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By Yin Wilczek
May 15 — In designing compensation programs, companies should ensure their incentive structures reinforce, rather than undermine, their business strategies, consultants said May 14.
Incentives are a prime opportunity to indicate to employees why the company is choosing to pursue long-term investments over short-term profits or vice versa, said Jim Heim, managing director in the Boston office of Pearl Meyer & Partners. “If you do this right, you can actually find yourself in this positive feedback loop where because employees better understand what they’re trying to accomplish, they’re actually able to accomplish it.”
However, although business strategy usually is pegged to financial indicators, there may be times—such as industry disruptions—when companies must undertake decisions that sacrifice immediate financial results, said Theo Sharp, also a managing director with Boston-based Pearl Meyer.
Heim and Sharp spoke at a webcast sponsored by the National Association of Corporate Directors.
To ensure the company's compensation plan continues to support its overall strategy, even through business and industry changes, the Pearl Meyer consultants suggested a three-step process for designing incentives in which compensation committees annually should:
• evaluate the state of the business, the industry and external forces;
• determine the balance of the prerogatives that drive their companies; and
• adjust their short- and long-term incentives to reflect their priorities.
Explaining the first step, Heim said that because business is in a constant state of flux, companies must periodically assess not only their strategic imperatives, but also their financial imperatives such as generating enough cash to pay their workforce and to fund investments.
In addition, they must evaluate their internal cultural prerogatives, Heim added. “There are certain behaviors you want your incentives to foster and others that are simply unacceptable,” he said. “It's really nice if your incentive plan is in sync with those cultural priorities.”
Sharp suggested that evaluation of corporate culture may be an “underrated piece” when it comes to designing incentives. “Unless the culture will embrace the incentive, I don’t think it’s ever going to work, no matter how well designed it is.”
Moreover, companies must review the state of their industry, including the competitive landscape, the consultants said.
As to external forces, Heim observed that in the era of say-on-pay, public companies must pay attention to the perspectives of the proxy advisors. Institutional Shareholder Services Inc. and Glass, Lewis & Co. LLC have very “specific thoughts” on how compensation plans should be structured, and the advisors will tell institutional investors how to vote based on those thoughts, he said.
Although the advisors' protocols may not work for every organization, a company still must be aware of how it deviates from ISS or Glass Lewis' prescribed approach, Heim said. “The onus will be on you” to convince the shareholders that the company is right and ISS is wrong.
On the second step—determining the balance of the imperatives—Heim noted that prerogatives change depending on what stage a company is in. Young emerging companies generally are not ready to assess their performance strictly in financial measures, given that they can't measure revenue growth until they have revenues, he said. Accordingly, their priorities generally will be strategic in nature.
According to slides provided by Pearl Meyer, there are three stages after the emerging company phase:
• growth companies—where the focus shifts from expanding markets, and there is an even weighting between financial and strategic imperatives;
• mature companies—where the focus shifts to maintenance and financial imperatives take precedence; and
• turnaround or industry disruption—where the focus is on efficiency and responding to a shifting market, where strategic imperatives take center stage.
Sharp noted that most companies will find themselves anywhere in between the different stages. “That’s the reason we suggest that compensation committees at least go through an exercise like this every year when they’re designing their incentives to be sure that something hasn’t shifted slightly one way or the other that will cause them to move up or down the scale,” he said.
Finally, companies should adjust their long-term and short-term incentives in line with how they balance their prerogatives, Heim said. Companies should avoid redundancy and ensure their short-term incentives have a different focus than their long-term incentives, he added.
Heim also noted that over the longer term, most investors and management teams want to see progress on margins and returns on investment, and this should be reflected in the long-term incentives.
Sharp suggested a “simple” shorthand: “It's income statement in the short term, balance sheet in the long term.”
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