Ensuring the right compensation for employees is a tightrope walk that company boards have to do every year
Devarath Nambiar

Year after year, we see articles in the business press indicating that executive compensation is overly generous or overly resistant, poorly linked to performance, and poorly controlled by management boards. Nothing has changed in that regard. Boards are caught in a difficult dilemma. On the one hand, they must ensure that they approve a plan that effectively attracts, retains and motivates the CEO, the top management and other employees. On the other hand, they must not appear to be giving away the store and must exercise due diligence in ensuring that pay and performance are properly tied to each other.

Following is advice for your company executive compensation committee when reviewing the salary, bonus, and stock option plans for employees of the company.

1. Tie bonus primarily to measures of both profitability and growth. Investors have come to realise companies who have growth without profitability or who have profitability without growth are usually less desirable investments. Stockholders want both profitability and growth.
   
2. Total compensation should reflect the diffi- culty of the performance objectives set relative to peers. If objectives are set aggressively high, then compensation should match this aggressive stance. If financial objectives are set at industry average, then it is a good practice to set total compensation at a level that is not much more than the industry average. Many companies set objectives that are average for the industry, but set compensation levels which are well above average because of executive attraction and retention concerns. The board must take a realistic look at whether there are special circumstances that might merit this treatment such as attracting key executives to a turnaround situation or labour market conditions that make attraction and retention of desired talent unusually difficult.
   
3. Analyse expected management compensation level as a percentage of expected profits when reviewing bonus formulas. Compare percentages to companies of similar size and industry.
   
4. The management team should put significant effort into developing or obtaining a database to measure financial performance against peers. This data should be presented to the board to consider in discussions about future objectives for the company. Sources that we use to assist clients in this area include stock analyst reports, trade association surveys, consulting firm surveys, analysis of financial statements for peer public companies, etc.
   
5. There is a tendency of companies to overweigh recent history of the company in setting future financial objectives. The financial objectives should reflect a balance of many factors including:
   • Recent financial history of the company – desired improvements must be realistic relative to past performance
   • Recent history of peer performance in the industry – objectives should be set at a level to improve performance relative to peers unless you are already the top performing company
   • Industry forecast for growth – objectives should reflect at least the industry average forecast for growth
   • Major changes in business strategy, new products/services, and operations that could significantly impact growth and profitability – these changes can change the model for doing business and make historical financial figures much less relevant in setting future objectives
     
6. Avoid cancelling and reissuing underwater options at a lower strike price. Management and shareholders should be in the same boat.
   
7. Put management stock ownership guideli-nes in place. In order for management to be in the same boat as the shareholders, mana-gement should have a downside financial risk as well as an upside opportunity.
   
8. 8 When setting the level of stock options, analyse both the expected value of options as a percent of the total compensation package as well as in relationship to competitive peer company stock practices. Stock option value, which focuses management on both long-term and short-term results, should be balanced with bonus plans, which focus only on annual results.
   
9. Cutting heads is often viewed as an easy way to improve profits. Downsizing is a growing trend even in financially healthy companies. It is difficult to keep the work force energised, positive, and focused when this occurs. Executive bonu-ses should be consistent with employment and compensation of other employees in the company. It sends the wrong signal to company employees, when top executives receive large bonuses while large numbers of employees are being laid off or when bonuses below the executive level are not being granted. If lay-offs are needed or a tightening of the compensation structure for the company overall, then the executive will likely find his/her rewards in the impact of those actions on stock option value. It may be best for the company if the CEO and the top management team forego their bonuses and perhaps even accept a cut in base pay. The long-term rewards for the executives and the company should outweigh short term compensation loss.
   
10. It is easy to be generous and complacent when times are good. The board as well as the compensation designer need to consider what safeguards are in place in the compensation plan should financial results take a quick downturn or should the financials need to be restated in a downward direction.
    
11. Executive employment contracts are a good idea. They are like premarital agreements and should state the terms for separation from the company in a way that balances the executive’s security with the safeguarding of stockholder assets in case of either a voluntary or involuntary termination.
    
12. Remember that it is always more motivational to pay above-average incentive and an average salary, than to pay above-average salary and an average incentive. Often it is a good idea to adjust the balance between these elements when they are found to be out of alignment. A competent and confident executive will welcome such a rebalancing because it should result in higher compensation for top performers.