How Not to Develop a Compensation Solution

Recently, my firm was engaged by a CEO who was grappling with the issue of retaining key talent in light of declining equity markets laying waste to option and restricted share value. A common issue these days. He had been working with his staff and external advisers as they explored various options including a deferred compensation program, option exchanges, re-pricings, phantom equity and variations thereof. The CEO was frustrated as no progress was being made and his neck was hurting from listening to the back-and-forth debate among the experts on the pros and cons of each alternative. This is a common blind-men-and-the-elephant situation.

Go to a cardiologist with a headache and you can be pretty sure that they will focus on the aspects of a heart condition that might cause a headache. Similarly, go to an accountant with a compensation issue and you will get an earful on Financial Accounting Standard 123. A tax attorney will tell you more about IRC Section 409A than you might wish and so on.

With apologies to my many brilliant colleagues who are attorneys and accountants (and to those who are sight impaired), our client made the mistake of asking a bunch of blind men to tell him what a retention program looks like. He spent his time listening to debates on whether the stock appreciation plan was “deferred compensation” under 409A and, if so, whether it was in compliance with the Code’s deferral and payment requirements. His outside counsel was concerned with whether a phantom equity plan needed to be a registered security or was exempt under Regulation D and his controller gave him a lesson in the accounting implications of an option re-pricing.

All of these are important issues that ultimately need to be considered but in order to effectively solve business issues through executive compensation design, the blind men (who also charge a lot per hour) should not be set loose without firm direction and a basic understanding of what the elephant looks like.

Commonly, after a business issue is identified, a team of experts is tasked with developing a solution. It seems to make sense. Let’s cut across the silos and deal with an issue holistically. This approach is also simpatico with our teamwork-oriented corporate cultures. But the silos have been built for a reason. Specialization brings economies of scale and is needed to deal with the complex US financial and legal structure. And, by definition, it brings a mode-of thought that is narrow. Starting with a team of silos can be a costly trap.

There is where a specialist-leader provides value. Usually that means an outside consultant but it can just as well be a strong internal compensation specialist or HR executive with compensation knowledge. Before even involving technical experts in a business issue that potentially involves pay and benefits, consider having a specialist-leader complete two broad steps:

• work with line management and staff to clearly define the business issue and business constraints around a solution. The latter may include cash-flow constraints, a can’t loose key employee, shareholder and key investor reactions, etc.
• develop a range of solutions in line with the business issues and constraints

Once a range of solutions are developed, by all means, let the finance types and attorneys have a go at it with the instructions that they are to apply their expertise to fine-tune the solution; not change it. Taking this approach will produce a business-oriented solution and save a lot of time, frustration and money.

Do Not Pay for Performance

The vociferous criticisms of the stay bonuses paid out at AIG, Sallie Mae and Merrill Lynch are a reminder that bad economic times have a way of stripping out the pretensions of business. When survival is on the line, there is less room for platitudes, conventional wisdom and faddishness. “Pay for performance” as it is commonly understood is one such nicety.

How could these companies pay retention bonuses to the same individuals responsible for the collapse of these entities? Don’t these companies pay for performance and the performance was poor, right? Wrong. When the going gets tough business is forced to face up to the reality of paying for future performance (PUP).

Professional sports teams are forced to recognize the harsh realities of PUP all the time. A team signs an athlete to a long-term contract and shortly thereafter he gets injured (see the Brave’s Mike Hampton). The team still has to pay him during his contract. When the athlete’s contract is up the team has to decide whether to “punish” him for taking their money without playing – pay for performance – or to pay him based on the team’s best estimate of performance for the coming season. Whatever their view of fairness, competitive pressures force the team to recognize that it must PUP; if it won't another team will.

So why in business do we get stuck on pay for past performance and too often relegate PUP discussions about employees to a quiet corner. For one thing, it is easy. At the end of the year, you give a performance rating to an individual on how they performed against their goals. Compare that rating against a table and you’ve got your merit pay increase and bonus. The practice is easy to support legally. Formulas are applied equitably regardless of race, color, creed, etc. There is no messy business of making subjective evaluations of future value and performance.

Unlike sports, business can get away with this because the competitive market for business talent is less public and much stickier than it is for athletes. Pay a key executive less than he or she is worth and in the short-term it probably will not result in a lost employee.

A strict pay for past performance approach works okay when there is plenty of money floating around. Business can still retain those employees who might not have performed well against goals for one reason or another through discretionary bonuses and pay increases. But when money is tight, strong business leaders acknowledge that they have to make some tough choices on talent with respect to pay and those choices cannot be made solely on the basis of past performance. PUP comes to the forefront.

Say you are running AIG’s financial services division. Your division is a party to thousands of complex trades. Most of those trades are in the red which has gotten your company into its present mess. But many of those trades are in the black and the counter-parties owe AIG lots of money. Who knows enough about the details of those trades to effectively collect? The very traders who also made the bad ones. Before you fire them, you need them to stick around to unravel the good deals and collect the money. You are not paying them for their past poor judgment and greed. You are paying them to make money for your shareholders going forward: PUP in its purest form.

No doubt about it. Past performance can be a good indicator of future performance. But there are enough instances when it is not the case that we need to remind ourselves that ultimately what we are really paying for is future performance.

Retrospective Leadership

Two of the most over-used terms in the business world these days are risk and leadership. Evidently, much of our economic problems are due to taking on too much of the former because of the lack of the latter.

It is certainly easy to find plenty of examples these days of poor leadership and over leverage. Just look at what those greedy fools at ________ (fill in the blank) did. Let us enjoy our brief moment of self-righteous satisfaction from pointing out the mistakes, greed, and inept leadership that is all around us. After we take that pleasant time-out, let us figure out what, if anything, we can do differently in our own businesses with respect to executive pay and risk management to avoid a similar fate. Unfortunately, it is a lot easier to point out poor judgment after the fact then to avoid it in the future.

I recently reviewed an employment agreement that allowed a CEO to be terminated “for cause” in the event that he made a decision detrimental to the Company’s financial well being without the board’s approval. The board was generous enough to allow the CEO complete flexibility to make all the good decisions he wanted without the board approval.

Similarly, at one company I used to work, leaders were encouraged to take “prudent risks”. Maybe this is a bit better formulation than the Employment Agreement but still, after watching a colleague get a dressing down for trying something that did not work out, you cannot help but puzzle over the meaning of Prudent.

Or, consider the TARP rules on executive pay. They require the Compensation Committees of companies taking TARP funds to certify that the compensation for senior executives does not encourage “unnecessary and excessive risks” that threaten the value of the financial institution. Further the rules require that executive compensation be aligned with creating long-term value. As I have commented previously, these are certainly good guidelines that Boards should be following whether TARP recipients or not. But no Board or management team that I have encountered has ever expressed a desire to create short-term value at the expense of long-term results or to take unnecessary and excessive risks.

While easy to poke fun at, who can argue with any of these? In all three cases management (or the Feds in the case of the TARP rules) are merely practicing good governance in trying to protect company assets against employees taking undue risks.

But let us face some perhaps uncomfortable facts about risk and pay. First, risk cannot be judged objectively. It is in the eye of the beholder. You can study the mathematics around standard deviations and VAR all you want but you cannot avoid the reality that one investor’s/executive’s idea of a reasonable risk is another’s imprudent and reckless adventure. Second, no amount of risk analysis can consider the unforeseen risk. Financial institutions like Freddie Mac, AIG and Lehman Brothers were highly leveraged in derivatives that ultimately were based on home prices and the ability of individuals to pay off their mortgage obligations. These derivatives seemed to be profitable in every situation except one: if the entire nation entered into a prolonged period of declining home prices and individual income.

And third, you cannot completely align the risk preferences of employees with the risk preferences of owners. Owners invest their savings. Employees invest their time and a portion of their compensation.

Business is all about balancing risk and rewards. Not only is there no government rule or reform that would have stopped or even ameliorated the current mess but there is nothing, except barring investment altogether, that will avoid the next systematic bankruptcy.

In one way executive compensation worked as it was supposed to. Most senior executives of large public companies receive 50%+ of their annual compensation in the form of equity grants that vest over a period of three years. While these individuals still received large base and bonus payments, the executives at the bankrupt or near bankrupt financial institutions have had their equity positions all but wiped out. They are not destitute but they are not laughing all the way to the bank either.

So what is to be done? A few suggestions:

Individual financial limits of authority need to be reviewed by Boards periodically along with stress testing of overall corporate investments.

Consider revisiting the mix of cash bonus and equity compensation to any individual in the organization who makes investment decisions. This would mean potentially granting larger equity stakes and smaller (or $0) cash bonuses to sales managers and traders as well as those members of the executive suite usually eligible for equity.

Consider stretching out vesting periods and/or stock holding periods from the more traditional three years to five or even 10 years depending on investment life-cycles. Perhaps the vesting period would vary by job.

To reduce the unfairness of the market, consider emphasizing relative stock performance when determining vesting thresholds and/or grant amounts.

Sales bonus/commission compensation should be tied to profitable cash flow rather than deal closings.

If Earnings are used to determine annual executive cash bonuses, adjust them by a measure of risk such as firm-wide leverage.

I have noticed that pick-up basketball games tend to be much cleaner and have fewer arguments when there is no referee. When a referee is added to the mix, players feel it is within their rights to push the rules to the limit as long as the referee does not call it.

All the risk management rules around compensation cannot substitute for management that is prudent and ethical. So my final bit of advice to Boards is to find the management team that does not need any of this sort of oversight.

The Small Business Owner Thinks Big on Equity Compensation

Early in my consulting career, I came to the realization that when a business leader uses the term “small business” as in, ‘I run a small business,’ it is purely a state of mind. And, when it comes to developing compensation approaches to drive growth, the generally poor economy is bringing out the most innovative and optimistic instincts of the small business leader.

I was reminded of my small business epiphany during a recent meeting with a CEO to consider a recommendation that would increase 2009 cash compensation by 3%. His reaction was “we can’t possibly afford that type of increase in this environment. We are just a small business after all”. This is not an exact quote as the CEO included some language that cannot be reprinted in a family business publication. But the point is that this CEO led a company with $250 million in revenue and 750 employees. And, like all “small business” owners this CEO was so close to how his organization makes and spends money that he felt like a small business owner with all the uncertainty, risk and tough trade-offs that implies.

I have commented previously on one characteristic of the small business owner. They can get stuck in a zero-sum way of thinking about compensation along the lines of ‘If I increase Joe Salesman’s commission by 5% that is 5% out of my pocket’ as opposed to the possibility that a well designed 5% increase in a commission might increase sales and net profit by 20%. No doubt about it, it is hard to resist the zero-sum thinking in a poor economy.

But the current economic environment has also brought out what I consider the best characteristics of the small business owner – the creativity and adaptability forced upon them by the perceived or real constraints they face. Many are reaching for any way they can to keep their key talent and poach on their slower moving competitors. They want to be prepared to come out swinging when the recovery comes.

While some small business owners remain reluctant to give up any share of ownership, many recognize that equity-type approaches to compensation are the best way to attract and keep talent during this economic environment when cash flow is at a premium.

This involves working through the pros and cons of a number of issues; and, as with many compensation issues, there is little in the way of best practice to turn to. Instead, every business has its own requirements, priorities and objectives.

For starters, what are the objectives of an equity program and what employees are being targeted? Am I trying to attract new talent, retain employees who might leave without a big pay increase or motivate employees to achieve particular goals? No one compensation program can ideally meet all three. A common mistake is trying to use one compensation program to achieve too many objectives or meet the objectives of too broad an employee base. The result is often an overly complex program or one that is not particularly transparent to the participant. An equity program that is overly complex or opaque is a waste of money.

Other considerations include:

• What percentage of ownership, profits, revenue, etc should be distributed?
• Should I use shares or options?
• How do I value the share price?
• Compliance with Federal and State Security laws and regulations (or preferably, identifying the appropriate exceptions).
• How do I divide up shares among the targeted employees?
• What kinds of restrictions or vesting should I put in place?
• What is the impact on a potential transaction?
• Should I add performance criteria to the equity grants?
• What is the cash Flow/accounting impact under various business scenarios?
• What is the time period for the grants?

The bang-for-the-buck of a well-crafted and communicated equity plan is tremendous. Designed correctly, it can replace the use of scare cash, send a positive message to employees and create a a compensation platform to grow on. Even a small business owner has to love this.

Surprise. The Government Has Some Good Advice on Executive Pay

Randomly pick a law, regulation or section of the tax code dealing with executive pay and chances are you could accurately describe it as superfluous, counterproductive, or inconsistent. My reaction when first hearing that the Troubled Asset Relief Program (“TARP”) would include executive compensation provisions was to wonder what kind of regulatory torture the government was going to inflict on the poor shareholders of financial institutions already sunk low. While there is a good deal of the aforementioned waste and counter-productivity in the TARP provisions, there is also some executive compensation wisdom that companies not partaking of TARP might consider.

As a recap, financial institutions seeking relief under one of several TARP programs implemented by The Emergency Economic Stabilization Act of 2008 (EESA) must enforce four broad rules around the pay of the chief executive officer, chief financial officer, plus the next three most highly compensated executive officers.

The rules along with commentary are as follows.

1. Companies agree not to deduct executive compensation in excess of $500,000 for each senior executive. This limit does not include the exception for performance-based compensation that is part of the existing executive compensation provision of the tax code limiting deductability to $1.0 million. It does not matter whether the deduction limit is a million or half a million. This rule will no doubt raise some needed tax revenue but otherwise it only serves to limit the flexibility and increase the costs for financial institutions trying to attract and retain the executive talent they need to get them out of their self-created mess. Conclusion: Counterproductive
2. A prohibition against making any golden parachute payment to a senior executive. This provision is more restrictive than the existing IRC Section 280(g) rules on golden parachutes that merely increase the cost of golden parachutes by disallowing deductions and imposing excise taxes. The TARP rules prohibit payments in excess of three times pay and define a parachute payment as due to any separation
   of service - not just those due to a change-in-control. The rule is not bad but somewhat superfluous as most companies do not pay out severance benefits in excess of three times compensation. Conclusion: Feels Good but Superfluous.
3. Executive pay programs must include “claw back” provisions requiring the repayment of any incentive compensation based on metrics that are later proven to be materially inaccurate. This rule sounds good on paper but requiring executives to pay back gains made on inaccurate metrics is impossible to consistently enforce outside of the obvious cases of financial restatements. For example, this provision would not have required a payback of the compensation gains made on the sale of mortgage-backed securities that turned out to perform more poorly than anticipated. Conclusion: Okay, but impossible to enforce
4. Ensure that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution. This rule includes all sorts of procedures, timetables and CEO and Compensation Committee certifications to try and make it meaningful. It is, however, unenforceable as a practical matter. Risk is purely subjective and at the heart of business investment. A risky investment that turns out well was a “bold” decision and one that turns out poorly was "excessive and unnecessary". But just because the government rule is unenforceable as a matter of policy does not mean that it is not a good idea for compensation committees and Boards to formally review how executive compensation arrangements incent behaviors that may not be aligned with shareholder preferences and risk profiles. For example, I have written on several occasions around how excessive option grants can lead to a misalignment of shareholder interests and management interests. Conclusion: Good Corporate Governance but not an enforceable law.

The misalignment of rewards to risk, particularly in the financial services industry, has been disheartening as many executives who made what turned out to be very poor investment decisions reaped large paydays prior to losing their jobs. Taxpayers have demanded some reassurance that this will not happen again with their TARP investment and Congress has complied about as best as possible. Unfortunately, even the best managed companies cannot create a compensation program (for executives or otherwise) that will be deemed to be perfectly fair and accountable in hindsight. Business is just too messy. While perfection is impossible, improvement is very possible and Owners, Boards and Compensation Committees should take the TARP rules as a reminder to fully test compensation programs against incentives and risks.

Top People Management Stories of 2008

The following are our choices for the top five human resource-related stories for 2008 based on their long-term resonance.

College graduates know fear for the first time in 25 years. The end of “Wall Street” combined with what looks to be the longest and deepest recession since the early 1980s will cause a reshuffling of convenient generational descriptors. Recent college and MBA graduates (is it generation x, y or z?) here-to-now best know for impatience with corporate hierarchy, “portfolio careers” and placing a premium on work-life balance will begin to appreciate just having a job. This group will become the most productive and focused cohort of graduates in 25 years.

Unions have a dead cat bounce
On the face of it, 2008 would seem to be a great year for Unions. The election of Barack Obama and Democratic majorities in the House and Senate brought the passage of the Employee Free Choice Act closer to reality and the economic uncertainty has created a more union-supportive atmosphere.

Consider the success of the sit-in by laid-off workers at the closed Republic Windows and Doors plant in Chicago. A year ago, the protest would probably have been ignored, even in Chicago. But in 2008, the protest for severance pay gained national press and support. Ultimately it ended in the protesters favor when several banks that had done business with Republic agreed to provide “loans” to Republic (which will never be repaid) to pay some of the severance.

A number of signs, however, show no let-up in the general anti-Union trend in the US. The public was so resistant to a bail-out of the UAW that the Democratic controlled congress could not enact any legislation in that regard. Even the Obama administration has publicly stated that it will not favor a bail-out without significant concessions from the UAW. The Screen Actors guild could not maintain any semblance of solidarity in its negotiations with the Producers and has punted on a strike due to lack of Union support.

The NFL players union reminded the public why they are distrustful of the motives of the modern Union. It filed a grievance challenging the suspension and fine the Giants levied against receiver Plaxico Burress after he accidentally shot himself in a nightclub on Nov. 29.

While all the union bodies have not been buried, the graves have been dug. 2008 further demonstrates that a global economy combined with bipartisan support for free trade leaves little oxygen to sustain traditional unions.

401(k) plans take the place of defined benefit plans as a regulatory punching bag. Since the passage of ERISA in 1975, defined benefit plans have been the beneficiary of annual visits by legal and accounting regulatory authorities (e.g., TRA ’86, TEFRA, REA, FAS 158) making them too expensive, too risky and too unattractive to higher paid employees compared to defined contribution 401(k)-type plans. Not coincidentally, over this same period defined contribution plans have supplanted defined benefit plans as corporate America’s predominant retirement savings vehicle.

In 2008 Congress and the Courts began to catch up with the trend. The Department of Labor published proposed regulations defining the kinds of investment advice that can be provided to individuals with defined contribution accounts and significantly enhanced the disclosures that Companies must make to plan participants around plan investment and administrative fees. Congress has several bills in various stages of Enactment requiring even more disclosures than Labor’s regulations. The Supreme Court, in its “LaRue” decision allowed individuals to bring suit against 401(k) plans to recover losses when their investment instructions are ignored or the account is otherwise mishandled. Prior to this decision courts generally held that only suits on behalf of the Plan for plan losses could be brought.

With the increasing importance of 401(k)s, Congress and the Courts will continue to tighten the regulations and make it easier for individuals to bring suit. If 401(k)s were a stock, now might be the time to sell it short.

The era of big CEO pay comes to an end.
This is of course a relative statement. The ability to effectively lead a large public company is a rare skill that will, and should, continue to get richly rewarded. But, 2008 was a tipping point bringing to an end an era of CEO dominance in setting CEO compensation.

2008 brought no major government legislation or SEC rule making around executive compensation beyond restrictions for the relatively few companies participating in the TARP. Instead, a more powerful force was at work. It became impossible for anyone to ignore the leadership failures throughout Corporate America that went together with large paydays. It was just too obvious that General Motors, Bear Sterns, Lehman Brothers, et al., were mismanaged for a number of years while CEOs were given star ratings and big bonuses.

As in the past, Boards will remain at a disadvantage compared to CEOs in negotiating pay. CEOs and their executive teams have the advantage in information, incentives and leverage. But what will change is what will be considered an acceptable range and approach to compensation. CEOs will moderate their pay demands and recommend less compensation in the form of pure equity or options. They will ask for more compensation with objective performance thresholds, greater use of claw backs and more truly stretch performance goals.

The stars align for major health care reform
2008 was also a tipping point for health care. The year saw the election of a president who put major health care reform at the top of his agenda and big Democratic majorities in both houses of Congress.

The last time this happened was in 1992 and health care reform cratered barely two years later. Unlike in 1994, however, reform will not flounder on middle class fears of change, insurance company lobbying and the public’s general distrust of government intervention in the private sector. The middle class no longer believes that the health care system, while flawed, at least provides pretty good health care for them. The costs and managed-care bureaucracy have started to hit even those with the best corporate plan and Government intervention in a major part of the economy does not seem as radical as it did in 1994.

Expect to see major health care reform enacted in 2010.

Rethinking the Annual Bonus

The boardroom battle over John Thain's 2008 bonus as CEO for Merrill Lynch is over. It will not be as lucrative as years past for the Thain family; the Board has awarded Mr. Thain and other top executives zero. The board deliberations over Thain's bonus are an unusually public manifestation of discussions held all over Corporate America this time of year over who gets how much?

These discussion are always heated and stressful for the organization. Teasing out the contribution individuals make to results is often impossible as many goals are team-based, depend on contributions made over a period different than the bonus year or depend on factors exogenous to the individual (e.g., market forces). Allocating bonuses has a further, emotional, complication because most individuals work hard and make every effort to contribute to their organization's success.

The annual bonus exercise does not need to be like this. What follows is a broad bonus "philosophy" that simplifies the process, removes much of the organizational angst and separates the pay discussion from the performance and coaching discussions.

Start with the notion that from an owner's perspective, it would be ideal if everybody's pay was 100% variable based on the organization's profitability. That is clearly not common practice as everyone needs some measure of predictability in compensation. Further, as you reach lower into the organization, the administrative costs of managing a bonus outweigh the financial and incentive benefits.

So begin with mid- to high-level jobs in the organization where you would put at least 10% to 20% of compensation at risk. Divide the target bonus into two categories. Base one portion of the target bonus on goals that meet three criteria:

the results of the goals are measurable;
the results are likely to vary from year-to-year;
the impact of the individual on results is measurable.

Call this the "Incentive Bonus". Call the remaining portion of the target bonus an "Allocated Bonus".

For some jobs, like a sales job, the Incentive Bonus will be all or a very significant element of the total bonus. For other jobs, such as those at the senior level or many staff jobs it is difficult to come up with goals that meet the Incentive Bonus criteria.

By definition, the Incentive Bonus is easy to define upfront and explain to an employee when paid out.

For all goals that do not meet the definition of Incentive Bonus - the Allocated Bonus - pay out the bonus based on an an allocated share of corporate-wide, division or team results depending on the employee's job level.

While the allocation methodology could be based on broad definitions of individual performance it should primarily be allocated based merely on job level. After all, if the individual contribution could be accurately measured, it would probably fall into the Incentive Bonus category.

Their are several benefits to this approach:

employees know upfront what their bonus will be based on;
the process is more mechanical and less emotionally loaded;
a significant portion of senior-level compensation remains variable;
there is a greater separation between ongoing performance or effort and annual results.

So how would this apply to the Thain bonus? It would clearly fall in the category of being an Allocated Bonus. It is impossible to quantifiably separate his individual performance in the areas of leadership, decision making, ability to motivate a team from from market factors when it comes to how well Merrill Lynch does. If the board directed upfront that his bonus was to be based on results such as EPS, profit or ROA, he would be entitled to zero bonus. Not based on his performance, hard work, dedication, etc but merely based on results.

Resurrecting Cash in Executive Pay?

The concept of paying cash to executives at retirement has fallen out-of-favor over the past 20 years, along with its broad-based counterpart - the defined benefit pension plan. But, this is an approach worth revisiting for companies concerned about retaining key talent and with the potential misalignment of financial incentives created by large equity grants.

Equity is a very popular form of executive compensation. Shareholder optics are great as executives do not make money unless the shareholders make money. Executives like equity because it offers the opportunity for a large paycheck if the business results are strong and/or the stock market broadly appreciates. Beyond the optics, however, equity compensation has significant hidden drawbacks for non-executive shareholders.

Large equity grants can create a misalignment of financial incentives between executives and non-executive shareholders. While executives have the opportunity to reap large rewards for making high risk/high reward bets but without the symmetrical risk of loss, non-executive shareholders have a different risk profile; they risk their entire investment on the same investments that executives find so tempting. See Lehman, Bear Sterns, AIG, et al for illustrations of this hazard.

Equity compensation is also an ineffective way to retain executives. When stock prices are falling, executives begin to attach little value to their equity grants and become more vulnerable to competitor entreaties. A competitor can easily make up for underwater options or otherwise provide large equity grants to compensate for a low stock price. An executive's current employer is trapped. They cannot revalue stock options or grant additional shares without appearing to contradict the original rationale of the pay-for-performance equity pay.

There is an approach that addresses these two issues. Replace a portion of equity compensation with a cash payment that increases in value based on service rather than performance. This approach provides a retention incentive even in a down stock market and reduces the misalignment of executive and shareholder risk profiles.

While the optics may be poor, the business rationale is strong under the right circumstances. The idea is not to motivate performance but to provide clear value to the executive for staying with the company through up and down markets and business cycles. Other incentive tools - short-term cash bonuses and variations of equity compensation can be used for employee motivation and business alignment.

There are tax, ERISA and security law issues to consider with a cash retention program but they allow for a great deal of flexibility in designing an approach around particular business and executive situations. As an example, a CEO who is 50 years old with a base salary of $750k might be provided with a benefit that is equal to four times this amount ($3.0 million)at termination of employment. The full payment is only made if the executive works until at least 60. Reduced payments might be added if the executive is terminated without cause prior to age 60 with increases for employment after age 60. The payment is made over five years subject to compliance with a non-compete agreement.

This approach would cost about $225,000 a year pre-tax for the 10 years following hire. The $225,000 could either replace an equal amount of equity which would typically leave plenty of compensation for incentive purposes or the $225,000 might be an add-on in exchange for the non-compete.

From the executive's perspective, they see a large payout waiting for them if they work until age 60 regardless of stock price or annual bonus. This incentive to stay with the current employer increases as the executive approaches age 60 and makes them less vulnerable to competing offers in a down stock market or in the event of poor short-term business results.

The retention incentive could be self-funded which allows the company to invest the deferred compensation in its business until the $3.0 million is due or it could purchase a tax-advantaged annuity to provide additional security.

Companies have a great deal invested in hiring and keeping key talent. A cash-based approach should be considered as a piece of an executive compensation program.

Strategic Human Resources (Do not Read This if Your Business is Going Great)

Bad times have a way of bringing out our most conservative instincts. Like a turtle facing a raccoon, the natural instinct of business leaders is to pull into a shell and wait out the danger.

But some of the business leaders I have talked to recently take a contrary perspective. They see a downturn as an opportunity to think ahead and gain a long term competitive advantage. As one CFO of a mid-size manufacturing company said to me, "the time to buy stocks is when they are beaten down and a recovery seems most improbable".

So why not think about the people-related opportunities afforded by the downturn. If not now when? After all, when times are good, you are busy with day-to-day stuff like meeting customer demands, stopping your best employees from walking across the street for more money and otherwise figuring out what to do with all the revenue rolling in.

Here are the people practices up for rethinking that some of the more aggressive business leaders are talking about.

They start with a big number. These leaders do not start their planning with a sober, conservative assessment of where their business will be in two or three years. Instead, they begin with positive, some would say aspirational business goals usually stated in terms of key financial metrics such as revenue, profit margin or market share. One said to me, "if you goal is to hang on, that's probably the best you will do".

They then move on to a sense of how many and what kinds of employees (along with capital) they will need to reach those goals.

They are not a sentimental group. Starting at the top jobs, these leaders are identifying the "A" level skills, experience and qualifications needed to achieve the stated business goals. If there is not a match with the incumbent, change is quick to come. That means firing the incumbent, moving the incumbent to a better fit or working to bring the incumbent up to speed (but only if it can be done in a time-frame of months not years).

They are aggressively poaching talent. These business leaders are taking advantage of the economic fear and indecision of their competitors to hire the best talent away from them - usually at a bargain price.

They use brutal honesty and openness to engage the workforce
These leaders are sharing the burden by educating the workforce about the business and engaging them in the shared goals. They are honest about the tough times and challenges as a way of making their bright vision that much more compelling. They provide forums for collaboration, feedback and idea sharing. This is typically done using 'lunch and learns', e-mail, and employee forums. I expect that the future will see more use of some of the newer web-based approaches to collaboration such as blogs and wiki-type software.

They use compensation to support the plan
They see this as a great time to lock in talent with long-term equity and cash compensation that is generous but that pays off only if aggressive goals are met.

Leaders are taking this opportunity to differentiate sharply in compensation among those who are truly strategic contributors to the business and those who are purely doing their jobs.

While it is too soon to tell if there will be a wide-spread rethinking of the amounts and approaches to granting equity compensation, there should be some changes in common practices. For example, the heads-I-win-tails-you-lose approaches have come up so obviously and awfully short in the finance/banking industries.

I will address this issue in more detail in a future post, but for starters owners and boards need to find alternative approaches to compensating their top talent besides granting huge amounts of options, SARS and restricted stock to executives as a way of purportedly aligning executive interests with those of owners. This approach is often ineffective and counterproductive. Investors are risking their capital when they take a stake in a business. Executives rewarded with large equity grants are playing with house money. Their incentive is to take big risks for a big payoff as they cannot lose their "investment".

They are positive These strategic business leaders are all realists,yet they are optimistic. They just choose to focus more on the opportunity as opposed to risk.

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The market is down, your customers are afraid to buy and your employees watch you for any sign that they are next on the list. Now may just be the time to be a strategic optimist.

Sales Compensation During Tough Times

In reviewing a sales compensation program with a CEO recently, he described his salesforce as cockroaches: "I try to wipe them out but they always seem to survive and come back stronger than ever".

Leaving aside the precise accuracy of the simile, there is no doubt that CEOs and CFOs running their fingers down a list of major expenses will often zoom in on sales compensation as a particular irritant. Costs can run as high as 40% of revenue in some businesses. And, whether stated explicitly or not, leadership often convinces itself that the company's products/services are so unique that it does not need a lot of high-end sales talk to convince customers to buy them. Even in good times, there is the temptation to reduce incentive payouts to the sales force. With revenue and margins under particular pressure today, the target is even more inviting.

But, if you fall into this category, resist the temptation to go scorched earth on your sales force. Bad times can create great opportunities to grow market share as existing customer/supplier relationship come under financial stress and reconsideration. And while there are a myriad of strategic and tactical issues to consider when looking at how the sales force is managed and compensated - and the two are somewhat intertwined - I see the following as key issues to focus on.

Open up your wallet. Be prepared to pay your good sales people a lot. Admittedly, you might not want to hear this. But, your sales force is the sharp end of the spear and your front-line in the efforts to grow revenue. An effectively designed sales compensation program is a means of growing the pie not of dividing it up. Sure, the shareholders might take home a smaller slice in the end, but it will be from a much bigger pie (this is making me kind of hungry).

The key word here is, of course, "good". The problem with many sales compensation programs is not that they pay out loads of money to their best performers but they pay out too much for not-so-good results.

Look at how often sales people meet their targets. If the percentage is consistently over 75% your targets are too generous. Also, analyze the relationship between compensation and sales volume. If the relationship is not highly correlated, the odds are you are paying out too much for mediocre performance.

Build in extra-large incentives for adding new customers. I have heard about the 80/20 rule to death. Yes, in most cases, 20% of your customers create 80% of your revenue and more than 80% of your profitability. So the smart money focuses most of its attention on retaining and growing revenue from that 20%. The conventional wisdom is that the easiest and least expensive way to grow revenue is to sell to existing clients who evidence a propensity to buy. This is the siren song: sweet, logical, cheap and quick.

But, if you are not adding new customers your business will die. Focusing revenue growth efforts on existing customers gradually erodes the customer trust in the relationship as your sales force is inevitably put in the position of trying to sell anything in the pipeline as opposed to picking and choosing what makes most sense for the customer. Also, under the best of circumstances, you will loose customers each year. The pipeline needs to be replenished. Some of the new, seemingly marginal customers of today will turn into the Fortune-500 companies of tomorrow. Unfortunately, you can't figure out who the winners will be a head of time. Finally, new customers excite the workforce by adding "wins" and bringing in new learning and growth opportunities.

All that being said, bringing in new customers is the hardest sales job of all. The investment of time is great, the outcome uncertain and often the revenue is tiny up-front. A business needs to invest in incenting the salesforce to bring in the new customers the same way it invests in new products - with the idea of losses in the short-term and gains and a healthy business over the long-term.

Simplify. Make sure your sales force's compensation program and performance management is not weighted down with accumulated goals, hanger-ons and responsibilities. Only those people who actually deal with customers and significantly influence the buying decision should receive a sales compensation incentive. Sounds kind of obvious but it is amazing how many roles pile into the sales incentive plan including sales support staff, sales management and technical advisers.

Ensure that your sales force has clearly defined and relatively simple responsibilities. For example, in most cases, a sales individual should have responsibility for either selling new customers or growing revenue from existing accounts but not both. They should not have the added responsibilities of mentoring, managing people or providing significant post-sales support.

Finally, make sure your incentive compensation program is simple enough that your typical sales employee can calculate their commissions in their head as they walk into a sales meeting. If your sales compensation program takes up more than a page it is probably too complicated. For example, it should usually not include more than one or two multipliers for certain types of sales (e.g., new customers, new products) or more than two commission rates.

Tough times can mean some great opportunities to grow market share. This is when existing, long-term customer/supplier relationship are under stress and most likely to break. So, when it comes to your sales force now is the time spend the money, incent for new customers and simplify.