Pay plan design doesn’t need an overhaul for a stakeholder approach.
By Barry Sullivan
The more things change, the more they stay the same. You could say that about the recent Business Roundtable’s announcement that the purpose of companies is to serve all stakeholders.
Albeit hugely symbolic in signaling that shareholders don’t stand alone as beneficiaries of corporate value creation, the statement didn’t change the biggest day-to-day challenge for CEOs: Making tough cost/benefit tradeoffs when it comes to spending company time, effort, and money.
The key to success is the same as it has been for years. After developing the right strategy, executives need to make the right tradeoffs to compete for investors, employees, customers, suppliers, and public support to execute that strategy. If executives succeed over the long term, they maximize profits and returns for shareholders along with benefits for stakeholders. What doesn’t change, in other words, is that the challenge faced by executives is one of running a system. How do we work together with all the parties inside and outside the company to generate value?
So what does change? For one thing, the context in which companies operate. American business leaders formally announced a broader role for corporations, suggesting that, in serving stakeholders explicitly, companies should help with some of the big-ticket challenges facing the country and the world. That means that CEOs and executives will now change the weight they give to the value of each player in the corporate system. What does each stakeholder contribute to the whole? What does the company give back to stakeholders to elicit top performance?
Society’s evolving values now influence that weighting. That’s evident in the timing of the CEOs’ statement. It comes as society and the media are ramping up their focus on corporate social responsibility and environmental, social, and governance issues. The timing horizons of different stakeholders also influence that weighting. Society cares about the very long term. Employees care about their individual career horizons. Shareholders care about their individual investment horizons, which means some may care most about the next quarter or year.
But in practice, competition influences the tradeoffs much more than specific social trends or time horizons — as executives have to decide daily how best to compete for capital, talent, vendors, community support, and so on. Company leaders thus need to re-weight their decisions to make sure they continuously serve — and in some cases take the right approach to winning over — the stakeholders most valuable to the company, lest value-creating potential slip through their fingers.
What does that mean for the board? When it comes to holding management accountable, performance measurement systems — and the executive compensation plan that pays against them — have to reflect the new weighting in making tradeoffs. That means that one of the biggest questions posed by the Business Roundtable is whether the current approach to executive compensations still fits.
For some time, the most effective executive incentive systems have been the ones that take a comprehensive and balanced view of company performance — and that has not changed. Historically, this has meant that pay plans focus on three questions:
The key business result: Did we meet the numbers? Did we improve our share price? How do profitability and/or growth look compared to the annual business plan?
The quality of the result: Did we get the result in the right way? Did the financial result deliver a profit margin or the capital efficiency sought in the business plan; a customer mix goal (e.g., market share) relative to either plan or the market; or adequate quality or productivity relative to historical levels?
The sustainability of the result: Are we better positioned for the future? How did we do on strategic initiatives critical to longer-term success? Think customer satisfaction/retention; new product development or new market entry; and systems implementation. Some goals of this kind are not always quantifiable.
The difference today is that when the executive team, and in turn the board, addresses performance measurement, they need to expand their thinking and responses to each question. For the first one, business results, most companies will keep financial and financial-market results front and center. These measures assure that executives are appropriately rewarded for stewardship of investor capital, particularly in the near term, as well as the continuing viability of the corporation over time (e.g., is the company returning a profit on its investments, and are those returns greater than its cost of capital?).
For the second, quality of results, the stakeholder view suggests broadening the scope to include metrics that show executives are running the whole system effectively. Have the CEO and top team partner with stakeholders in ways that stimulate maximum long-term value creation? Has the C-suite adequately performed in the care and feeding of those value-creating constituencies?
For the third, sustainability, the stakeholder view suggests further broadening to include qualitative metrics to show executives are executing strategic milestones preparing the whole value-creating system for the future — a future alliance of stakeholders to create maximum value. In this and with the quality of results, the focus has to be on the long term. How do you acquire the most economical and patient capital, the smartest and most productive people, the most innovative and reliable suppliers, the most supportive communities, and so on in the next decade? For example, has the executive team invested in talent such that the next generation of leadership is “in the building” and developing with pace?
How will compensation plans then change in their look?
First of all, let’s look at the past for perspective, and as an illustration, let’s take the case of, say, a consumer products company with a long history of growth, both organic and through acquisition. Let’s also assume the company is global, has a multiline, matrixed organization, and thrives, in part, by virtue of its massive supplier network.
With a shareholder-first mindset, you would base incentive programs on goals for, say, earnings (the financial result), with margins as a modifier (the quality of result), and revenue growth plus share price (the sustainability of the result). See the accompanying box. In a way, this shows how comparatively straightforward the job was for compensation committees in the past.
But how has this evolved? Compensation committees today have already taken a big step. They have broadened the scope of the financial result, quality of result, and sustainability of result. As you can see, accountability for the quality and sustainability of results has emerged as a prominent new feature in pay design.
As for the future, these changes are likely to continue. One reason the view of tomorrow doesn’t differ more is that directors need to be careful not to dilute executive focus with too many metrics. As many critics of the Business Roundtable’s announcement have pointed out, accountability for too many goals translates into a lack of accountability for any of them.
The risk is that, as priorities become too diffuse, executives will pick and choose favorites without a significant penalty for foregoing other stakeholder interests. And that’s why, in practice, boards should continue to approach the new stakeholder view in the most robust way by digging into the same categories as the past: business result, quality of result, and sustainability of result.
Executives tomorrow have to juggle more when it comes to tradeoffs in running the corporate wealth-creation system more holistically. One approach to annual incentives is for management to establish objectives for each stakeholder and related milestones, whether annual or multi-year. Then track performance over time, paying out the annual incentives to reward progress and allow flexibility to change priorities. This, of course, calls for even more judgment by executives, and in turn more judgment by the compensation committee, which cannot rely strictly on formula-based incentive systems to pay for desired outcomes. Executives have to balance priorities, and they have to respond to specific pressure points as they arise.
Since many goals won’t rise to the level of importance for incentive pay, they can be highlighted outside the incentive system in, say, balanced scorecards. Retaining them as goals, albeit not directly linked to incentives, would still inform capital decisions, make operational priorities clear, and encourage the stewardship of long-term organizational health. Some stakeholder-related goals might fit in individual executives’ personal development plans as well.
Although the CEOs of the Business Roundtable issued a milestone statement, the practical impact of their announcement, when it comes to the design of executive pay and incentives, is to highlight the need for tradeoffs. Stakeholders have always been critical in value creation, so what kind of arrangements with stakeholders will maximize corporate wealth? That wealth depends heavily on the capital of investors — that’s a given. But it depends also on other stakeholders who have become increasingly able to give companies a competitive edge.
Boards can’t, and shouldn’t, dictate stakeholder tradeoffs. That’s management’s job. But they can retool the incentive plan to encourage executives do a better job of making the tough choices within the system of stakeholders. Executives in successful companies have always realized they need to define “winning” in more than financial terms. No company thrives by serving one stakeholder alone. And no company can reward just one stakeholder alone and win — yesterday, today, or tomorrow.
Barry Sullivan is a managing director at Semler Brossy Consulting Group.