Balancing Operating/Financial Metrics-Chapter 11 Summary

Chapter Summary
One of the key functions of an incentive plan is to align participants with the interests of shareholders; such a pay objective has become especially relevant in the post-Say on Pay world’s focus on good compensation governance. As a result, recent years have seen increased utilization of total shareholder return as a specific metric in incentive programs, specifically long-term performance plans. In many instances, however, total shareholder return is not an appropriate incentive plan metric as it lacks “line-of-sight”. Therefore, companies should assess which metrics best align participants with the interests of shareholders. We typically suggest using a combination of operating, financial and TSR based metrics in their incentive programs as this will help drive long-term value creation.

Key Points
1. Business Life Cycle: Our research using correlations found that early stage public companies have relatively low revenues and are focused on efforts that will increase future income streams. Meanwhile, mature companies are flush with cash, and have more predictable and steady growth prospects. Early stage companies were found to focus on research and development and operating profit in their incentive plans, whereas later stage companies focused more on EPS and revenue growth. These metrics were generally found to have the highest correlation with TSR indicating that most companies already identify value drivers and include them in incentive plans. Not surprisingly, earnings metrics tend to correlate highly with TSR among companies in all industries and growth stages.

2. Case for Using Total Shareholder Return: TSR, the stock price appreciation plus reinvested dividends over a period, is the ultimate measure of a company’s achievement for shareholders over the long term. However, the use of TSR as a long-term incentive plan performance metric may diminish executive engagement and motivation as it has a weak line-of-sight. Despite this, TSR has become more prevalent with nearly 40% of large companies using it as a metric in their long-term incentive programs.

3.  TSR Plan Design Alternatives: We explore several alternative TSR plan designs: Relative TSR, (which compares the company’s TSR performance to a selected group of companies), absolute TSR (which compares the company’s TSR performance to a performance schedule set at the start of the performance period), both relative and absolute TSR, and using TSR as a modifier (uses TSR performance to adjust the award amount determined by financial or operational metrics).

4.  Key Takeaways: The use of TSR is less about the incentive-related effects on participants and more about the optics of executive pay delivery. The use of relative TSR is likely to increase in prevalence as companies continue to review their executive pay programs to ensure the strongest possible relationship between pay and performance outcomes and to minimize potential external criticisms. Choosing the right operating and financial metrics in combination with TSR and high stock ownership will help ensure that executives are truly aligned with shareholders’ interests over the long-term.

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