In public companies, executive compensation is crucial for attracting top talent, aligning interests and driving sustainable growth. Crafting compensation plans that incentivize performance while ensuring accountability is challenging. With increasing scrutiny from shareholders, effective compensation design has become a priority for the board members. Here are key considerations and best practices for fostering long-term value creation and shareholder alignment through executive compensation plans.

Aligning with Corporate Strategy

Effective executive compensation plans must be closely aligned with the company's strategic objectives, vision and values. Compensation packages should incentivize executives to prioritize actions and decisions that contribute to the long-term success and sustainability of the business. Whether it's driving innovation, expanding market share, or enhancing operational efficiency, compensation metrics should reflect the company's strategic priorities.

Peer Benchmarking and Market Competitiveness

Benchmarking executive compensation against industry peers and market norms is essential for ensuring competitiveness and attracting top talent. Compensation committees should conduct regular reviews of executive pay levels and practices to ensure they remain competitive within the industry while considering the company's performance, size, and market position. However, while benchmarking can provide valuable insights, compensation decisions should ultimately be driven by the company's unique circumstances and strategic objectives.

Key Criteria for Peer Selection

1. Industry Classification: Use systems like GICS or SIC codes to identify similar companies.
2. Revenue Size and Market Capitalization: Ensure peers are of similar size for relevant comparisons.
3. Business Model and Operations: Select peers with similar models and operations.
4. Financial Performance: Choose peers with comparable financial metrics.
5. Corporate Governance Practices: Prefer companies with strong governance and transparent disclosure.

Annual Performance-Based Incentives

Performance-based incentives lie at the heart of effective executive compensation plans. By tying a meaningful portion of executive pay to measurable performance metrics, such as revenue growth, earnings per share, or any other relevant metric(s), companies can align executive interests with those of shareholders by ensuring short-term goals work toward long-term results. Performance-based incentives encourage executives to focus on achieving tangible results that drive value while discouraging excessive risk-taking.

Components of Annual Incentive Plans

1. Performance Metrics: Financial, operational, or strategic goals that executives must achieve. Common metrics are industry specific but typically include 3 – 5 quantitative goals, and an additional discretionary/subjective element. At the executive level, quantitative goals typically account for 75% - 85% of the total payout potential.
2. Performance Targets: These establish thresholds, targets, and stretch goals for varying incentive payouts. These targets are typically set based on historical performance, industry benchmarks, and the company's strategic objectives. The range of threshold (as a % of target) is prevalently 80% - 85% and the range of stretch (as a percentage of target) is prevalently 115% - 120%.
3. Incentive Payout Structure: Defines how performance achievement translates to payouts. This may involve linear, graduated, or threshold-based payout scales, where executives receive a percentage of their target incentive based on the level of performance achieved.
4. Performance Period: Annual incentive plans operate within a defined performance period, typically one fiscal year. This allows for a clear and measurable assessment of executive performance against established goals and objectives.
5. Long-Term Incentive Plans: Equity awards like stock options, restricted stock units, or performance shares align compensation with long-term shareholder interests. These awards, which vest over time or upon meeting performance goals, ensure executives are invested in the company's long-term success.

Components of Long-Term Incentive Plans

1. Equity Award Vehicles: Common awards include stock options, RSUs, and performance shares. These awards provide executives with a stake in the company's future performance and align their interests with those of shareholders. Each of these award types may have different tax and accounting rules, and may also impact shareholder dilution differently.
2. Performance Metrics: Performance-based LTIs often include performance metrics tied to specific long-term goals, such as total shareholder return (TSR), earnings per share (EPS) growth, revenue targets, or strategic milestones. These metrics ensure that executives are rewarded for achieving tangible, value-enhancing outcomes over the long term.
3. Vesting Schedules: Vesting schedules dictate when executives become eligible to receive their LTI awards. While vesting periods range from 3 – 5 years, 3-year vesting terms are by far the most prevalent.

Importance of Long-Term Incentives

• Alignment with Shareholder Interests: LTIs align executive interests with those of shareholders by tying compensation to long-term stock/unit price performance and value creation. This alignment encourages executives to make decisions that maximize shareholder returns and enhance corporate performance.
• Retention and Talent Management: LTIs serve as powerful retention tools, incentivizing executives to remain with the company and contribute to its long-term success. By offering equity-based incentives with extended vesting periods, companies can attract and retain top talent, reducing turnover and ensuring continuity in leadership.
• Risk Management and Strategic Focus: LTIs encourage executives to adopt a strategic, forward-looking mindset and prioritize initiatives that drive sustainable growth and mitigate risk. By linking compensation to long-term performance metrics, companies can deter short-termism and promote prudent decision-making that benefits the organization over time.

Risk Mitigation and Clawback Provisions

To mitigate excessive risk-taking and align executive incentives with prudent risk management, compensation plans should incorporate appropriate risk-adjusted performance metrics and clawback provisions. Clawback provisions allow companies to recoup compensation in cases of financial restatements or misconduct. This promotes responsible governance and safeguards shareholder interests. Starting December 1, 2023, NYSE and Nasdaq-listed companies must implement policies for clawing back inaccurately granted incentive-based compensation per Rule 10D-1 under the Securities Exchange Act of 1934.

Transparency and Shareholder Engagement

Transparency is paramount in fostering trust and accountability in executive compensation practices. Companies should clearly disclose executive pay arrangements, including the rationale, performance metrics and potential risks. Engaging shareholders in compensation discussions enhances transparency and alignment.

Regular Evaluation and Adaptation

Compensation plans should be regularly evaluated and adapted to remain effective. Boards should review plans, solicit stakeholder feedback, and benchmark against industry practices. Flexibility ensures responsiveness to changing market conditions and stakeholder expectations.

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