"It is impossible for ideas to compete in the marketplace if no forum for
  their presentation is provided or available."           Thomas Mann, 1896

Back to the Future: 
A Balanced Approach to Long-term Incentives

The Business Forum organized a meeting for a
Luncheon discussion on the above subject at the
Los Angeles Marriott Hotel in Los Angeles.

Those attending included:  

BAE Systems Corporation - Vice President Human Resources * Maxicare Corporation - Senior Vice President * Maxicare Corporation - Vice President, Employee Services Infonet Services Corporation - Director Quality Programs * Pacific Architects & Engineers - Human Resources Director * Nestle USA Inc. - Director Human Resources Services * Time Warner Communications - Vice President of Human Resources Sanford Papermate Corporation - Supervisor Training, Compensation & Benefits Pepperdine University - Director of Personnel * Turner Construction Company - Vice President of Human Resources * Union Bank of California - Senior Staffing Manager Wherehouse Music Inc. - Vice President of Human Resources * University of California Manager of Employment Services * Sony Pictures Entertainment Inc. Director International Human Resources * The Los Angeles Times - Human Resources Systems Analyst * Distribution & Auto Service Inc. - Chief Financial Officer * Merle Norman Cosmetics Inc. - Director of Information Services * Telcom � Satcom Military Wireless Director of Human Resources * Los Angeles Police Department � Manager Rampart Operations Support Division * California Pension Administrators � President Dumonde Solutions � Manager * The Wall Street Journal  - Western Region Recruitment Manager * Xerox Corporation - Human Resources Operations Manager

For the benefit of those of our members and supporters who could not attend the meeting we present the following white paper, with contacts.

Back to the Future: 
A Balanced Approach to Long-term Incentives

The sustained bull market of the �90s has ended with a suddenness that has left investors shocked and companies searching for solutions to a whole new set of unanticipated human capital problems. For management and employees the �drowning index� of underwater stock option grants is staggering, wiping out billions in real and paper value, reducing future expectations and causing major retention and motivation dilemmas.

Compounding the problem is that after a decade or more of a robust economy, companies now are facing the challenge of a rapidly weakening economy and in many cases the need to adjust their base business model-fast.

Each drop in stock prices cinches another inch in corporate belts: new business strategies, layoffs and other cost-cutting measures are announced almost daily, with companies explaining that they are either adjusting to short-term dislocations or taking a new long-term view.

In this environment, strategy execution is ever more precarious-and critical-demanding talented, experienced leaders. The challenge becomes how to retain key talent, motivate them to operate in a new way to achieve new strategies, and reward them for their success. The challenge is even greater given the devaluation of stock options that once represented such rich, and comparatively low cost, rewards.

To understand what is appropriate for management rewards going forward, it is helpful to recall where they have been. The bull market and strong economy of the 1990s had a profound influence on compensation.

The hot economy and the technology boom that fueled it heightened the competition for talent, which, in turn, fattened management pay packages considerably, fueled largely by �zero-cost� stock options. For example CEO total direct compensation (TDC) increased by an average 23 percent per year during 1990-1999, more than double the growth rate in the 1980s.

The exuberant equity markets fueled a significant shift toward equity-based reward vehicles, especially stock options for all levels of management, and in some cases for all employees. They made millions, but few cared because shareholders made billions. And everyone came to believe that such rewards were their right.

Super-sized equity awards coupled with broad-based grants to individuals at lower organizational levels resulted in significant increases in annual stock option run-rates and (of particular interest to shareholders) in stock option overhang over the last 10 years. For example, according to recent studies, the overhang and annual run-rates for many large companies have nearly doubled in the 1990s. The technology sector�s overhang rates have outpaced those of other industries by an average of 24 percent in 2000 versus an average of 13 percent for S&P 500 companies.

Such high rates of dilution were already an area of concern for institutional shareholders, but they were tolerable when stock prices were rising rapidly. Now, they are an anchor around the neck of many companies whose shareholder tolerance for overhang increases is gone. This limits the availability of meaningful responses to the disaffected populations who are needed to drive the company forward.

And, to add insult to injury, not only do falling stock prices reduce shareholder tolerance for dilution, in fact they also increase stock option overhang. Data show that employees in large companies in 2000 exercised options at half the rate compared to the mid-�90s. As more options are underwater, fewer options are exercised and, thereby, taken out of the overhang equation-in effect, driving overhang up with each new grant (just the opposite of the positive effect created in the 1990s rising market).

The new millennium has provided a sharp dose of reality. Volatile, but essentially bear markets have replaced the bull runs across all major indices. Since the highs in early 2000, the S&P 500 has fallen by 20 percent, while the NASDAQ has fallen by 60 percent.

At the same time, the booming economy is rapidly slowing, as reflected in key economic indicators. In February 2001, the Conference Board�s Consumer Confidence Index fell for the fifth consecutive month to its lowest level since June 1996. Also in February, according to statistics released by the Federal Reserve, U.S. industrial production fell for the fifth consecutive month for the first time since October 1990 to March 1991, the last period of recession in the U.S.

Most companies will experience slower growth this year. In December 2000, the Livingston Survey projected that after-tax corporate profits would grow just 3.5 percent in 2001 and 5.0 percent in 2002 after an expected growth of 14.4 percent in 2000. The survey expects growth of the U.S. economy�s output (measured by real GDP) to decrease from a projected 5.1 percent in 2000 to 3.1 percent in 2001 and 3.4 percent in 2002. The slowing economy and its likely effects on companies are clear-the windfall gains of the past are behind us. Managers will need to focus on getting their people to change their business models to adapt to this new environment, without the motivation and retention power of highly valued stock options.

What does this imply for companies and management compensation going forward?

Companies must strengthen their focus on doing what is necessary to once again grow their stock prices in a more conservative market. This is not so different from where companies were circa 1990 before the markets took off. The focus must be on managing expenses, capital and debt, and achieving profitable revenue growth.

An analysis of the best and worst performing companies among the S&P 500 illustrates that business fundamentals drove stock market value creation in 2000. Companies performing in the top quintile of the S&P 500 for 2000 had a median sales growth of 23 percent, net income growth of 22 percent, and a 22 percent EBITDA margin. In contrast, companies in the lowest quintile had a median sales growth rate of 10 percent, a net income growth rate of -14.6 percent, and a 16 percent EBITDA margin.

More than half of U.S. companies report that at least some of their options are underwater today. That makes companies vulnerable to losing their most talented people. Unfortunately, dealing with underwater options is not straightforward.

FASB rules are complex around a cancel and reissue and the extremely onerous earnings charges can be imposed if options are replaced within a six-month time frame. In addition, shareholders express negativity to most repricings.

The most common response has been to issue a new, supplemental stock option grant at the new, lower current stock price. However, this tactic is not without risks as well. Companies that take that track may compound their problems.

EXAMPLE: Microsoft is a good example of trying to time the equity markets with supplemental grants. In April 2000, Microsoft granted 70 million plus options at an exercise price of $66.63 (a 12-month low) to approximately 34,000 employees in response to the 40 percent decline in its stock price and the employee consequences of their highly underwater stock options. Microsoft bet with its equity that the company�s downturn would be short term; however, the stock price subsequently fell further to $41.50, meaning that the 70 million new options granted in April 2000 were also underwater (as of the date of this article, the stock price has started to recover again).

Many other companies have taken similar action-an understandable response. However such strategies may not only fail to provide the intended value to employees, they also may handcuff the companies from a dilution perspective, limiting future option availability.

In some situations where the talent drain is extreme, simply continuing to run the business can require maneuvering around the FASB rules to cancel existing options and issue new ones six months later, or institute similar radical stopgap measures. Restricted stock, while expensive and often tied to performance, may be a necessary retention tool in some circumstances.

However, all of these actions may be stopgaps to ease the transition from the unprecedented �90s bull market to a more normal, and less lucrative, era of stock options-an era in which options will provide gains to successful companies over time (but will not create the immediate, quick wealth of the past decade).

One can also view the last decade as an aberration-albeit a fortuitous one-which distorted some basic compensation principles. It turned wealth creation from a reward for sustained business success into a kind of immediate lottery, where being in the right place at the right time (or the wrong place at the wrong time) could be more important than actual performance.

It is now possible for many companies to return to a more balanced approach to compensation design-one that reflects business needs and fundamentals while at the same time accounting for shareholder alignment and key talent management needs. The principles we are proposing are ones that have endured; they just sometimes were overwhelmed by the wealth potential created in the last decade.

One part of the solution is to focus and reward executives for improving those aspects of company performance that will drive shareholder value. These can be addressed through both cash-based long-term incentives and annual incentives.

We are not suggesting that the rules be changed to keep management whole, e.g., providing cash to replace lost stock option opportunities. Rather, we suggest that compensation plans can be restructured to motivate executives to do the things that are necessary to restore company value.

Nor are we promoting cash awards to the exclusion of equity. Corporate-based equity programs will continue to be essential to align executive interests with shareholder gains and to motivate and reward long-term value creation. This is particularly true for senior corporate executives. However, management motivation, focus, and retention can generally be heightened by also providing vehicles that more directly address those aspects of performance that drive shareholder value and that managers can control. This is particularly important in a time of needed change in business models and employee behaviors.

This approach helps improve line of sight, which increases motivation and accountability for delivering results, and differentiates rewards based on contributions and performance.

These approaches can be used at the corporate level, but are especially effective for business units, particularly if they are relatively autonomous. And, cash rewards for performance results have a strong motivation of their own-they are without short-term market risk, representing a reward for actual accomplishments. You earn them.

The second part of the solution is to address talent management-what it will take to attract and retain the executives who have the right stuff to lead the organization, particularly in complex times.

Companies can least afford to lose their best people when their viability hinges on managing the business effectively and capturing all available value. The best talent is most likely to leave when handcuffs are weak and overall company performance creates a tough environment in which to work. Conversely, poor talent hunkers down to keep their jobs. A company�s aggregate wealth creation opportunities must be sufficient to retain and attract the best. In addition, the differentiation for performance must be steep enough to weed out the also-rans who are not contributing.

Faced with a cash/profit crunch and already high levels of stock option dilution (which are less acceptable with lower stock price growth rates), companies are finding they must be more deliberate in how they use their cash and equity compensation. Pay for the best talent will continue to rise significantly because top performers are at a premium, and they will continue to be in short supply throughout the near term. However, the widespread largesse of the past few years will not be sustainable going forward.

One approach is to introduce significant differentiation in pay and link rewards to the results most directly contributed by top-performing business units, teams, and individuals. Other special retention-oriented programs for the very top performers can be added to the mix, providing both extrinsic rewards and the clear message that the individual is valued (restricted stock can be effective here if used judiciously).

These types of investments aimed at retaining top performers will yield a high ROI, paying the dividend of stronger company performance. In addition, paying for retention is significantly more economical than paying the premium that is often required to replace departed managers with external hires.

In summary, companies should consider three key actions in order to manage pay and performance effectively during these challenging times:

Strengthen the focus on business strategy and fundamentals. Link rewards to those drivers of value that produce clear line of sight, particularly at the business unit level. The rewards can come through annual as well as intermediate-term cash and long-term incentives.

Slow the growth of average pay levels, but strongly differentiate for performance in determining salaries, cash awards, and options so that the best performers still earn significant rewards.

Rely less on options as the only pay delivery mechanism. Let options return to being the long-term incentive they were intended to be. They are less affordable now due to high dilution and slower stock price growth rates. (They may also be less competitive and less desirable to recipients since their potential for quick rewards has diminished.)

This focus on fundamentals will go a long way towards retaining key talent and rewarding their results to position the company for the long term.

Throughout some sectors of the economy, a sense pervades that the party is over. While for many this appears to be true, the current economy and the uncertain stock market presents a whole breadth of new opportunities. For the managers and Boards of public companies, one of the opportunities is to re-focus around fundamentals. The topic of executive compensation looks and feels like a bad car accident for those feeling the pain of unrealistically priced options. However, there are ways and means of using pay to help get everyone back to the basics of creating real and sustainable growth in shareholder value.

We maintain that the universal starting point in pay design is company strategy. While today�s environment offers a host of complications-ranging from a severely mixed bag of still-rising stock prices, to dramatically declining stock prices, and just plain, volatile stock prices-pay must still be linked to the actions required to realize value. The following scenarios outline many of the challenges facing companies today, with our thoughts on how companies should respond.

Yahoo! was one of the few Internet companies that made money. The rise in its market value was stunning. The profitable and immediate success of its advertising revenue model was similarly impressive during a time when clicks and eyeballs sufficed for investors as a proxy for future profits. But the model has quickly become challenged and revenue from advertising has dropped precipitously. Today, Yahoo! has a new CEO, and it is in the midst of overhauling its business model to return to profitability. Shares have been trading some 92 percent off their peak.

Yahoo! is a prime example of a company that could use pay as a significant lever in affecting a turnaround. Most of the attention on Yahoo!�s pay programs has focused on underwater options. Nevertheless, companies in this type of situation can benefit tremendously by introducing both annual and long-term incentives focused on the few, key performance measures that are the levers of a new strategy. The stock market response to a strategic shift may well be delayed; the market may require sustained signs of success before it rewards a company with renewed interest. Annual and intermediate plans that pay in cash or in a stock with a low basis can be effective tools in galvanizing a management team around a new strategy.

Indeed, companies in this position also need to address their underwater options. Some options may need to be replaced, which is not easily accomplished under new accounting rules. The investment community will be scrutinizing overhang (the sum of options currently granted and in employees� hands plus the remaining shares authorized to be granted to employees). To manage overhang to a lower level, many companies must find ways to cancel outstanding options if they are going to replace them with new options that have a realistic chance of being valuable to the holder.

Finally, companies undergoing strategic surgery also need specialized pay packages to help manage the attrition and attraction of talent. Some individuals may be unnecessary to a new business model, and therefore will need to be managed out. Other individuals may be important in a transition but not in the long term. In addition, new skills may be required that are not resident currently in the organization. Tailored severance packages, stay or project-completion bonuses, and new hire packages may all be required simultaneously to address talent issues.

A U.S.-based homebuilder is well positioned for the long-term, or so it seems. The prospects for home building are strong. The company�s target customer segment has good long-term prospects. Its land inventories are plentiful and bear moderate carrying costs. Its execution ability is strong and improving. Despite the positive horizon, a potentially serious threat exists: several of its geographic markets are being hit hard by layoffs, particularly in areas where technology is a large employer.

From a business perspective, the company needs to re-balance its focus. Where it previously wanted maximum growth from each of its geographic divisions, it now wants to re-focus on those markets least affected by the downturn. It needs to manage its risk in other markets by slowing its building activity and shifting from a spec-build mode to build-on-order approach. It is also keen to use these market circumstances to increase its share and presence in key, still-growing markets. Finally, without taking wholesale hits to its organization, it inevitably must tighten its belt and shrink expenses to help maintain margins.

From a talent perspective, the company�s challenge is to re-focus the organization quickly on these near-term priorities. To use pay to this effect, the company first needs to alter its annual incentive plans to reflect the need for focus on margins. It also needs to shift away from a �one size fits all� approach for its geographic division plans. Those divisions in still-growing markets may be relatively untouched although market share may be added as a measure of success, while margins might receive increased weight as a balance. In the challenged geographies, the division management teams need to be re-focused away from all out growth in volumes and revenue. Profit per home and margins may take precedence over the top line. At the same time, local management may be encouraged to stockpile land inventory, taking advantage of falling land values, even though the increased carrying cost hits the short-term P&L.

As far as pay mix is concerned, a shift to more variable pay may be in order. When a greater percentage of pay is delivered through variable means, pressure on salary increases is lower, and salaries may be held flat. Instead, target annual incentive amounts may be increased, leaving the company with a more leveraged pay program.

Equity programs might be largely unaffected in this scenario. While option holders may be disappointed that older grants have gone underwater or lost much of their positive spread, a strong communication program can explain how standard grants made during this time could have a big upside. In some cases, targeted restricted stock grants may be granted to key strategic contributors, but the grants should be severely limited for maximum impact.

Perhaps one of the most frustrating positions to be in today is to be part of the team leading a company to sustained success but nonetheless, having the stock caught in the downdraft. The following chart shows nine companies that have been recording sustained quarter-over-quarter improvements in their earnings but are still getting penalized in their stock price.

The business implications for companies in this position are largely to stay the course while the investor relations experts try to get Wall Street to notice. From a talent perspective, the challenge is to maintain the motivation of the whole team and hold on to any key executives who may be at risk.

One of the dangers companies face in this scenario, and even in some turnarounds, is the near panic over what it will take to keep a team focused and in their seats. Companies may selectively re-stake or provide retention grants (usually restricted shares), but should do so cautiously. If they choose this course, they may find later that they have another problem, namely multi-millionaires with new and very high expectations about what a compensation program should deliver.

Communication should be the first line of defense. The elements of an effective communication program include financial education that highlights the continued growth opportunities in share-price drivers, (e.g., earnings before interest, taxes, depreciation and amortization [EBITDA], return on capital employed and top-line growth potential) along with historic bands of valuation for the sector. This understanding can help option holders develop their own view of the stock�s future potential and the gain opportunities therein. This will help build recognition of the future spreads that may be achieved on new and potentially, on earlier, option grants.

A tough stock market may be especially unkind to companies that are perceived to have a mixed or unfocused portfolio of businesses. For example, a Fortune 200 diversified manufacturer with multiple autonomous business units had a track record of creating significant shareholder wealth. However, it needed to demonstrate a continually strong growth trajectory to drive shareholder value even further. With a perception among analysts that it was too patient with some of its units, the company sought to find a way to sharpen focus across the board and get all of its businesses operating with full margins and on good growth trajectories. In this scenario, the company needs to refocus the organization on key value drivers and milestones plus do so with greater line of sight to the results managers can impact.

In this example, the company knew it needed to achieve growth at the business unit level. A history of small, independent business units had left the company with weaker accountability than it thought was desirable. There was also a limited sense among the various management teams that their decisions and actions had much impact on the stock price.

To encourage stronger growth in each of its business units, the company introduced a two-part long-term incentive plan. Part one was based on a matrix that measured a business unit�s real earnings growth and return on investment performance.

Payments within the matrix were calibrated to actual value creation and then �tilted� slightly to encourage growth over return on investment. (The business units had historically been conservative and valued returns over growth. The new payout matrix sought to reinforce growth.) This part of the plan measured each business� contribution to shareholder value and represented the most significant opportunity in the two-part plan.

The second part of the plan provided annual nonqualified stock option grants. The grants reinforced the tie to overall company results as well as the need to translate individual business performance into long-term shareholder value creation.

Finally, the company made some adjustments to annual incentive programs for business unit leadership, introducing milestones related to identifying and opening up growth opportunities.

While education and communication around stock price potential plays a part in this scenario, the emphasis is more internal, i.e., getting managers focused on what they do that drives shareholder value.

The last business cycle seemed to emphasize the market�s attraction to �pure plays.� Spin-offs and divestments of businesses reached record levels in the last half of the �90s. Nonetheless, record mergers and acquisition activity also led to the creation of behemoth organizations designed to achieve broad dominance and synergy: Time Warner and AOL, Citicorp and travellers, GTE and Bell Atlantic all being prime examples. Inevitably, the new Time Warner/AOL, Citigroup and Verizon and many other companies will find assets that do not fit or cannot meet their performance expectations. A new wave of spin-offs and divestitures will ensue.

Spin-offs and divestitures each present their own set of issues with regard to keeping talent and keeping talent focused. Some business spin-offs or sales present trophy-assets to a new owner (or set of owners), but the management team is not always part of the trophy. Management teams may be needed through the transaction but not wanted after it. Conversely a strong management team may greatly increase the value of the asset in question. The importance of the management leads to a wide variety of possible approaches for the seller. On the short end, it may require nothing more than stay bonuses to get through a transition. Other permutations vary with the form of the transaction and may include a stake in the sale price, a re-staking in the buyer�s entity or in an actual public offering, or a whole new set of equity programs geared both to the IPO and the long-term success of a new, independent entity.

Whatever the situation, the right solution must be led by the business case. Quick fixes are just that-they cannot be considered a substitute for re-thinking the compensation design vis-�-vis the current and future realities of the business. One-time �silver bullets� can be fatal to the organization�s long-term health and success.

How to handle underwater options? Should a company re-stake, re-price, cancel and re-issue, buy them out, or do nothing and hope they come up for air in time to retain and motivate the holders. There is no easy answer, but there are many actions that could prove fatal if not thought out completely.

Many companies with options that are deeply underwater see no alternative but to take immediate remedial action. Such companies may be facing extreme pressure to restore the motivation and retentive power of their equity-based compensation programs. Conventional wisdom seems to suggest that any delay is fraught with the danger of executive defections, at least in mind if not in body. Some companies are also trying to eliminate the demoralizing reminders of how far the stock price has declined. Still other companies are motivated by the perceived need to be fair to employees who were encouraged to hold their options, rather than exercise and sell them to realize a quick gain.

Making the wrong decision about options now can create even greater dilemmas down the road. We caution companies not to act without carefully considering four factors: the business case for the action; the potential risks involved; the possible cost/dilution consequences; and disclosure requirements.