Why Equity and Not Just a Bigger Salary?

This February, the Harvard Business Review published Stop Paying Executives for Performance” by Dan Cable and Freek Vermeulen. The basis of the article is that we do away with all executive incentive pay and replace it with high (in cases much higher) salary. Their argument is that there is no evidence that pay for performance works and some evidence that it is dangerous. Since this post is part of my ongoing “Stock Options on the Precipice” series (earlier articles: 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11), I will try and focus only on that one aspect of incentive pay. Perhaps some of you will add additional information in the comments.

Note: We are not arguing that top managers such as CEOs should be paid less. That may very well be the case too, but that’s not the focus of our analysis. HBR , Cable, Vermeulen, Feb. 2016

Let’s start with the premise that pay for performance does not work. There is some truth to this, at least in a couple of narrow definitions. Most executives would likely perform as well with a salary that is equal to their current total compensation package. But, some (likely the 5-10% that investors worry about the most) would not perform as well. But, we must keep in mind that pay for performance is as much about paying less as it is about paying more.

The deal between the company, shareholders and executives is essentially this. “We are fine paying you really well as long as the company and investors are doing really well. If you do not deliver, we don't want to have to pay you so much.”

For come companies the deal also includes, “If you do a GREAT job, then we will pay you even more than you or we might have expected.”

Pay for performance is often as much about protecting the upside and downside risk of each stakeholder as it is about driving performance.

The article then discusses five insights as to why performance pay is not suited for executives.

• Research shows that pay for performance only works for routine tasks and not creative issues. This point presumes that much of what executives do is creative. In fact, most of what executives are expected to do is execute. It’s probably not a coincidence that they are called executives.
• Fixating on performance can weaken it. While research may show this is sometimes true; research, common sense and just about everything shows us that NOT focusing on performance seldom results in performance.
• Intrinsic motivation is more powerful than extrinsic. This one is probably true, but we will come back to it in a minute.
• Contingent pay leads to cheating. Smart people will exploit both the documented and undocumented rules of almost any game. This is why plan design, modeling and management are all so gosh-darned important!
• All measurement systems are flawed. This one is also true. It is also true that often in their zeal to create a perfect plan many companies will include metrics or goals that they have neither capability to track and communicate nor the ability to fully understand the long-term downstream impact. Again, plan design, modeling and management (execution) are essential.

Lastly, the authors define pay for performance as pay for results. As we have discussed numerous times here and elsewhere, GREAT pay for performance programs focus as much or more on the things that drive performance, rather than simply pay because a goal was met.

But, are there things beyond all of this that are driving pay for performance, especially in the form of equity compensation? Yes, Mathilda, there are.

• Equity costs less than salary on the books of the company. When designed properly, the expense is fixed. Add performance criteria and you may not have any expense to book until deep into the performance cycle, if ever (I will try to cover that one in a future post.)
• The amount of incentive pay we are talking about can often be 500% to 3000% (or more) of salary. Your shareholders might go berserk if you suggested increasing your CEO by 30x. The SEC also expects pay to be linked to performance. It is just too hard to have enormous swings in salary each year.
• Often you are paying for results that are difficult to predict and model. Pay for performance allows companies to navigate the murky and unstable waters that make up executive pay.
• If you think executive pay goes up quickly now, imagine if the amounts were all guaranteed in advance! And, imagine if the only way to deal with less than excellent performance was replacing the executive.

Equity is a pragmatic, if sometimes mercurial, way to pay executives in many highly volatile industries. While it is by no means perfect, the alternative of simply paying salaries at the same levels is inconceivable in the current business climate. Compensation professionals have to continue to improve pay for performance if it is to remain a credible compensation tool.

Dan Walter, CECP, CEP is the President and CEO of Performensation. He is passionately committed to aligning pay with company strategy and culture and has been deeply involved in equity compensation for a long, long time. Dan has written several inustry respurces including the recent Performance-Based Equity Compensation. He has co-authored “The Decision Makers Guide to Equity Compensation”and “Equity Alternatives” and a few other books. Connect with Dan on LinkedIn. Or, follow him on Twitter at @Performensation and @SayOnPay.

Comments

[E. James (Jim) Brennan]

Thanks for veering into difficult and dangerous ground, Dan, to discuss those supposed "insights." The initial points you offered seem more theoretical contentions than indisputable facts. Various hypotheses about the uncertainty of performance management techniques need verification via the legitimate scientific method before being universally accepted.

Alas, poor implementation of fragile concepts applied outside their potency area will always produce unpredictable or negative results. Water can extinguish flames but only exacerbates oil fires. Some cures kill, under the wrong circumstances. Conclusions should derive from the circumstances. Assertions should be qualified judgments. Overgeneralization is hazardous, especially when based on controlled student behaviors or other foreign contexts.

In addition, shareholders/owners find it much easier to justify sharing their wealth when the potential beneficiaries have skin in the game. No risk, little reward. Mutually beneficial conditional guarantees make more sense.

[Ted Weinberger]

Dan:

Great post, but why is it "just too hard to have enormous swings in salary each year"? Would it really be so difficult to introduce a partially "variable salary" program at the executive tier?

Also, if "paying for results are difficult to predict and model", doesn't this fact negate the causal assumption underlying the pay-for-performance at the executive level -- that company performance can be largely attributed to the actions/decisions of the executives, rather than exogenous factors?

Can't have it both ways.

[Dan Walter]

Thanks for the comments Ted.

I think the difficulty in having a variable salary is mostly in execution and somewhat in communication. As a profession we have spent the past three decades or more focusing on "market data" to defend pay levels and practices. With a strong base like a fixed salary (base pay) survey data would be so variable that it would likely no longer be useful. Of course, that may abetter result than current practices, but it is something that is truly unlikely to happen with so many professionals (and service providers) who have learned the current paradigm.

And, as soon as you have a fully or partially variable salary, you essentially are just creating a new angle on Short Term Incentives. Since shareholders, and most companies, would like their executives to focus on "Long-Term" (even though most could argue three years is, at best, mid-term), the thought of aligning pay only to short periods would never gain traction. This is likely why the authors of the original article focused on simply making fixed pay (Salary) consistently higher. Variability defeats their conclusions that pay for performance doesn't work.

As for paying for results Vs paying for actions and decisions that should align with success....
Paying for results, when those results are often driven by outside factors, seldom works in the long run (well, maybe in the very very long run).

Paying for the actions and decisions that should drive results generally makes more sense. If your executives are doing what you want them to do and the market, or just their industry simultaneously experiences hard times then your company should be outperforming its peers or better positioned to recover after the downturn. Simply cutting their pay because the results were poor doesn't make much sense.

Of course, determining the correct metrics and goals for driving success is more difficult (and sometimes more contentious) than simply statins that "TSR must be above X" or "EBITDA must be above Y".

Sort of like a sprinter. It is important to win the race. It is also important to set world records. But, if there is a tremendous tailwind, you may run incredibly fast and win the race, but the WR wil be disallowed. If there is a tremendous headwind, you may win the race with a very slow time, but it may still be impressive. Lastly, someone else may simply be faster than anyone in history and second place may prove to be an incredible achievement.

Many moving parts, Some are in the executives control, others are not. Pay for Performance only works if there is balance. Too often we let executives get away with "world record" pay when the tailwind was factor in their success. Too often we blame executives for terrible performance, when the headwinds were unusually strong.

It ain't easy (as we all know.) Until the entire world agrees on a pay scale and measurement system for executives and their success, we will need to keep working on the ongoing experiment that we call "pay for performance.