workspan, April 2002, Volume 45, Number 4

Finding the Sweet Spots: Optimal Executive Compensation

By Jonathan Lee, JL Strategy

How to determine the best compensation plan for your business and your leaders.

How much should executives be paid? How competitive should executive compensation be? Why should executive compensation be competitive? Compensation plan designers in search of answers to these questions can use a new way of obtaining optimal executive compensation (OEC).

OEC represents the “sweet spot,” or a compensation package that delivers the most value to a company while motivating and rewarding executives. For the company and shareholders, it achieves the most return from the investment in executive compensation. For the executive, it represents a fair and equitable compensation package. These, in turn, provide an optimal scenario for the employee, business partners and customers.

Optimal executive compensation focuses on:

• External competitiveness. Executive compensation is market competitive so that the organization can attract, retain and motivate the right individuals.
• Internal strategic fit. Executive compensation is aligned to the organization’s business strategies, supporting the creation of value for shareholders and employees.

Traditionally, executive compensation plan designers have done well in analyzing external competitiveness because it is simple to do and compensation data are abundantly available. However, the same cannot be said of analyzing internal strategic fit because it is less straightforward, requires an understanding of the business strategy and there is no formal methodology. Consequently, relying mostly on external competitiveness, required analysis causes certain inefficiencies to form in executive compensation.

OEC achieves an overall efficiency in executive compensation by addressing current inefficiencies:

• Insufficient link between company strategy and executive compensation. Executive compensation often is set or justified using industry data independent of the company’s business strategy. The desired process is to set the business strategy, then structure executive compensation that can drive and support the business strategy.
• Companies paying executives with insufficient regard for the company and individual performance. For example, executives are paid the median salary because the company’s compensation strategy is to “pay the market median,” regardless of the company’s performance within the market or the type of executives needed in the organization. Stock options, a popular means of executive compensation, rise and fall in value primarily based on stock market movement and not necessarily the executives’ performance.
• The market inefficiencies in executive compensation spiral further inefficiencies. Simply focusing on external competitiveness (and not enough on internal strategic fit) in executive compensation design has forced companies to match changing market compensation levels regardless of whether changes are warranted.

This is a win-win proposition for the company and executives because few executives have to cope with compensation practices inefficiencies, allowing them to focus on the business at hand. Appropriately applied, it will help attain market efficiency in executive compensation for the benefit of the company, employees and, ultimately, the public. (See Figure 1.)

How Does OEC Work?
OEC is a concept rather than a predetermined formula because the internal strategic fit aspect of the analysis cannot be captured with a single formula for all companies. What goes into the formula and how it is analyzed should be customized and tailored to each circumstance.

The following is an example of designing optimal executive compensation for the CEO position in a specific segment of the financial industry. Although the data are actual and public information, company names are not disclosed to focus on the application of methodology rather than the specific companies. All information in this analysis was obtained from documents filed with the Securities and Exchange Commission, including the most recently available proxy statement for each company.

Comparison Company Profiles
Figure 2 shows the profiles of the select seven companies in the specific financial industry. Comparative and financial analysis show the following:

• There is a range of company size in terms of number of employees (from 331 to 1,114) and revenue (from $332 million to $1 billion).
• Company C shows a significantly higher revenue growth, primarily from its international operations, at the expense of profitability (net income and return on equity) and shareholder returns (earnings per share [EPS] changes). Company B, in spite of the median number of employees, had, by far, the lowest revenue and market capitalization, dismal net income and poor shareholder return.
• Companies D and E, with the highest market capitalization, had the highest net income. Company A, with the least number of employees, had the best shareholder return in the past five years. Companies F and G, overall, were close to the median levels.

Market Compensation Analysis
Figure 3 shows some drastically different pay structures. In the past three years, Company D has awarded its CEO long-term incentives worth $27 million ($9.2 million per year), while Company C awarded none to its CEO. As noted earlier, Company C, at negative $28 million, was the only company in the group to post a negative net income for 2000 and declining EPS in the past three years, primarily from its unsuccessful international operations. This may explain the significantly lower CEO total compensation.

Business Strategy Link
To link and align business strategy to executive compensation, identifying and analyzing key strategic factors for both the company and the industry are required. For the finance industry example, the six strategic factors in Figure 4 are identified. In analyzing the factors two sets of data are compiled: One set with the actual past performance to see the alignment with current compensation, and another set with the future strategy to determine an optimal future compensation. For the calculation example, the following three
companies are selected:

• Company B, the “losing” performer. Currently, with the least revenue by far and with the negative total shareholder return in the past three years, Company B needs a “turnaround specialist” to jump start the business. It needs a CEO who can manage higher-risk tolerance and business intensity. The CEO tenure in this specific industry is not as important as the ability to bring fresh perspective and new ideas. An A-quality CEO will need to make tough, drastic changes, even at the cost of short-term financial performance.
• Company E, the industry “top” performer. Company E is performing at the top of the industry in terms of revenue generation, return on equity and total shareholder return. It needs a “visionary leader” to maintain its leadership position. The company also needs a CEO with high ownership intensity who can inspire employees to attain even higher financial performance.
• Company F, the “mediocre” performer. Currently a median performer, Company F needs a “seasoned superstar” CEO who can grow its market share. It needs to increase its CEO’s ownership intensity. Also, against the current conservative company strategy, it needs a CEO who can implement a business strategy that is higher in risk tolerance and business intensity.

Finding Sweet Spots
Now link the strategic factors to the design of CEO compensation. For simplicity here, summary analysis of three compensation components (base salary, bonus pay, stock options) are presented separately. In practice, one would analyze in greater depths all components separately, as well as together.

CEO Base Salary (See Figure 5.)

• Purpose:
  – Attract and retain key talents.
  – Form a basis for other pay components.
  
  
• Sample methodology:
  – Pay base salary competitively (within one standard deviation of the market average) based on similar revenue size and industry.
  – Adjust pay level based on the current financial condition/performance of the company and the individual executives’ talent and potential.
  – May consider other determinants, such as company size (market capitalization, number of employees), company developmental stage, private versus public, etc.
  
  
• Analysis:

Company B requires slightly higher base salary; Company E’s current level is close to the OEC level; Company F requires a lower base salary.

Recall that Company B is the smallest, worst performing and it may be surprising – and counter-intuitive at first – to say that the company needs to increase its CEO’s base salary. However, this illustrates the importance of being strategic and forward-looking. Company B requires an A-quality CEO going forward who can turn around the ailing company.

The business strategy is set first, followed by definition of required CEO competencies, then a market competitive pay level is set. (Of course, the next nontrivial challenge for the organization is to find that A-quality CEO.)

Note that the Company B business strategy of a “turnaround” is the hypothesis but, if the company does not have such a business strategy going forward, then the required CEO and the pay level may be different. The company strategy and needs determine the CEO requirement/pay – not the other way around.

CEO Bonus Pay

• Purpose:
  – Motivate executives
  – Improve short-term performance.
  
  
• Sample Methodology:
  – Pay bonus competitively, based on similar revenue size.
  – Adjust “target” level based on risk tolerance, in which higher tolerance for risks would warrant higher target bonus level.
  – Adjust bonus range based on business intensity, where more CEO influence on results would warrant wider bonus range.
  – May consider other determinants, such as type of industry and volatility, company goals stretch, leverage, etc.
  
  
• Analysis:

Based on the OEC methodology and hypotheses:

• Company B’s target level should be increased with a wide range.
• Company E’s target level should be decreased with a narrow range.
• Company F, whose current bonus plan information is not available, should offer a mid-range bonus plan.
• This means that Company B (in need of turnaround) needs a more aggressive incentive plan, while Company E (the top-performing company in need of leadership maintenance) needs a less aggressive/ risky plan.

CEO Stock Options

• Purpose:
  – Align executives’ and shareholders’ interests
  – Improve long-term performance.
  
  
• Sample methodology:
  – Grant options based on market competitiveness, company strategy and stock performance.
  – Adjust grant size and frequency based on the current ownership level and industry volatility.
  – Adjust grant size and vesting schedule further based on the company developmental stage (e.g., new products, focus on core products, etc.).
  – May consider other determinants, such as the CEO’s current options holding, management intensity, etc.
  
  
• Analysis:

All three companies are providing a less-than-optimal amount of stock options to their CEOs. While Company B should consider a shorter vesting duration on the stock options so that its business urgencies can be better met, Company E should consider a longer vesting to encourage longer performance horizon.

On The Mark
Finding sweet spots in executive compensation involves analyzing many complex factors, both external (market prevalence) and internal (strategic factors). OEC methodology is meant to provide a logical, justifiable way of determining the compensation levels, but it is not meant to be applied without a sufficient thought process and consideration of individual situations. It provides flexibility to choose appropriate factors and adjustment degrees.

Optimal executive compensation can be attained when executive compensation is treated as more than just a data crunching exercise. The word “compensation” is a misnomer because compensation implies paying for services received. But the idea behind OEC is more than looking at the past or even present. It is about being more forward anticipating, goal oriented and strategically fit. Perhaps a better terminology would be “optimal executive investment.” One should expect a payback from executive compensation as in any investment. There should be a justification for paying a certain salary, bonus and stock options to the executives’ expectations in return.

About the Author
Jonathan Lee is a managing consultant at JL Strategy in San Francisco. He can be reached at jlee@jlstrategy.com.

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