True Performance-based Pay is Difficult but Attainable

Posted by Dan / on 02/16/2009 / 0 Comments

First let me note that this entry may not make me any friends in the executive compensation world.

I have always a bit of an issue with the fact the 162(m) defines includes growth in stock price as a legitimate form of performance for inclusion of compensation in tax deductions.  This become more of an issue for me as the stock market become increasingly short-term oriented over the past ten years.  The result of this is an limit on tax deductible compensation that has little in the way of accountability for companies or executives.

While stock price is a excellent end result of performance it is certainly not a driver of performance. The hole in 162(m)'s definition of "performance" is that it defines the growth of stock price over time as a performance measure. This qualifies nearly every stock option grant given since 1993. When 162(m) was put in place in 1993 there were serious downsides to companies rolling out true "performance-based" vesting equity compensation. Among these were accounting treatment that was punitive when compared to "time-based" vesting, a lack of analysis and details on how such programs could work and essentially no tools for properly managing these plans.

Of these it was the accounting expense that was the worst problem. With the advent of FAS 123R in 2005, the dichotomy between time-based and performance-based vesting was essentially eliminated, but no one thought to look at 162(m) to make a similar modification. With the recent structure of H.R. 1 – The American Recovery and Reinvestment Act of 2009, 162(m) amounts are being lowered to $500,000 for some companies, but the fundamental structure of the rule has still not changed. If we want "performance compensation" to work, we need to change how performance is defined in 162(m), and elsewhere.

The second piece of this puzzle is that shareholders, advisors and most executives are stuck in a world of "executive summaries". This means focusing on small bullets of information rather than the meat of the topic. Because of this, we tend to look at performance delivery as the final result, rather than the pieces that drive the final result. For performance to work it must be about achieving the many steps on the road to a result, not just about the result.

Just as coaches and players in the NFL say they "take it one game at a time" and the Super Bowl is just a culmination of all of those games.  Executives should be asked to take it one step at a time and the final performance payout should the result of all the steps that preceded it. This will reduce payouts on false performance and provide accountability in the process.  At times this will mean meeting goals without immediate cash value for compensation.  At other times this will mean payouts even when the stock price, or some other corporate indicator of performance is down.

The result will be more consistent performance that more people can agree upon. This doesn't mean that compensation will always be more consistent, or even predictable. But I think that's fine. If we were right about our predictions in the past we would not have so many people upset about executive compensation right now.  If we start now, we should be able to get it right in the next 4-5 years.


NOTE: I do not believe that executive compensation or equity compensation were a big driver of our current economic crisis.  Unfortunately, in our world if simplicity it is easier to focus on this highly visible issue that it is to educate people about all of the complex underlying causes.


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