Determining Executive Compensation

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:

  1. Establish the compensation philosophy and peer group;
  2. Review current executive compensation against market practice;
  3. Assess the business impact before making final approvals;
  4. 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:

  1. How did the executive get compensated?
  2. What is the rationale behind that executive compensation?
  3. 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.

How to Adopt a Dynamic Approach to CEO Compensation

Mitigate Risk and Improve Compliance

CEO compensation governance is fast paced, and it can be seemingly impossible to stay ahead of the ever-changing industry trends. The industry tends to move so quickly that a seasoned executive may not even be aware that they are at risk for creating a Board that is non-compliant when creating dynamic incentive plans for the CEO and other key senior managers.

“Many classical models of CEO compensation consider only a single period, or multiple periods with a single terminal consumption. However, the optimal static contract may be ineffective in a dynamic world. In reality, securities given to incentivize the CEO may lose their power over time: if the firm value declines, options may fall out-of-the-money and bear little sensitivity to the stock price. The CEO may be able to engage in private saving, to achieve a higher future income than intended by the contract, in turn reducing his effort incentives. Single-period contracts can encourage the CEO to engage in short-termism/myopia, i.e., inflate the current stock price at the expense of long-run value. In addition to the above challenges, a dynamic setting provides opportunities to the firm, the firm can reward effort with future rather than current pay.” Alex Edmans, Xavier Gabaix, Tomasz Sadzik, and Yuliy Sannikov; Harvard University

Global Governance Advisors (GGA) provides a wide-ranging review and evaluation of board structure, director pay, governance policies and board performance. We also help to define and articulate each client’s organization compensation philosophy in terms of desired pay positioning, peer group, short and long-term compensation, performance management, succession, retention and recruiting strategies.

Global Governance Advisors works with its clients to address the challenge of creating and maintaining a compliant Board room, by helping Corporate Directors prioritize the following 4 Ps of Effective Corporate Governance:

1. Participation 

An impactful Corporate Director will foster an environment that encourages open dialogue between the Board and management and urges them to engage in human capital discussions. The dialogue and advancement of strong corporate governance is fundamental – not only to your bottom line for the next quarter, but to the long-term goals of your organization for many years to come. All in all, participation is needed to ensure that the Board and management are steadily collaborating to fulfil their compliance requirements.

2. Perception

It’s essential for a Corporate Director to understand his or her shareholders. To accomplish this, Corporate Directors need to work hand in hand with their IR and Corporate Secretary to efficiently monitor the institutional and retail shareholders along with advisory firm guideline changes.

3. Preparedness

Preparation breeds success. To maintain compliance, Corporate Directors must stay prepared and ahead of industry trends including shareholder perspectives, industry, capital markets and exchange rules.

4. Proactivity

Corporate Directors are responsible for completing an annual risk assessment, which includes the production of an annual work plan. Since compensation adjustments work in annual cycles, Corporate Directors need to carve out a sufficient amount of time to efficiently develop annual work plans, prior to the beginning of the new fiscal year. At a minimum, the work plan should reflect the compensation committees charter. To accomplish this, they need to appoint their compensation advisor early so that he or she has ample time to prepare preliminary drafts for the Chair’s review and schedule any pre-meetings. Compensation trends move relatively quickly, and an active advisor with access to deep resources can be invaluable to directors and help management get ahead of potential issues before they may arise.

Global Governance Advisors (GGA) is a top 5 North American Human Capital Management firm that services boards of directors and senior management by providing transformative Human Capital Management governance advisory services.

Striving for Good Governance Should be Universal

There is a wide array of organizations that exist in the market place:

  • for-profit/not-for-profit
  • privately-owned/publicly traded
  • public sector/private sector

And unfortunately, with this variety, there tends to be a false assumption that there shouldn’t be a similar array of board governance standards.

The truth is that ALL Boards of Directors operate under the same three fiduciary duties:

  1. Loyalty;
  2. Prudence; and
  3. Impartiality.

Whether you sit on the Board of Alphabet, a charity, or your local condo board, ALL Boards must do their best to adhere to these same duties. Quite often, Board members suspect that because they are “only” on a board for a not-for-profit, start-up, small privately-owned company, etc. they don’t need to adhere to the same expectations/obligations of a larger, more complex organization.

Prudence is defined by Merriam-Webster as “the ability to govern and discipline oneself by the use of reason” which is why the “reasonable person” test is often applied to Board member actions whenever legal action is taken against them.

In any type of organization, Board members often know that there is, or should be, a better way to conduct their Board activities and complete their annual workplans, and it is fair to argue that in such cases, reasonable people should investigate what that improvement should be. Regardless of our level of skill or experience, all Board members experience a time when something doesn’t seem right or does not pass our personal “smell test.” What we often miss is that, if we feel that things could improve, there is a very high probability that there are others on our Board that feel the same way.

However, the identification of problems or shortcomings is a thing that we, as Board members, often shy away from because it requires us to either admit our own failings, the failings of our Board colleagues, or the failings of our entire Board. Whatever the issue, the duty of Prudence should compel us to act. But what is the best way for us to proceed without potentially embarrassing ourselves or our colleagues?

Board Effectiveness Assessments are a current governance best practice and an easy tool that Boards use to identify shortcomings, establish improvement plans, and track their progress. Board Effectiveness Assessments are annual board surveys that help Board members improve their collective ability to oversee their organization and ensure that they are prudently looking for ways to improve. Specifically, there are several benefits that Effectiveness Assessments provide:

  1. Understanding that most problems are often identified by more than one Board member. Collectively completing an effectiveness questionnaire enables members to collect views and opinions on Board practices and mutually identify areas where there are or could be problems.
  2. The surveys safeguard reputations and relationships because individual responses are often kept anonymous and aggregated with the other responses.
  3. Boards easily use the findings to establish proactive development plans that help them become more effective by improve shortcomings.
  4. Year over year results clearly show if a Board is making progress toward improving problematic areas.

If, for any reason, your Board has shied away from conducting such an assessment, or has not conducted one for a long while, the duty of prudence should compel us to ask “Why?” Regardless of the type of organization you oversee, the same fiduciary duties apply to ALL Boards, and ALL Boards should reasonably strive to be the most effective they can possibly be while fulfilling their Board duties.

Three Types of Board Assessments

Board Assessments that Benefit an Organization’s Board Governance Practice

Board assessments can range in scope from simple, post Board meeting questionnaire of 5 to 10 questions on how to improve future meetings to detailed reviews at the end of the year that cover not only Board performance, but also director’s views on Committee performance and their peers’ performance. While organizations tended to conduct these types of assessments internally in the past, more and more organizations are relying on independent third parties to help them during the assessment with 45% of Boards reporting the use of consultants during their Board assessment, according to a recent Global Board survey, conducted by InterSearch and Board Network.

There are three types of Board Assessments that will benefit an organization’s board governance practices:

Overall Board Assessments

This is the most common assessment utilized by Boards and involves having directors evaluate the Board’s overall performance by asking questions relating to:

  • The Board’s overall understanding of organizational strategy
  • Director skills and competencies
  • Board Chair performance
  • The effectiveness of Board meetings
  • Board meeting materials and preparation time for meetings
  • Director relationships and collegiality
  • Director orientation

Typically, questions are provided with a 1 to 5 rating scale format and directors are given the chance to leave a  comment  where they may have evaluated performance at a low level (e.g. a rating of 1 or 2). Once the ratings from each director are consolidated, the range and average of ratings are generated for each question. From there, the Board is easily able to identify those areas where they have assessed performance as being weaker (i.e. Average Rating of 3 or lower) and is able to develop action plans to improve performance.

Committee Assessments

This is another common assessment utilized by Boards and involves having committee members evaluate the performance of the committees they participate in by asking questions relating to:

  • Committee Chair performance
  • The effectiveness of Committee meetings
  • Committee meeting materials and preparation time for meetings
  • Access to management and independent advisors

Like the Overall Board Assessment, a 1 to 5 rating scale questionnaire can be used to evaluate performance in these areas and, in turn, weaknesses can be identified and addressed through appropriate action plans to improve committee performance.

Peer Assessments

This is the least common assessment. Boards use it as a professional development exercise for directors and as part of the annual re-nomination and director selection process. Directors can evaluate their peers’ performance in several areas, including:

  • Meeting preparedness
  • Knowledge of the organization
  • Level of engagement
  • Understanding of their role
  • Collegiality and ability to work with other directors
  • Contribution to the Board

Peers can also be evaluated on a 1 to 5 rating scale using a questionnaire with directors who receive lower average ratings identified quite clearly. The evaluation can identify “problem” directors who can then be provided with the opportunity to improve their performance or resign well in advance of the re-nomination process.

Following Up on the Results of the Questionnaire

The most powerful used of the questionnaire is combing the results with individual follow-up interviews. The follow-up interviews can help the directors identify why they rated certain areas higher or lower and explore specific ways for the Board, Committees, and Peers to improve their performance. The feedback from these interviews must be kept confidential, with only the high-level themes of the interviews summarized. After the questionnaires and interviews are completed, boards can use the results to develop strong action plans that will establish specific ways in which performance can be improved.

GGA notes that communicating the results of the assessment (specifically peer evaluations) is a sensitive issue and typically is handled by either the Board Chair, Governance Committee Chair or an independent third party. Typically, the summary results are provided to the full Board, along with any action plans required to improve performance moving forward. Peer Assessment results are typically discussed individually with each director. Conversations with directors on their own performance are sensitive matters, so effective and diplomatic communication is required by whoever is delivering the feedback. They must identify existing areas of strength and contributions, so that they understand where they are already effective. When raising shortcomings, they must provide specific examples and keep comments constructive by avoiding personality-related comments. Most importantly, they cannot dodge the sensitive issues. Sensitive issues must be addressed for improvements to be made.

Five Critical Human Capital Management Questions

Questions Every Board Must Address

“Given the pace of business change today, companies increasingly need agile boards with the expertise to guide the company amid emerging threats and opportunities. And investors increasingly expect that boards will embrace rigorous practices to ensure they have the right expertise in the boardroom to respond to evolving market and competitive demands. The highest-performing boards will adopt a continuous improvement mindset, ensuring that their composition evolves in light of new strategic imperatives.”

Global Governance Advisors (GGA) works with its clients to address the challenge of meeting these threats head on and taking advantage of the opportunities to gain a competitive edge by addressing five human capital management questions for boards of directors.

Five HCM Questions for Boards of Directors

How does your organization approach these five questions?

  • How can our board better impact the success of the organization?
  • Have we fostered an environment that encourages individual directors to think critically about their contributions and the relevance of their skills to the company strategy?
  • Are we using our annual board assessment and regular executive sessions to assess the culture and dynamics in the boardroom and identify ways to operate more effectively?
  • Does our board have a platform to analyze and scorecard senior management compensation plans?
  • Does our board have access to an oversight vehicle for shareholder engagement activity that makes valuable information readily available to the board – in real time?

GGA’s offers a unique approach of weaving together a blend of services that address board productivity, governance and develop Senior Management compensation (incentive) plans to deliver outcomes that align with company goals.

Defining Board and Management Responsibilities

Making Sense of Your Role

To ensure good governance practices, Board members must acknowledge and adhere to three primary fiduciary duties, which was the message that I recently delivered in education sessions to public pension plan trustees and board members for not-for-profit organizations.

  1. Duty of Loyalty;
  2. Duty of Prudence; and
  3. Duty of Impartiality.

Part of making sure that you are fulfilling your primary fiduciary duties is to make sure that you and your Board are following proper operating processes. As has been said many times by governance and legal experts, you cannot be sued for the decisions you make as a Board, but you can be sued for not following proper processes in making your decisions.

One key problem area for boards of all sizes, in all industries, is the separation of roles between the Board and management. Often boards get too far down into the weeds on operational issues that can be better delegated to management and, as a result, do not spend the necessary time focusing on the important strategic issues facing the organization. This pattern of behavior can lead to several negative outcomes, including:

  • The loss of influence of your Top Executive over implementation and operational decisions, which can ultimately hurt them in commanding the respect of other senior staff members.
  • Friction between the Top Executive and the Board that ultimately leads to a lack of trust on both sides.
  • Potential loss of key talent due to the dysfunction between the Board and management.

The common mantra in governance circles is for boards to have their “nose in and fingers out,” which refers to a board’s obligation to be on top of all governance matters, but to not stray down into trying to manage the day-to-day operations of the organization. In recent years, a new term: “nose in and fingers on the pulse” has emerged. This describes a board that succeeds by playing a role in overseeing the execution of the strategic vision, while simultaneously keeping on top of strategic developments that will affect the organization. In either case, it is important that Board and management have a clear understanding of their responsibilities, which starts with identifying situations where the Board is being over-active and straying too far down into management issues.

Signs of an Over-Active Board

Four ways to spot an over-active board

  1. Too much time is spent in Board meetings discussing operational issues.
  2. Board meetings are constantly running behind schedule.
  3. Your Top Executive’s relationship with the Board is strained.
  4. You find yourself, as a Board confused, over your responsibilities vs. management’s.

If you spot any of these situations you need to discuss your concerns with your fellow Board members, as well as management, to see how you can improve.

Starting points to consider when delineating between Board and management responsibilities

Common Board Responsibilities

  1. Review and approve annual and long-term objectives for the organization.
  2. Review and approve policies and procedures that govern the organization.
  3. Review and approve strategic plan and annual operating budget.
  4. Hiring, firing and compensation for the Top Executive.
  5. Provide direction and strategic input to the Top Executive and management.
  6. Monitoring performance and risk of the organization.
  7. Setting and approving the organization’s overall Board governance framework.
  8. Review and approve required public disclosure documents.

Common Management Responsibilities

  1. Initial formulation of annual and long-term objectives for the organization.
  2. Initial formulation of policies and procedures that govern the organization.
  3. Prepare Board reports and draft annual operating budget.
  4. Provide continuous input into the strategic plan of the organization.
  5. Hiring, firing and compensation for staff below the Top Executive.
  6. Managing risk and monitoring performance of the organization.
  7. Preparation of required public disclosure documents for the Board’s review.
  8. Run the day-to-day operations of the organization.

Real-World Application

Let us consider the responsibilities of the Board and management as it relates to setting the annual operating budget. In this case, it is management’s role to develop the budget by considering all the potential areas to allocate funds on while balancing that with consideration of the fiscal constraints that the organization faces. Management must also draft the budget quickly enough so that the Board has adequate time to review and ask questions about the budget before it needs to be finalized. Once the budget is drafted and presented to the Board, by management, it is the Board’s role to ask management good questions about the assumptions, omissions and estimates used to draft the budget.

The following are types of questions that the Board should ask at a strategic, not granular, level to better understand the budget and ultimately be able to approve it. Please note that the Board should not be asking questions on every single line item of the budget.

  • What did management consider including, but ultimately decide to exclude from the budget and what was their rationale?
  • What is the impact on the budget if a certain estimate is missed?
  • What are the key variables that will impact the organization’s ability to meet the budget?

Ultimately, better defined roles lead to a positive working relationship between the Board and management, which should lead to better decision-making, a collaborative approach to solving issues, candor in speaking about difficult issues and a high level of trust on both sides.

We all desire clarity in our day-to-day lives, why shouldn’t we ask for it in the Boardroom as well?