It is commonly said that compensation should follow a company's strategy: a company develops its strategy and then aligns its structure, talent, and compensation accordingly. But sometimes (quite surprisingly) the process goes the other way and compensation discussions reveal gaps in assumptions, leading to important, deeper conversations that clarify strategic intent. In the first of this three-part series, we examine three case studies that show how executive compensation discussions can drive value creation by highlighting misalignments and unfounded assumptions. In the process, they spark conversations that lead management and the board to reframe and more clearly articulate strategy. In the second part, we explore how compensation impacts talent decisions. In the third part, we focus on the impact of compensation on changing how work gets done.
Compensation “wags the dog” moments may feel uncomfortable at first, but when fully worked through, they create an opportunity for the board to unify around business priorities and lead the company to discover significant economic value.
As compensation committee advisors, we have seen how these discussions can have a profound impact on organizations. They provide an opportunity for the board to pause, dig deep into strategic assumptions, and communicate the intended messaging through compensation programs. Left undiscussed, compensation design can undermine strategic outcomes. Rethinking the messaging of compensation programs can fundamentally change an organization.
Signal Strength: Refocusing Rewards for Strategic Alignment
A telecommunications company had a straightforward, “middle-of-the-road” long-term incentive plan focused on earnings growth and relative total shareholder return. In a short time, the company made significant capital investments to ensure the relevance of its product offering. Belatedly, board members began to discuss adding return on invested capital (ROIC) as an important long-term measure to validate the large investments. Some also suggested focusing on free cash flow to eventually pay off the debt levels associated with the investments. Further investigation yielded a key insight: the company would not be able to fully benefit from its investments without a significant increase in new customers. Management had initially proposed spending heavily to maintain product parity with competitors, but the investments had grown share and needed to be supported by new revenue streams to pay for them. This insight led to a restructuring of the organization to focus on growth. The company shifted incentives to focus on earnings growth rather than measuring ROIC or free cash flow, the two metrics best understood by the few executives involved in capital allocation decisions. Revenue growth was a metric that was broadly applicable to nearly all participants. The “tail” in compensation design led to both organizational change and clarity of strategic intent.
Addressing Healthy Margins in Healthcare: Compensation Reform Drives Process Improvement
A healthcare company in transition developed an annual incentive program based on activities and milestones that aligned with strategic plan priorities. These activities engaged the entire organization and were all important metrics. But the company's financial situation was not improving fast enough. As the board approached annual approval of the incentive plan, it realized that the plan was skirting the issue of profitability, and without that focus, no level of activity could save the company. As the conversations progressed, it became clear that there was not enough clarity in the strategic plan discussions about how to align activities to achieve profitability. The new focus led to discussions about how to improve processes such as billing, member enrollment, and provider interactions to reduce costs, improve payments, and increase profitability. It also led to productive discussions about where to focus new member growth and how to integrate new members into the organization to drive higher profits. The compensation program sparked new substantive discussions and analysis about what it would take to win.
Metrics in Motion: Redefining Value Creation to Drive Profitable Growth
At one logistics company, an activist investor participated in board discussions with the compensation committee to review the compensation program that management wanted to maintain. The investor highlighted that the program did not adequately reflect how the company creates value in a cyclical industry where targeting is difficult. The activist investor believed that one business unit was the primary driver of value creation and wanted the company-wide plan to focus solely on the performance of that business unit. After several discussions and a thorough analysis of the contributions of the various business units, the board and management developed a plan that focused primarily on the one business unit. It also included measures for other units that management believed complemented the company-wide value proposition and drove growth. This new incentive plan incorporated an alternative top-line metric because a new analysis of value drivers revealed that revenue did not accurately reflect industry growth. The compensation program raised questions from the activist investor, leading to new insights into where value was created for the business.
Conclusion
Strategy and compensation have a symbiotic relationship. When compensation does not follow strategy, opportunities are likely to be missed. Sometimes compensation can unintentionally “wag the dog” and highlight the need to reconsider key business assumptions. When this happens, the board will benefit from embracing the process and taking the time to perform additional analysis and have deep discussions that drive strategic clarity and reorientation, if necessary. These discussions also create opportunities to refine the organizational model and renew leadership commitment. Overall, compensation is a call to action to clearly signal what is important to the organization and drive superior performance outcomes.
