How do we really drive the value in the pay for performance plan?

by on June 23, 2009 · 0 Comment POSTED IN: HR Info Center

Value indicators in a pay for performance plan

Are you going to have an annual valuation or you’re going to just look at multiples of EBITDA within other transactions in your industry? What are you going to do to drive the value? Because obviously, we need to look at performance measures that enhance value, that’s what long term incentives are all about.

Indicators or limitations in pay for performance
Over hang, burn rate, fair value transfer, those are not only indicators but probably what I’ll consider more like limitations when you look at a long term incentives in a pay for performance plan.

If you look at the burn rate, basically that’s the amount of annual options or restricted stock that you’re giving out as percent of the shares outstanding.

The over hang – this term has been around for a long time, but it’s really the authorized options or restricted stock as a percent of outstanding shares. It’s an indicator of how much of the value of the company that we should set aside for key management to incent them to grow the value.

If companies want to put in a long term incentive into pay for performance and we think we’re going to transfer 40% or 50% of the value, that’s just not appropriate. So, we have to keep these things in mind. We have to look at it in light of succession planning and other things we have going on.

But certainly, you know, these are guidelines and it might be appropriate to be a lot higher or a lot lower depending on the individual circumstances. Now, I don’t know if we have a whole lot of time or desire to run into all the restricted stock versus option stamp stock and deferred comp or performance units.

Pay for performance in private companies
I think that some of the key things to keep in mind, if you’re a privately held company with the new deferred compensation rules and all that, I think it may actually be a little easier to move to options versus phantom stock. But the downside of that is you’re going to need an annual valuation to that because of the IRS rules regarding 409A and deferred compensation.

As you look to what’s going on more in the market place and the public company markets, there’s certainly a trend to use more restricted stock versus options. You could see some of these limitations here.

Again, these limitations do not differentiate between options and restricted stock. But restricted stock has a higher value than (us). It’s typically you know, three times depending on the industry and a lot of other factors.

The major driver in pay for performance with stock is that we want executives to think like shareholders.

Well, with the Enron and all the other things that are going on, the option is only rewarded upside. They did not penalize for downside. The executive had no cash or nothing at risk other than the upside (head) of the stock .

So, all those things — all those games that were played at Enron were basically there to enhance the value of the stock because the executives had no downside risks.

While to grant a share of stock at $20, and it goes down to $10, they’ve got downside risk because they have to pay tax on that value as it vest. Obviously there are ways to make an election to control that tax but they have skin in the game. As that stock goes down, they are actually losing their worth.

The overriding comment is market pay for market performance.
Okay, we can penalize the organization by demanding higher performance for too little pay. And as a result, we’ll have probably a lot of turn over of our A players with that kind of process.

So, if we don’t pay enough, that’s going to lead to turnover. If we pay too much, then that’s taken away from shareholders. So, I think we need to look at those things and balance it out.

As one of my partners in a company said, “You know, pigs get fat and hogs get slaughtered.” We don’t want to have a plan that’s so egregious that it over rewards without the pay for performance and vice versa.

,cite>Edited remarks from the Rapid Learning Institute webinar “Incentive Pay Plan Blunders That Can Cost You a Fortune.” By Kevin Nussbaum and Ed Rataj

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