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workspan, January 2003, Volume 46, Number 1
Focus on Executive Compensation
Innovative Executive Compensation Programs in the New Millennium
By Barbara Parus, WorldatWork
Five companies rise to the challenge of creating innovative compensation programs that address the issues of today's uncertain economy.
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Editor's Note: This article is based on a presentation at the WorldatWork 2002 Annual Conference and Exhibition.
Necessity is the mother of invention in creating innovative compensation solutions in the new millennium. A slowing economy, unprecedented dilution levels, and an extremely volatile stock market represent new challenges that require new thinking.
Innovation is happening not only in incentive plan design, but also in analytic methodologies and measurement systems used to develop the plans, according to Robin Ferracone, worldwide partner, Mercer Human Resource Consulting.
Painting the Backdrop
In terms of economic context, the '90s was a decade of labor scarcity, technological revolution (particularly with respect to the Internet), high-flying company valuations driven by an emphasis on growth and market share, and changing employer-employee relationships. For the first time in history, the employee became a truly free agent. "In terms of context, there was a lot of capital chasing relatively few people," Ferracone said.
This unprecedented economic boom led to new practices in executive compensation. The '90s marked a power shift from financial capital to human capital in response to the labor shortage, and drove executive compensation packages to new heights. "We also had a love affair with stock options and very high levels of dilution," Ferracone said. "After all, everyone was conditioned to think that stock plans had 'nowhere to go but up.'"
Ferracone pointed out, for example, that, "When Amazon was about $100 share, everyone implicitly expected its market cap to equal the size of the economy of a small country someday. Expectations were looming large and were very unrealistic."
But now, the new millennium presents a vastly different picture than the roaring '90s. Companies are faced with a sluggish and uncertain economic outlook. People show a heightened sensitivity to risk in the secular, business and ethics arenas. The emphasis is on doing more with less. "Before, there was a strong emphasis on retention -- keeping people in chairs," Ferracone said. "Now there is a strong emphasis on performance. In addition, investors want to know that the demonstrated performance is real."
These changes have led to a renewed interest in cash and a more balanced view of stock options. Operational performance -- not just stock price performance -- is recognized, and there is more emphasis on demonstrated performance (versus future expected performance).
These new issues, and this new environment, beg for innovative solutions.
The Search for Innovation
How do companies create an environment conducive to innovation? Research shows that cultural characteristics, such as adherence to narrow company goals and cohesiveness, can increase employee morale, enhance productivity and improve effort. These characteristics, however, will thwart innovation. "When everyone is focused on making the numbers, they tend not to be as concerned with innovation," Ferracone said.
Conversely, a culture that is open to dissent and accepts minority views will create unity without uniformity, improve decision-making and stimulate innovation, she observed.
Ferracone cited the words of noted management guru Peter Drucker: "Above all, innovation is work rather than genius." However, she added, "A company needs the right cultural characteristics to make innovation happen."
Leaders of the Pack
Given the recent environment, Ferracone noted, innovation in pay has been hard to find, even among high-performing companies in the Fortune 100 "Most Admired" and "Best Companies to Work for in America" ranks. "The pressure today is to 'keep up' results," Ferracone said.
Mercer used the following criteria for identifying innovative executive compensation methods or plans:
Ferracone identified five companies that stand out for their use of innovative pay methods to address both old and new issues. "These organizations and people are willing to go against the grain, apply innovative thinking to executive compensation, and revisit existing compensation practices to ensure that they address current issues," she said.
These companies and their innovative ideas include:
Overture: Innovative Performance Measures
Overture is a premier Internet search provider that went public in 1999 and is migrating from an "emerging growth" to an "early mature" stage company. Its customers are advertisers who pay Overture when Web users click through to the customer's site. Customers pay more for higher placement in a key word search.
Overture invented a new performance metric that captures the heart of its business model: product value relative to competitors. Measures that truly capture the heart of the business model and complement more traditional financial measures have the greatest potential to help build competitive advantage and get key employees to rally around a common cause. The measure itself, as well as the fact that it is a relative measure, is unique in a short-term incentive plan.
Hewlett-Packard: New Thinking on Valuing Long-Term Incentives
Hewlett-Packard needed a way to value stock options following the collapse of the Internet bubble and high-tech company valuations. Because a key input to the Black-Scholes model is exercise price, inflated exercise prices also inflate the stock option valuation.
Hewlett-Packard devised a way to value options using a modified Black-Scholes model by inputting more normal company stock prices and using 10-year versus three-year volatility.
"This method demonstrates the power of adapting methodology so that it truly makes sense, rather than using rote applications," Ferracone said.
Internet Company: Innovative Approach to "6 and 1" Option Exchange
An Internet company needed a way to motivate people who had significantly underwater stock options, and still control dilution. "This company considered a traditional '6 and 1' option exchange, but wanted to avoid certain negative outcomes associated with this method," Ferracone said.
A "6 and 1" option exchange requires option recipients to cancel their options and wait six months and one day (hence, the "6 and 1" moniker) for a grant of new options. The criticisms of this method are:
This Internet company flipped the "6 and 1" process and granted new options with long-term (i.e., five-year cliff) vesting prior to offering participants an opportunity to cancel their old options. Six months later, the company gave these employees the ability to cancel their old underwater options in return for faster vesting on the new options. "This case demonstrates how companies can solve problems by thinking unconventionally about solutions," Ferracone said.
BASF: Encouraging Real Performance and Real Ownership
BASF is a large German chemical company with global sales of $30 billion in 2001. It created an innovative stock option plan to encourage real performance and real ownership, according to Ferracone.
Stock options became prevalent in Germany in the late '90s. BASF enjoyed good operational and stock price performance, but the company wanted to provide additional incentives to focus executives on value creation.
The program works like this: Participants can invest between 10 percent and 30 percent of their annual bonus in BASF stock and will receive four "A Rights" and four "B Rights" options for each share purchased. The stock options have an unconventional eight-year term and a two-year minimum vesting period. If the stock price increases 30 percent or more, the "A Rights" options are exercisable. If the option price increases less than 30 percent, however, these options cannot be exercised. If the stock price outperforms a benchmark index, the "B Rights" options can be exercised at a discounted exercise price. "These truly are performance-based options," Ferracone said.
The program is innovative because the executives must buy shares to participate in the program and performance must occur, both on an absolute and relative basis, to get incremental value.
"The BASF program carries variable accounting," Ferracone said. "Companies that are willing to question conventional wisdom around accounting are more likely to come up with innovative solutions to key issues."
Korea First Bank: Developing an Innovative Turnaround Incentive Plan
Korea First Bank instituted a "best-in-class" plan to reward a turnaround. This one-time plan sits on top of stock options and encourages the achievement of high "best-in-class" performance. The plan pays out sometime between 2003 and 2006. Each participant is assigned a large, one-time award maximum. When the "best-in-class" performance hurdle is met, a 50 percent of maximum payout occurs. If sustained performance is demonstrated in the next consecutive year, another 50 percent payout occurs. The plan goes away at the earlier of the second payment or 2006.
This program is innovative because there needs to be sustained performance in order to get payouts under the plan, and because the timing of the award is variable. "This is a plan that delivers a big message around a turnaround mission," Ferracone said.
Innovate With a Purpose
Many of the plans presented in this article are simple. "Innovation doesn't have to be complex," Ferracone said. "Innovation can play to the current environment."
Further, innovation can add real value, not just perceived value. To be successful, though, "innovation needs to solve a true problem -- not be innovation for innovation's sake," Ferracone concluded.
About
the Author
Barbara Parus is a contributing editor to workspan and can be reached at bparus@worldatwork.org
or 480/922-2050.
About
the Presenter
Robin A. Ferracone, worldwide partner, Mercer Human Resource Consulting, is
based in Los Angeles and can be reached at robin.ferracone@mercer.com.
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