How Boards Can Calibrate Executive Compensation to The Risk of Disruption

Seymour Burchman and Blair Jones are Managing Directors at Semler Brossy Consulting Group. This post is based on their Semler Brossy memorandum. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

Thanks to emerging digital technologies, many industries are now facing a new wave of disruption. Artificial intelligence is powering autonomous vehicles, while data analytics are reshaping financial services and other consumer industries. AI-powered advances by themselves, according to a 2019 McKinsey study, could boost annual global GDP by $13 trillion, or an additional percentage point. And the coronavirus pandemic, by promoting remote work and commerce, has accelerated this process.

Companies in many industries now face serious threats to their business models. Yet executive compensation as a whole has been surprisingly slow to adapt to the challenge. Most programs still emphasize the same basic financial metrics on growth and profitability—which tend to focus executives on current programs rather than creative projects to meet the looming disruption.

Metrics that promote innovation and transformation are still relatively weak. Many companies rely on three-year performance periods that are too long or too short to capture the strategies they are implementing—and may thereby be contributing to the steady decline in corporate investment over the past decade. Also, boards frown on using discretion and qualitative measures in pay packages, even as they want their companies to be more agile and adjust strategies frequently. A clash is inevitable.

Not every company, however, should overhaul its executive pay immediately. Boards need to calibrate compensation to the state of their business.

At one end of the spectrum are stable innovators: industries that have yet to face major technological disruption. In most consumer products, for example, changing customer preferences are leading to new products, categories and shifts in strategy, but not fundamental changes in business models.

In the middle are intermittent disruptors, which face discrete challenges. Carmakers, for example, are moving to electric vehicles now, and see that they will eventually need to offer autonomous and connected vehicles. They’ll probably become platforms for mobility services more than sellers of individual cars. While electrification is a major change now, these other disruptions won’t fully occur for several years, and all of these changes are fairly knowable already. Car companies have a good sense of the future, even if the timing is uncertain.

At the far end of the spectrum are ongoing disruptors, which regularly face dynamic upheaval. Financial service companies are scrambling to address collapsing market boundaries, “fintech” rivals, and new blockchain products. Health care delivery is wrestling with not only a variety of technological advances, such as artificial intelligence, remote connected sensors, and advances in gene editing, but also with intense pressure on costs and potential government intervention, all exacerbated by the pandemic. Media companies are likewise dealing with the far-reaching rise of streaming and other digital distribution channels, as well as competition from deep-pocketed software giants. Here everything is uncertain: both the timing and the future state.

Designing Compensation to Support the Business Model

Intermittent and ongoing disrupters must continuously adapt and develop new business models, which generally involve wholesale changes in strategy, talent requirements, organizational structure, and other areas.

Compensation can be an effective way to prepare for disruption and clarify key priorities and areas of focus. As they guide companies through the straits of disruption, boards will do better by calibrating their incentives according to the pace and magnitude of likely changes.

Stable Innovators

In these industries, boards can continue to pay leaders within the traditional compensation parameters: a salary and annual bonus in cash, and long-term incentives through a mix of stock options, restricted stock awards, and performance-based equity grants. Boards can adjust these parameters to best support the strategy.

Some boards are innovating a great deal here. Most interesting are those adding non-financial goals to encourage operational and strategic improvements, or to promote the interests of stakeholders beyond investors. Some are also evaluating different measurement time frames.

For example, a major branded food company is fighting longstanding pressures to commoditize the business. Retailers’ private labels are gradually weakening the company’s mainstay brands. The solution is the same as always in this industry: Innovate ahead of the commoditizers. A big current food trend is toward healthier choices and more socially responsible practices. This company has determined to be all in on this trend with low-sugar, low-trans-fat, and low-salt recipes to address the obesity and hypertension crises. Sustainable sourcing, of both food and packaging, is another customer focus.

These goals are ambitious in advancing the customer value proposition, but they do not alter the fundamental business model. So the board can follow historical practice with executive compensation. It uses targeted metrics tied to the profitability of the healthier-product strategy and its effect on market share. For the annual bonus, 70% rewards sales growth and profit margins, while 30% follows non-financial targets such as net promotor score, productivity, and sustainable sourcing. Because changing a full product line to healthier choices is likely to be more difficult than the usual innovation, the board might want to create interim milestones for the long-term incentive (LTI) program, with measures such as market share and the proportion of revenue from new products.

Intermittent Disruptors

These companies are in a transition period where the legacy business must generate the cash flow to finance innovation for the new offerings. Boards at these companies may opt for a hybrid compensation model, with an annual bonus that looks more traditional while the long-term incentives incorporate new elements to support the transition.

A major car company, for example, has focused its annual bonus on the cash flow and profitability (not growth) of the legacy internal-combustion business. A third of the bonus is tied to operational metrics such as efficiency to help fund investments in electrification and mobility.

Long-term incentives can then be focused on building the future business model, and denominated 100% in shares. Boards can award most of those shares according to performance, incorporating proof-point milestones at critical time periods (such as two and four years) and perhaps with relative shareholder return as a proxy for the new strategy gaining traction. The remaining awards would be restricted shares or stock options, gradually vesting over the period to deliver the benefits of the value created.

Ongoing Disruptors

Industries in this group have the toughest compensation design challenge, as they face what is likely to be a continuing series of disruptions. The challenge is not just in the variety of disruptions, but also in the great uncertainty over timing and magnitude. (We’re excluding from this group industries such as retail that are going through disruptions so intense as to be existential. Those boards have to focus on sheer survival.)

Companies facing ongoing disruption can work from some strengths, but they must revamp their business model regularly. As one of us argued recently, these companies should no longer center compensation on strategies that may be obsolete in a year or two. Instead they should work from their underlying mission, which is enduring. The mission offers consistent, yet flexible guidance for long-term transformation, agile course correction, and building the stakeholder-rich ecosystems the company needs for a highly uncertain environment.

Let’s take a conventional bank with the mission of “providing a full range of affordable and timely financial services solutions with full regulatory compliance and an acceptable level of risk.” From that mission, and adjusting to the current disruption, the bank’s leaders might derive a new customer value proposition emphasizing speed and lower transaction costs, out of which would come the profit formula and other elements of the business model. The board would then translate that model into a set of mission-focused compensation goals.

Indeed, because the board needs the executive leaders to stay agile, it might drop narrow financial goals from the annual bonus. The bonus should still have operational metrics, such as customer satisfaction and time and cost per transaction, that promote the mission without constricting the strategic possibilities. With financial goals removed as specific targets, the board might still set a financial floor to ensure responsible investment in strategic and operational measures.

As for the longer-term incentive, the board could switch to three-year non-overlapping LTI cycles tied to key outcomes such as building employee talent, passing banking stress tests, and meeting targets for return on invested capital. These would emphasize continual improvement and rankings relative to peers, with goals set as a standard against which the business model expects to deliver. If the industry is just too dynamic for non-overlapping cycles, then the board could offer a large stock grant with a lengthy vesting period such as six years. This latter approach focuses management on the long-term and allows for strategic agility, though the board would want to ensure that this structure did not overly bias management towards investors over other stakeholders.

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The coronavirus pandemic has been a sharp reminder that industries have very different dynamics of supply and demand. The same is true for disruption generally: Some companies are already in the hurricane, while others have time to prepare, and still others expect only moderate winds for now. These differences will only widen as emerging technologies spread. Boards and management teams need compensation plans to respond accordingly. As always, compensation incentives, applied appropriately, can signal change and instigate executive action.

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