Ten Considerations for Performance-Based Compensation

08 January 2020 Manufacturing Industry Advisor Blog
Authors: Leigh C. Riley

With the dawn of the new year, many companies are taking the initial steps that they hope will allow them to meet their financial and strategic goals in 2020 and beyond.  Often, one core element of this process is designing a system of performance awards that will be granted to the executive team, with the intent to motivate executives to achieve the company’s goals by aligning the executive team’s interests with the performance of the company.   Performance awards can come in many forms, including stock options, performance-vesting restricted stock or stock units, or cash bonuses.  The process of designing performance awards is often messy because there are too many choices and too many unknowns, and companies must also face the risk of inadvertently designing a program that could incentive bad behavior.   As you think about your performance awards, here are ten considerations to keep in mind:

  1. Performance goals should reflect a company’s business strategy.  While it may seem obvious, in setting compensation performance goals, a company should ask two key questions – first: “what is our business strategy?” and second:  “what performance goals will help us motivate employees to further that strategy?”  Don’t be afraid of including “soft” or non-financial goals, such as rewarding the CEO for completing certain steps in a succession plan or for increasing customer satisfaction.

  2. If you are a publicly-traded company, one benefit arising from the changes made to Section 162(m) of the Internal Revenue Code by the Tax Cuts and Jobs Act, is that you can now exercise more discretion to modify performance goals.  Under the prior Section 162(m) rules, in order for compensation to be “performance-based” and fully deductible by the company, the Compensation Committee could not exercise any discretion to modify the performance goals after they were initially established.  Now that the automatic deduction for performance-based compensation is gone, Compensation Committees have more leeway to (judiciously) increase their use of discretion.  This ability to exercise discretion alleviates some of the stress of trying to get the goals exactly right on the front end, and provides a path to make adjustments when unforeseen changes in the business arise during the performance period. 

  3. Typically, long-term incentive compensation programs use more than one performance goal, including at least one earnings metric (such as Net Income, EBITDA, or net operating profit) and one return metric (such as ROIC, EPS, or TSR).  Therefore, companies shouldn’t agonize to figure out the “one right goal” or feel like they should have their executive team focused on only a single outcome.   If more than one goal is selected, use their weighting (e.g., achievement of goal #1 results in 70% of the award being earned and achievement of goal #2 results in 30% of the award being earned) to reflect their importance to the company’s overall business strategy.  

  4. Relative performance goals, which compare the company’s performance to a peer group (such as relative total shareholder return), are popular performance goal choices because relative goals do not require a “crystal ball” to predict future income, profit, or expenses. Even though relative goals typically are used by publicly-traded companies, large privately-held companies should not shy away from them, but should ensure that the peer group companies are publicly-traded so that financial information is readily available.  

  5. For publicly-traded companies, Economic Value Added (EVA) is a performance metric that has been well received by the investor community and is now being used by Institutional Shareholder Services (ISS) in its pay-for-performance modeling, but it has not yet been widely adopted.  It is currently estimated that only about 6% of companies use EVA as a performance metric in their incentive compensation programs.  EVA is calculated as Net Operating Profit After Tax minus (Weighted Average Cost of Capital x Capital Invested).  So, if you are struggling to select a goal (whether your company is publicly-traded or privately held), this is one metric that may be worth considering. 

  6. Regardless of the performance goals a company selects for its annual and long-term incentive compensation programs, those goals and the progress towards achieving those goals should be communicated to program participants to maintain their focus and line of sight.  Quarterly communications between the company and executives on progress toward achievement of performance goals are evolving as a “best practice.”

  7. Compensation clawbacks that cover financial restatements have become a “best practice” for publicly-traded companies even though the Securities Exchange Commission has not yet issued its anticipated rules on clawbacks.  Even though privately-held companies are not subject to any legal obligation to implement a compensation clawback policy, they should consider doing so.  Such policy would allow the company to “claw back” any bonuses that were erroneously paid, or equity awards that erroneously vested, as a result of financial performance that, after-the-fact, was found to be incorrect. Including such a policy can help keep executives and employees honest and focused on achieving the company’s goals, while deterring bad behavior or trying to game the system.

  8. A recent trend is the expansion of clawback policies to include clawbacks in instances of violation of company policies (including, for example, anti-harassment policies) or other behaviors that could be detrimental to the company’s reputation.  However, if these policies are so broad that they are unlikely to actually be enforced by the company, they may create issues from a public relations perspective in the event that a company can clawback compensation, but chooses not to do so.  Therefore, while it may be advantageous to use a clawback policy to help enforce a company’s policies and discourage bad behavior by employees and executives, the policy still needs to be sufficiently tailored to avoid putting the company in a difficult position when it catches behavior that the company would view as not warranting a clawback.

  9. Companies considering adopting or expanding compensation clawback policies should confirm that such policies are consistent with their other executive compensation documents.  For example, companies should consider whether their clawback policies cover the same range of behaviors as the provisions in their employment agreements relating to “for cause” terminations.  Companies should also ensure that their standard separation and release agreements account for potential compensation clawbacks post-termination of employment.  For example, if a release agreement is mutual – not only does the terminating employee release the company, but the company releases the terminating employee – the company may have given up its right to enforce its clawback policies.  

  10. Finally, companies should check their employment agreements to see if they contain obligations relating to performance awards.  Employment agreements may contain certain guarantees about performance-based compensation, such as that the performances goals will be based on EBITDA or will be established and communicated within 90 days of the beginning of the year, or the executive will be permitted to earn a bonus of up to 200% of target.  When companies deviate from those contractual obligations, they set themselves up for potential lawsuits when the performance-based compensation is less or different than what the executive expected based on their contract.
 

These 10 suggestions were among the “Top Ten Takeaways” on various corporate governance topics developed at Foley’s recently held National Directors Institute (NDI).  For more information on NDI, please see the attached link.

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