Finance’s Critical Role in Incentive Design

Why companies need to tap the function’s analytical tools and quant mind-set in pulling together incentive compensation plans.

The role of the finance function has changed dramatically over the past couple of decades, and it continues to evolve. Traditionally, the primary responsibilities of finance included financial reporting, cash flow management, and activities around securing corporate funding. Increasingly, though, finance leaders are being asked to play a more strategic leadership role in their organization.

One area in which leaders of the finance function can be particularly instrumental in reinforcing corporate strategy is in the design of companywide incentive compensation. Finance can help with the selection of performance measures, the evaluation of possible performance targets, and an assessment of the cost and affordability of alternative compensation-program designs. Getting an analytical finance manager’s perspective is especially important for companies evaluating long-term incentive plans, with which the range of alternative designs is virtually limitless—and the selection is high-risk.

In many companies, decisions about incentive pay continue to be made by a combination of human resources and the compensation committee of the board of directors. These decision-makers simply hand their plans to finance for execution. The problem is that with so many different design levers in play, it is easy to inadvertently set performance targets that are either unrealistic or overly lax. The end result of that mistake is disengagement and skepticism among recipients of the incentive program.

One more reason to include finance from the beginning of the process is that equity compensation awards are subject to complex accounting rules1, meaning that back-of-the-envelope estimates can create negative surprises on the company’s financial statements. When finance managers play an active role in the incentive-design process, the company will have better information, face fewer surprises, and achieve more holistically consistent results.

 

Finance’s Unique Perspective on Metrics

In most companies, the finance organization is not wholly responsible for establishing corporate strategy, but the function’s leaders may be asked to provide insight into which accounting and operational metrics would best reflect the company’s effectiveness in achieving strategic objectives. Identifying and then emphasizing the most effective performance measures helps keep executives and key managers and staff focused on those activities that will enable the company to achieve its strategic goals. Using the wrong measures—for example, focusing on earnings per share when cash flow is critical—can encourage counterproductive behaviors that are not aligned with the strategy (e.g., excessive inventory, lax payment terms). Even worse, picking the wrong metrics for determining executive compensation can lead to an investor relations nightmare: high incentive payouts when shareholder value is crumbling.

Finance executives have a unique vantage point into which metrics are most meaningful in terms of the performance objectives of their particular organization, and they have a unique perspective on setting balanced targets for those metrics. The finance organization sees firsthand which measures are most closely tracked by the CEO and the board in assessing the organization’s overall performance. Finance also has insight into which measures the analyst community is prioritizing.

Moreover, their role in both annual and long-term planning processes gives finance managers insight into which metrics are most critical over a one-year time frame, and thus are fitting for annual bonus plans, and which metrics are critical over the longer term—and thus are more fitting for a long-term incentive program such as performance shares. The longer-term perspective has become more important as companies have increasingly begun to incorporate multiyear performance periods into their long-term incentive plans.


 

1. Accounting Standard Codification (ASC) Topic No. 718: "Compensation—Stock Compensation."

Although the annual incentive plan tends to receive the most attention from the management team, developing an effective long-term plan is ultimately more critical for shareholders. In most industries, major capital allocation decisions or strategic reorientations can be effectively measured only over a multiyear time frame. As a result, long-term incentive programs have become the primary focus for most CEOs and board compensation committees, and have become the main driver in overall executive compensation.

Several characteristics contribute to the effectiveness of a particular performance measure within an incentive plan, regardless of the time period:

Alignment with business strategy. Measures should help focus participants on strategic objectives or results that will come from successful execution of the corporate strategy.

Connection to shareholder value creation. Achieving success as measured by the performance metrics will increase shareholder value over the long term.

Understandable to incentive-plan participants. Participants understand how their actions and decisions can impact their performance as gauged by the measure.

Simplicity. A successful incentive plan includes a manageable number of metrics, and the approach to assessing performance is well-understood.

Finance is in a good position to judge metrics on these criteria, but it is important to recognize that there are sometimes tradeoffs between measures. For example, a company’s finance organization may contend that economic profit is the best metric to use for long-term incentives because it’s the best measure of shareholder value creation. However, the company’s long-term incentive plan may include participants who have limited ability to impact long-term capital allocation decisions. Economic profit may be the right metric for the top 10 executives, but perhaps incentives for the next layer of key employees should be based on operating profit and working capital management. Although these metrics aren’t as closely linked to value creation, they may be easier for lower-level managers to understand and act on.

A related issue that finance teams should watch out for is the risk that they’ll get tangled in the weeds and design an overly complex incentive plan. Even if it’s well-aligned with shareholder value creation, a plan will be ineffective if managers cannot see clearly which of their behaviors and results it will reward.

It is not uncommon to slice the organization into levels, each with its own metrics. Top executives may be judged in terms of metrics that are closely linked to shareholder value creation. Sometimes, in fact, the metric literally is shareholder value creation, also known as total shareholder return (TSR). Meanwhile, performance of lower-level managers may be evaluated using measures of business unit performance, such as revenue, operating income, or return on assets for the manager’s particular business unit.

 

Scenario Planning in Goal Setting

Just as the finance function can add value to the process of selecting performance metrics, the team’s quantitative mind-set and analytics tools can be invaluable in the establishment of performance goals. You can think of performance measures as the key statistics that baseball fans use to track a player’s performance, such as batting average, home runs, and runs batted in, while performance goals are benchmarks for assessing how the individual is doing—e.g., a batting average of 0.250 is poor, 0.280 is at expectations, 0.295 exceeds expectations, and 0.310 is outstanding.

In the world of executive compensation, many companies base most of their incentive plan’s performance targets on the internal budgeting process. Annual incentive-plan performance goals are derived from the annual budget, and long-term performance goals are derived from the multiyear business plan. As a company sets these goals, finance may be asked not only to “report the news,” but also to have a point of view on what targets are realistic to achieve through operating leverage, distribution channels, workforce expansion or contraction, etc. In other words, finance may be asked to bring to the table scenario-planning and stress-testing skills, a view of what the market and/or investment community expects, and overall rigor with the numbers.

Most businesses start by doing a bottom-up assessment of performance levels that are considered to be achievable within different areas of the business. Finance may then stress-test the bottom-up view by reconciling it with external (market) expectations, as well as an assessment of the rigor of the performance goals relative to the company’s past performance and the performance of comparable organizations. By reviewing analysts’ expectations for future performance, the company can assess whether performance that achieves its own internal goals will meet or fall short of market expectations. Incorporating such a perspective into the budgeting process helps to avoid a situation where the company meets its internal targets but disappoints shareholders and underperforms relative to the competition.

Finance can also provide sensitivity analysis around target performance levels to understand how external factors or market conditions are likely to impact the company’s ability to achieve its goals. Incentive plans are generally structured on a sliding scale, defining three key performance levels for each metric: the target, at which the executive receives 100 percent of her incentive payout; a threshold for minimum acceptable performance, below which the executive receives no incentive compensation; and a level of “outperformance” at which the executive receives the maximum possible payout. As a rule of thumb, finance should shoot for the following probabilities of achievement for each of these performance levels:

  • performance above threshold: 80 to 90 percent of the time
  • performance above target: 50 to 60 percent of the time
  • performance at or above maximum: 10 percent of the time

Applying these rules of thumb is challenging in practice. The finance team’s input can be invaluable in this process because finance staff understand the historical variability of the company’s financial performance and the sensitivity of that performance to economic growth, materials prices, and other operational data points. The end goal of setting performance targets is to give management confidence that the financial goals are achievable, while assuring the compensation committee that the plan will not result in a windfall for management.

 

Accounting for Plan Costs

The accounting cost of an incentive plan is unlikely to be a primary consideration in plan design, but it is another area in which a company can avoid negative surprises by involving finance early in the process. Negative surprises may arise in the form of unanticipated cost hits or in reduced grant quantities if the company has not done the analysis to understand the accounting fair value of an award in advance of the grant date.

Reduced grant quantities may result in disengagement and frustration among recipients. This is a major risk with the growth in awards based on comparative TSR, which under ASC 718 are classified as market conditions. A typical TSR award yields payouts based on a comparison of the issuing company’s total shareholder return to the average TSR of companies on an index such as the S&P 500, or a custom group of comparable companies. See Figure 1, below, for an example.

Under ASC 718, this type of award is valued using Monte Carlo simulation, and for most standard award structures, the value exceeds the face value of the stock. In fact, it is not unusual for the plan design illustrated in Figure 1 to yield an accounting cost of 130 percent of the stock price on the date of grant. This result is shocking to many participants, who expect the upside payout opportunity to be offset by the downside risk; they expect the accounting cost to equal the face value of the stock. They care because a higher per-unit value means fewer units are granted, since grants are usually awarded on a total value basis.

Enter finance. The fair value of an award will depend on specific design parameters, such as the performance level required to earn the threshold, target, and maximum watermarks and the number of shares earned at each level of performance relative to the target number of shares. In addition, fair value will depend on technical factors like the volatility of the company’s stock price and the cross-volatility of the company’s stock price with comparable companies. Finance should be involved early, first to help provide a baseline estimate of cost and then to collaborate with other members of management and the board’s compensation committee to assess the accounting impact of different design alternatives.

Beyond market conditions, which affect TSR-based plans, numerous other design factors can have complicated accounting impacts, including:

  • Settlement in cash instead of shares, which leads to balance sheet classification as a liability, although this treatment also may solve share reserve problems.
  • Combination of market conditions and performance condition for the same award (for example, an award that is earned based on a combination of relative TSR and achievement of a threshold level of earnings per share, or EPS).
  • Timing of the periods over which performance is being measured relative to the timing of the granting of the award (e.g., grant of an award based on relative TSR where the grant date is in March but the performance period begins at the start of the fiscal year on January 1).
  • Discretionary vesting of performance awards.
  • Discretionary modifications to the vesting of awards after the date of grant.

When finance does this job well, the company experiences fewer eleventh-hour surprises because more alternatives were explored.

Finance professionals are trained to think in terms of materiality thresholds. Executive compensation disclosure in the proxy has evolved such that even small deviations from a planned accounting cost can cause proxy voting problems. Quite simply, even when the effect of a design lever is not material to the overall financial statements, it may be very material to what is being disclosed in the proxy, and to say-on-pay voting outcomes.

 

Broken Silos Are a Win-Win

Too often, corporate functions operate in silos in isolation from one another. In the world of incentive design, this can be a major problem. The human resources and legal departments do not always have all of the answers, particularly when it comes to selection of performance metrics and estimation of accounting cost.

In our experience, finance has a unique opportunity to add value throughout the design process for both annual and long-term incentive plans. The result is truly a win-win. Finance will take an important step toward achieving its mission of informing organizational strategy, and the broader organization will be less likely to encounter negative unintended consequences as a result of design decisions being made in a vacuum.

 

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Eric Hosken is a partner with Compensation Advisory Partners, LLC. He advises the compensation committee and management of companies on executive compensation, with a focus on annual and long-term incentive design.

 

 

Takis Makridis is the president and CEO of Equity Methods, LLC. Equity Methods assists clients in the valuation and accounting of equity compensation awards, with a specialization in larger or more complex equity award vehicles.

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