In an evolving business environment, companies frequently engage in mergers and acquisitions to strengthen their competitiveness and create value. For companies making acquisitions, questions often arise about how the results of the acquired business should impact ongoing performance-based long-term incentive (LTI) compensation.
For serial acquirers, performance-based LTI goals can explicitly include a defined level of inorganic growth. In these cases, the hurdles for adjustment are high, and adjustment is often not guaranteed.
Companies with infrequent acquisitions need to ensure fair treatment of ongoing performance-based LTI compensation. Remuneration committees typically seek to ensure that:
- Management is not prevented from pursuing acquisitions;
- Management has sufficient compensation related to the acquired business;
- Companies are protected from passive income windfalls and the perception that executives are making acquisitions to earn their paychecks.
Below is a framework that companies can use to assess the impact of acquisitions on their ongoing LTI cycle.
Small acquisition flow-through
For smaller acquisitions, it often makes sense to leave performance targets unchanged and simply include the acquired business in performance from the closing date. This approach is less likely to result in windfalls, rewards employees for executing the transaction, and establishes performance accountability for the acquired business.
Responding to large-scale acquisitions
Larger acquisitions will require a more formal evaluation to determine the appropriate treatment of the ongoing LTI cycle. Because of the greater risk of windfall rewards, companies should carefully consider the impact of incentives and ensure they support the goals of the compensation program and broader business objectives.
The default treatment may be specified in the planning document, grant agreement, or another policy. In some cases, there may be little or no formal guidance. In practice, the remuneration committee has the discretion to adjust results if it determines this is consistent with shareholder interests.
Several approaches are used in practice:
1. Exclude achievements obtained without adjusting goals. In this approach, these results of the acquired business are excluded from the ongoing performance cycle and targets are not adjusted. As a result, we have no direct responsibility for the acquired business until the start of the next LTI cycle. This approach may weaken the short- and medium-term link between performance-based LTI and the outcomes of acquired businesses.
Some companies may address this concern by creating separate, one-time incentive arrangements that directly measure the performance of the acquired business throughout the integration period.
2. Include achievements obtained without adjusting goals. If a company has a clear strategy that combines organic and inorganic growth, it may be appropriate to include the results of acquired businesses in incentive metrics without changing objectives. Before adopting this approach, companies should model the expected impact on incentive funding and determine whether it is likely to produce disproportionate wage outcomes.
3. Adjust your goals and include the business results you obtained. Here, we are resetting our performance goals to incorporate the acquired business. The revised goals reflect the company's increased size and capabilities since the closure.
In some cases, companies align adjusted targets with performance assumptions used to price deals. The Committee will need to evaluate this approach very carefully. Acquisition prices often include an acquisition premium, and incentives are just one of many factors that drive financial results. In certain circumstances, raising targets may deter management from proceeding with an acquisition, particularly if targets are not met and major restructuring is required, or if the acquiring company takes time to reap the benefits of the acquisition.
4. Implement a hybrid approach. The most practical solution is often a customized approach that depends on the metrics, the time remaining in the cycle, and the performance profile of both the company and the acquired company.
For example, revenue metrics may require higher targets to reflect the size of a major acquisition. If the acquired business has a similar profit margin profile or is functionally break-even, there may be no need to adjust profitability or net income goals, and there may be more incentive to increase the profitability of the acquired business.
It may also be appropriate to adjust goals for cycles with significant time remaining, while leaving goals unchanged for cycles that are nearing completion and have limited impact. Finally, companies should pay particular attention to impacts on cash flow metrics and measurements that rely on balance sheet entries.
A thoughtful approach can create appropriate performance accountability for acquired businesses while protecting against windfalls and maintaining management incentives to pursue value-enhancing acquisitions.
No adjustment for TSR, options or stock compensation
You do not need to adjust your goals for total shareholder return (TSR) plans or other stock price-based products such as stock options, restricted stock, or restricted stock units. These awards are automatically corrected because the stock price already reflects investors' expectations for the acquisition.
Additional accounting and disclosure considerations
Remuneration committees need to understand the accounting and disclosure implications of departing from default treatment. In some cases, a decision to adjust targets or results may be treated as an accounting change and may result in additional costs based on the stock price at the time of the change. Companies may also benefit from advance guidance on how incentive plans will be applied in these situations and how related expenses will be measured.
From a disclosure perspective, companies should be prepared to provide clear and transparent explanations of incentive funding arrangements related to acquisitions.
Right-sizing and balancing the LTI approach
Effective goal alignment of performance-based LTI plans is essential to driving long-term success and performance-aligned pay outcomes, especially in acquisition situations. By applying a proportionate approach, such as using simple flow-throughs for smaller acquisitions and rigorously testing the impact of incentives on larger deals, companies can design incentive plans that motivate management, support value-creating acquisitions, and protect shareholders.
