Structuring executive pay is no new topic – in fact, some would say it’s been in play since the Viking Era when raids began on England in the late eighth century. Likened to a ‘corporate takeover’, monks were slaughtered and countless treasures or ‘cash incentives’ were carried away. Taking advantage of political instability after the ‘acquisition’, the Viking Leaders became wealthy kings or ‘executives’ and their armies, ‘the shareholders’ reaped the value they had helped to create.
Although we live in civilised times, this system isn’t too different from what we see today – many complain that ‘executive kings’ are being paid even when they get conquered in battle and lose valuable company assets, and shareholders expect a return on their invested funds.
So how do we avoid a situation where enrichment is not one-sided? Where one party does not succeed at the expense of another?
Creating fair enrichment
When looking at executive remuneration this simple equation can establish what is fair and reasonable. Fair is when both parties – the executive and the company – make money with each other and not from each other. This means one party does not succeed at the expense of the other.
Executive packages must be competitive, but they can’t be competitive at the expense that they can’t be commercial. This is the cornerstone of any executive remuneration policy.
Getting enough ‘executive skin’ in the game
The challenge today is offering a competitive package that creates long-term value. What we see too frequently is Boards reverting to general market practice, implementing a large short-term incentive (STI) plan that vests annually, and a long-term incentive (LTI) plan which is too large and hard to grasp. This scenario is to the detriment of the company and its shareholders, placing the executive in a position of comfort that allows them the opportunity to cash out before the impact of their decisions is felt.
When you think about it, executives are there to manage for the long-term and their performance should, therefore, be based on long-term performance. This, in turn, creates an accountability trail, which means that the executive will bear the pains or gains of the decisions they have made.
Getting enough skin in the game is not an LTI scheme that promises riches based on some future date, but rather a mechanism which forces executives to hold equity in the companies they lead. Skin in the game ultimately means giving your executives a piece of the business and the opportunity to participate in long-term celebrations with the company and its shareholders.
Striking the balance – when is it time to reassess?
Protecting the interests of both the executive and the company should be your priority – if you are not experiencing the successes and pains together, then it’s time to reassess your incentive design.
1. Executives are there to manage for long term performance - therefore, limit the size of your short-term incentives and limit the amount they can cash out at the end of the year – large short-term incentives create a short-term view.
2. Increase or introduce a deferral component that translates into equity – it’s called ‘skin in the game’. The only way you can make someone really accountable is when they bear the financial brunt of their own decisions.
3. Limit the size of the LTI component and introduce non-market measures – this ensures relevance of metrics. Reconsider the use of relative Total Shareholder Return (TSR) especially for companies below a billion-market cap, this measure is too volatile and is not representative of company performance. Alternatively, if you decide to utilise relative TSR include one or two other non-market measures as well.
4. Business are in the business of making a profit - if you are going to use non-financial measures make sure that the measures can be linked to financial targets and do not represent an additional payment for executives doing their job.
5. Make sure your schemes pay out only if financial objectives are reached - if you wish to pay out for milestones then ensure those milestone payments are subject to a service condition or the final value creation event. Executives should not be allowed to realise their investment in the business before their performance can be evaluated.
6. Lastly, understand market practice and don't blindly follow it - no company is the same, they have their own nuances, people and plans and this needs to be reflected in the company's incentive arrangements.