the same. In addition to the issues described by the WSJ article, people need to feel a sense of stewardship about the future enterprise. This is more likely to happen when there is a remuneration component that defines a financial partnership between ownership and key producers in the organization. Companies that focus long-term in their compensation plans build a more unified financial vision for growing the business. In the private environment, we often recommend phantom stock or stock appreciation rights to mitigate against a short-term focus or manipulated outcomes. Vesting schedules and staggered payout periods can help to solve the problems Edmans articulates in this regard. )
"Be flexible. Change the structure of the compensation package as circumstances change. So, for instance, the CEO gets more stock and less cash after the company shares plummet, restoring the CEO's incentives to boost the long-term share price."
(Similarly, in private companies, key people can be compensated with more phantom shares of stock during down periods to encourage the regeneration of company value over the long-term. Bonus payouts can be replaced with additional shares during times when profits have declined and the organization needs to recalibrate its performance. Short-term value sharing arrangements such as annual "bonuses" can then be revived when the company's financials return to a normal or more robust status. At that point, the longer-term plans can release fewer shares or units. Once the favorable economics have returned, it will be reflected in the value of the shares issued during the downturn--creating the exact economic outcome that kind of program was intended to produce.)
"If companies employ [these] principles...executives will be aligned with the long-term health of their companies. And that will not only help keep individual companies safe, it will reduce the risk of another financial crisis."