Guidelines to Establishing Executive Compensation
This year’s FIFA World Cup highlights the importance of using defense to create a top-notch offense. The same can be said for Boards of Directors. The board’s best offense is a good defense, and good defense starts with a great fundamental base. That base, in the world of compensation, is the Compensation Philosophy, and that philosophy needs to mirror the business strategy of the company.
Two critical roles of the board of directors are establishing CEO succession plans and establishing executive compensation plans that both attract and retain executive talent and deliver the outcomes that align with the goals set by the board. While the board may act in good faith, there are times when there is shareholder push back. How can the leading boards of directors develop executive compensation plans that are shareholder friendly? Let’s take a deeper look at how executive compensation should be established in order to better align executive pay with shareholder returns.
The data from CEO compensation research continues to illustrate that the top paid CEOs have many layers of executive compensation. When a board’s Compensation Committee finally agrees on how executive compensation is determined, it must ensure that it is market defensible and will pass the seemingly infinite views on “appropriate compensation”.
Four Steps a Board Should Follow
There are four steps a board should follow when determining executive compensation:
- Establish the compensation philosophy and peer group;
- Review current executive compensation against market practice;
- Assess the business impact before making final approvals;
- Report the process and compensation results to the executives and shareholders via the annual Proxy.
Establish Compensation Philosophy and Peer Group
The compensation philosophy for the company is the foundation the board needs to ensure so that the outcome, at the end of the process, is highly defensible, if ever scrutinized. The compensation philosophy must account for the business strategy, risk appetite and the principles and objectives of the total compensation program. This philosophy can and will be unique to every business – even those competing within the same sector. Take two of the Top 4 tech companies: Amazon and Facebook. Amazon has stated that its business culture and strategy is built on experimentation, and as a result they do not believe in rewarding top executives with an annual bonus. They have claimed, in the 2018 Proxy Circular (DEF 14A), that some of the examples of successful experimentation include the creation of Alexa.” Alexa…how do you define executive compensation?” …you might ask. In contrast, Facebook says that it acknowledges the business still being in the early stages of its journey, and that it must hire and retain people who can continue to develop the strategy, quickly innovate and build new products, bolster the growth of the user base and user engagement and constantly enhance the business model. To achieve this, Facebook believes in more equity compensation, so it has further stated that it intentionally positions the cash compensation (base salary and annual bonus) below market but provides more of a heavy focus on equity-based compensation. Overall, Facebook has stated it wants its executives to be bold, move fast and communicate openly. In contrast to Facebook let’s examine Amazon and its approach to motivating executives.
Amazon, in line with its compensation philosophy, expressed that an annual bonus paid to the top executive officers is counterproductive to supporting an experimental business, and that short-term objectives will only focus on the “known.” Amazon says that without a bonus program, the executive team will be more willing to truncate projects when early failure is detected. Amazon states, in the proxy, that by not having a bonus program, it allows the executive team to abandon “failed” experiments, to focus on the “winning” ones. One example that Amazon states, in the proxy, is that the management team was able to exit its auction type business early and focus on other winners such as Amazon Web Services (AWS), which has become a dominant force in Amazon’s revenue growth. In lieu of the use of an annual bonus, Amazon has focused on a reasonable base salary but a dominant equity-based compensation arrangement, that ultimately will link future realized income for executives tied to the future Amazon share price (positive or negative).
What each board has demonstrated is that while Amazon and Facebook both compete for exceptional executive talent, the compensation philosophy has been customized to reflect the unique business strategy each company is employing.
Your board, with the aid of the Chief Human Resource Officer, CEO and a knowledgeable independent executive compensation advisor will work through the process of coming to an agreement on the compensation philosophy that best fits your organization.
My advice is to be bold, dive deeper, and ask the hard questions about the business strategy to eventually arrive at the strong foundation level that the executive compensation program will be based upon.
After the compensation philosophy is established the peer group will start to gain clarity on finding the best organizations a company needs to benchmark against. It’s important to understand that the peer group itself can be used in a few ways. First is the obvious, the peer group helps to identify market pay levels of similar executive roles within the industry. Second is perhaps less obvious, and that is that the peer group helps to establish market precedence and pay structure trends. This is one of the most valuable pieces of information for the board to understand when determining how its executives should be paid. The peer group can help give clarity on the use of various bonus and incentive awards, such as the general structure of the annual cash bonus plan, the use of stock options, restricted or performance shares, the use of pension and benefits etc.
A deeper dive in the peer group data helps to appreciate where the market is today and where it is heading tomorrow. The latter of course, is best interpreted from an independent advisor that has a pulse on market trends before they are made public.
Review Executive Compensation
Now that the foundation is laid, and the board and management are in agreement with the overarching compensation philosophy, it’s time to compare current pay levels and structure with the market.
As mentioned earlier, the peer group data is highly valuable in multiple ways. The independent advisor plays a key role to guide the board through identifying gaps between the current executive compensation program with the compensation philosophy and business strategy.
Depending on the gaps identified, the advisor will need to prepare some stress tested recommendations that will bridge the gap between the current and future executive compensation program. Here is where a board can get nervous, as it may be reluctant to wake the sleeping giant. The giant being the mass of shareholders, of course. However, in order to drive management behaviour and shareholder returns, the compensation program needs to reinforce those behaviours that drive success. In Amazon’s case, it’s experimentation that leads to life changing technology ~ “Alexa, is the blog almost over?” “Yes, you’re almost done.” ~ and therefore counter to the market norm – rewarding executives using an annual cash bonus. Amazon boldly linked more of the compensation to long-term shareholder value creation by awarding more of the total executive compensation program in equity.
Assess the Business Impact Before Making Final Approvals
Now that the process has clarified the business strategy and its impact on the compensation philosophy and the peer group is examined, the board will face decisions to potentially modify pay levels, pay structure or both. When the board considers modifications, it is important that the board weighs the impact of those recommendations. As I reflect upon pay adjustments, I place these adjustments into two broad categories – “opportunity” and “actual”. The recommendations we make today are nothing more than an opportunity for the executive to receive the compensation. As we know, it is common that more than 80% of an executive’s pay is at risk, so “opportunity” is nothing more than that. The “actual” is the real impact on the business financials, share price and dilution levels, and to the executive.
The board must see a scenario analysis and stress test of the various impacts any compensation adjustments will have today and in the future under various scenarios of success or failure; and the potential financial impacts on the business and shares.
Lastly, the stress test should examine shareholder advisory firm guidelines to focus on potential areas of risk that the compensation arrangements may trigger.
Report the Process and Compensation Results to The Executives and Shareholders via The Annual Proxy
Now to the fun part – reporting. The board has the duty to shareholders to disclose in “plain language” the executive compensation program. The fundamentals of great shareholder communication fall into three key categories. To ascertain if the company’s proxy has done an effective job at communicating and rationalizing the executive compensation to shareholders, the board (at the end of reading their Compensation Discussion & Analysis section of the Proxy) must have a comprehensive understanding of the answer to these three key questions:
- How did the executive get compensated?
- What is the rationale behind that executive compensation?
- How much did the executive receive?
A quick read of Facebook and Amazon’s proxy help to illustrate the rationalization of rewarding pay packages in the echelons of $20+ and $30+ Million (Facebook’s Sheryl Sandberg 2017 reported compensation of $25,196,221 and Amazon’s Andrew Jassy 2017 reported compensation of $35,609,644). For reference, Facebook passed its last say on pay vote in 2016 with a 91% YES and Amazon passed the say on pay vote in 2018 with a 98% YES.
Remember to examine the performance metrics within the bonus plan, the types of equity used, and if performance conditions are attached to the vesting criteria. The board must understand that even when the future share price is higher or lower than the grant date, the board must be comfortable with the level of pay the executive may receive.
Final Words of Thought
At the end of the day, it is highly unusual for a board to be successfully sued for how much compensation they elected to award to executives. However, that does not mean they will not find themselves under shareholder pressure from time to time. After all, the board’s best offense is a good defense, and good defense starts with a great fundamental base … the four steps every Board of Directors should follow when determining executive compensation.