Since the use of long-term incentives (LTIs) has become more standard, there is an increasing expectation from shareholders that payout of LTIs will link to company performance. This naturally leads to two questions:
1. How do you define and identify goods versus bad company performance?
2. How do we link payouts to company performance?
This article will answer these two questions and provide some guidance as to how you can be a resources to your organization’s leadership when linking long-term strategic goals to compensation.
What is good versus bad company performance?
There’s no easy answer to this question. There are essentially two components of company performance that we pay attention to and they don’t always align. Those are stock performance, as indicated by share price and dividend distribution, and operational performance, as indicated by a variety of measures, both financial and non-financial.
As illustrated in the graphic, strong operating performance during a time of weak stock performance is probably a better indicator of “good” performance than weak operating performance during a time of strong stock performance. The logic is that stock prices fluctuate due to a variety of factors, some beyond the control of the organization, and are not always an effective indicator of long-term “good” performance when taken at a specific time point. Strong operational performance, however, suggests that in the long-term, the business will continue to create value for its investors.
Since strong operational performance is the best component on which the organization should focus to drive future value for shareholders (i.e., “good company performance”), we need to define “strong operational performance.” What operational measures indicate strong performance? Defining operational measures and what equals strong performance is business- and industry-specific. For your company, you need to consider a variety of questions and perspectives.
Consider the Internal Business Context:
- What performance measure captures the industry dynamics?
- Example: A retail company may focus less on revenue and more on measures that capture the cost of that revenue (e.g., marketing costs, cost of labor, rental of retail space, etc.) while a social media company may focus more on number of monthly users.
- Is the performance measure appropriate for the company given its financials and/or operations?
- Example: A small biotech company may not generate revenue or any profit as it waits for a drug to be approved for sale to the market, so, pre-revenue, they are more likely to measure performance based on achieving different levels of regulatory approval.
- Does the performance measure support the company’s business strategy?
- Example: A hotel company’s strategy may focus on generating consistent and positive returns from their properties, so their measure should capture that returns focus.
Consider the External Value Correlation and Design Tradeoffs:
- Is the performance measure simple to understand, communicate, and implement?
- Example: A performance measure based on long-term employee satisfaction may be simple to understand (i.e., how satisfied is the average employee with the company?), but challenging to implement given the amount of time necessary to run a survey, gather employee responses, develop changes to be implemented, and then implement those changes to increase satisfaction.
- Does the performance measure have a clear connection to the performance of the company?
- Example: Investors are not keen on companies that choose number of users as a performance measure because there is not a clear line of sight to future company profit.
- How well does the measure correlate with the company’s value creation?
- Below is an industry analysis that Mercer conducted by assessing the relationship between three-year operating measures and three-year shareholder return.
Most industries have a weaker long-term relationship between revenue and shareholder returns (i.e., growing revenue does not appear to have much impact on shareholder returns), as indicated by yellow, orange, and red shading; whereas, others such as Utilities and Telecommunication Services, have a fairly strong relationship between revenue and shareholder returns, as indicated by green shading. Those industries with a strong relationship may want to consider revenue as a possible performance measure. Conversely, a retail organization using total revenue as a performance measure might be better suited to shift their focus to earnings from continued operations net income or an Earnings Per Share (EPS) measure. These measures show more of a correlation to driving shareholder return than total revenue in the retail sector.
Understand the Company-Specific Fit:
- Is the measure meaningful to your managers and leadership?
- Example: Leadership of an airline company may focus more on passenger revenue than on number and age of aircrafts. Therefore, measures that connect to number and age of aircrafts may be less appropriate than a performance measure that includes passenger revenue.
- Will the measure drive shareholder value and the desired behaviors?
- Example: Though a particular measure may be beneficial to shareholders, in order to ensure overall company success, you also have to consider the message it sends regarding how you do business and achieve success. The analysis shows that growth in total assets for real estate companies has historically led to growth in total shareholder return. However, if a real estate company focuses on growing total assets (i.e., buying properties) while not paying attention to the returns those assets generate, they may buy the wrong assets and ultimately hurt their business.
Once you have narrowed down the specific measures that will define good versus bad performance for your organization, then comes the task of linking that performance to payouts.
How do we link payouts to company performance?
In its simplest form, using stock-based incentives naturally links payouts to company performance. The underlying assumption is that strong company performance will lead to an increase in stock price. If executives are being issued stock, they will benefit from the higher stock price.
Given that stock price is not determined solely by company operating performance, a common approach to promoting long-term company performance is to align LTI payouts using goal-setting (i.e., set threshold, target, and maximum payout goals). A key component of linking payouts to goal-setting is to understand leverage and probability of success. Based on Mercer’s experience, the table below outlines typical guidelines for payout ranges and probability of success or achievement.
In the table above, we show a range of possible payouts and their related probabilities, but let’s walk through an example to show how this would actually work.
In the above example, the executive’s target goal is set at the time of grant. The stock price at that time is used to convert that target value into a target number of shares.
To put numbers behind this, let’s imagine the company has set a target goal of $300M in revenue to be achieved over the next three years (i.e., $100M in revenue per year on average). The company sets this target goal believing they have a 50% to 60% chance of achieving it. They also set a threshold goal of $270M in revenue and a maximum goal of $350M in revenue (assuming they have an 80% to 90% and a 10% to 20% chance of achievement, respectively).
In our simplified example, the company’s CEO has a target LTI value of $500,000 and this value will be received in shares. At the beginning of the period, the company grants $500,000 worth of unvested shares. If the stock was priced at $100 per share on grant date, the executive would receive 5,000 unvested shares.
The company has also set the below payout opportunities for the CEO, based on goal achievement:
At the end of the three years, the company has achieved a revenue of $325M. Since $325M is halfway between $300M and $350M, the CEO has earned the midpoint between Target (1x) and Max (2x). In other words, at the end of three years, the executive earns 7,500 shares. At the original stock price of $100, these shares would be worth $750,000.
Now, given the company’s strong operating performance (exceeding the target goal), it may seem fair for the CEO to receive $750,000 worth of shares. However, a key underlying reason why LTI is often paid out in shares or equivalents of shares is to align the CEO’s final payout with the return experienced by shareholders.
Imagine that in this example this company’s industry has experienced a dramatic decrease in market value (e.g., this is a real estate construction company and the Federal Reserve has increased interest rates higher than expected). The company’s shares have decreased in value by 1/3 since grant date (i.e., shares are now worth ~$67). That means the payout of the CEO’s grant is now worth $500,000 (i.e., 1/3 less than grant date). Due to the stock’s decrease in value, the CEO now “feels the pain” of the shareholders by realizing $250,000 less than the expected value.
The keys to a successful LTI program lie in selecting the right performance measures for your organization and setting up the right correlation between success and payout. By considering market, industry, and internal perspectives – with guidance from Mercer experts when necessary – you too can put in place a plan that will engage and motivate the leaders in your organization.