Six Essential Steps to Implementing Performance Metrics

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Six Essential Steps to Implementing Performance
Metrics
October 23, 2008

• Melissa L. Means Managing Director
• Pearl Meyer Partners
• 132 Turnpike Road, Suite 300
• Southborough, MA 01772
• [phone]
• melissa.means_at_pearlmeyer.com

David G. Johnson National Service Line Leader
Compensation Strategy Design Ernst Young
LLP 925 Euclid Avenue, Suite 1300 Cleveland, OH
44115 [phone] david.johnson2_at_ey.com
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Agenda

• The Changing Landscape of Long-Term Incentives
  (LTI)
• Six Steps to Implementing Performance Metrics
• Additional Considerations
• Conclusion

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The Changing Landscape

• External influences continuing to change the use
  of LTI
• Perceived abuses
• SEC disclosure rules (CDA)
• Tax and accounting rules
• Unprecedented investor scrutiny
• As a result
• LTI remains in the forefront of public interest
• Companies continue to re-evaluate the efficacy of
  their existing LTI programs and instrument mix

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Instrument Usage Mix

• Headline - Companies continuing to evaluate and
  rebalance the mix of LTI instruments
• Companies are also using multiple instruments to
  deliver LTI awards

Source 2007 Pearl Meyer Partners CHiPS
Long-Term Incentive Report
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Instrument Usage Stock Options

• Headline - Stock options are on the decline for
  another straight year
• Companies are continuing to use other LTI
  instruments in lieu of options to address various
  issues
• The following outlines option usage levels in the
  high technology industry (by industry and
  revenue) over the past 3 years

Source 2007 Pearl Meyer Partners CHiPS
Long-Term Incentive Report
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Instrument Usage - Restricted Stock

• Headline - Use of restricted stock (RS) continues
  to increase 20
• Restricted stock delivers same SFAS value as
  options using fewer shares
• Continued investor pressure when using restricted
  stock
• The following outlines restricted stock usage
  levels in the high technology industry (by
  industry and revenue) over the past 3 years

Source 2007 Pearl Meyer Partners CHiPS
Long-Term Incentive Report
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Instrument Usage Performance-Based LTI

• Headline - Many companies are implementing or
  investigating the use of performance metrics in
  an LTI plan
• Stronger link between pay and performance
• More in line with shareholder and institutional
  expectations
• 44 of the Fortune 1000 and 62 of the SP 500
  have a performance-based LTI plan
• Typically a 3-year plan that pays out in stock

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Instrument Usage Performance-Based LTI

• According to the 2007 NASPP Domestic Stock Plan
  Design Administration Survey, 64 of
  respondents offer performance-based plans in
  2007, up from 30 in 2004
• The top 3 objectives of a performance-based LTI
  plan, as stated in the 2007 NASPP Survey, are to
• Attain performance targets
• Align with shareholder interests
• Incent and reward
• However, performance-based plans can be
  challenging to design and administer.

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• Six Steps to Implementing Performance Metrics

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Six Steps to Implementing Performance Metrics

• The following outlines six key design
  considerations for a implementing a
  performance-based LTI plan
• Metric Selection
• Performance Measurement Period
• Absolute vs. Relative Performance
• Cumulative vs. Point-in-Time Metrics
• Consecutive vs. Overlapping Performance Cycles
• Set Performance/Payout Scale

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Step 1 Metric Selection

• Creating value
• What performance measures drive shareholder
  value?
• Which performance measures are valued?
• For the industry, the company and by
  investors/analysts?
• Which performance measures align with the
  companys business strategy?
• Company value proposition may lead to use of
  different metrics
• Immature, high growth, technical/innovation focus
  - revenue growth, product introductions
• Mature, modest growth, operational focus -
  profitability and returns
• Motivation reduced for less predictable metrics

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Step 1 Metric Selection

• Performance metrics may be
• Financial (e.g., Revenue, EBITDA)
• Milestone-oriented (e.g., biotech needing drug
  approval)
• Operational (e.g., reduced error rates)
• Market-based (e.g., share price appreciation,
  TSR)
• The most commonly used performance metrics,
  according to the 2007 NASPP Survey are
• Revenue profit metrics (revenue, EPS, operating
  income)
• Return/margin metrics (ROIC, ROE, operating
  margin)
• Value metrics (TSR)
• Number of metrics to use and weightings
• Interdependence of metrics

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Step 1 Metric Selection - Company Value Drivers
Determine Correlation of Select Measures Over
Time as Compared to Stock Price
Determine Predictability of Select Measures Over
Time
Example
Example
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Step 2 Performance Measurement Period

• Typically 3 years
• Most frequently reported performance period in
  the 2007 NASPP Survey
• Encourages longer-term performance focus and
  retention
• Serves as a bridge between performance in an
  annual bonus program and stock options (i.e., 10
  year term)
• Performance periods may range from 1-3 years
• Challenges associated with establishing
  longer-term performance goals
• If unable to reasonably establish valid and
  predictable performance metrics over a 3-year
  period, consider
• Shorter measurement periods with subsequent time
  vesting

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Step 3 Absolute vs. Relative Performance

• Absolute goals
• Measures performance based on actual performance
  of the company against established goals
• According to the 2007 NASPP Survey, 56 of
  respondents use absolute goals
• Relative goals
• Measures performance of the company as compared
  to a peer group of companies or an index
• Used to mitigate difficulty in setting
  longer-term performance goals

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Step 3 Absolute vs. Relative Performance
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Step 4 Cumulative vs. Point-in-Time Metrics

• Cumulative metrics
• Requires that specific goals are met each plan
  year and at the end of the full performance
  period
• Promotes and rewards for consistent financial
  performance achievement
• Point-in-time metrics
• Requires a company achieve a stated goal at the
  conclusion of the performance period

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Step 4 Cumulative vs. Point-in-Time Metrics
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Step 5 Consecutive vs. Overlapping Cycles

• Consecutive performance cycles
• A new cycle begins at the completion of the
  previous performance period
• Overlapping performance cycles
• A new plan begins each year so that multiple
  plans run simultaneously
• Larger and more complex companies may be more
  inclined to use overlapping cycles
• 69 of respondents in the 2007 NASPP Survey use
  overlapping cycles

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Step 5 Consecutive vs. Overlapping Cycles
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Step 6 Set Performance/Payout Scale

• Generates specific payouts to executives for
  specific levels of performance
• Threshold generally 50-80 payout opportunity
• Target generally 100 payout opportunity
• Maximum generally 125-300 payout opportunity
• Scale should be based on both quantitative
  metrics (e.g., revenue, EPS) and qualitative
  metrics (e.g., execution against companys stated
  business strategy)
• The threshold-to-maximum range will vary based on
  metrics selected

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Step 6 Set Performance/Payout Scale

• Companies need to be able to accurately forecast
  future performance metrics
• Targets set too low
• May lead to overpayment for performance
• Creates a sense of entitlement
• Does not drive changes in behavior
• Targets set too high
• Decreases motivation
• Creates conflicts with management
• Does not drive changes in behavior
• Targets should require effort to achieve, but be
  reasonable not an easy task!

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• Additional Considerations

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Additional Considerations

• What are you trying to achieve and what behaviors
  are you trying to drive?
• Has past pay been commensurate with performance?
  If not, why?
• Will any of this change behaviors?
• Balance LTI with other elements of pay
• Consider usage of performance metrics used for
  other elements of pay
• Qualitative vs. Quantitative

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Additional Considerations

• Ensure line of sight
• Sensitivity of performance metric to individual
  contributions
• Ability and perception of individual to influence
  the outcome of the metric
• Adjusting/revising goals during performance
  period
• Impact of extraordinary events
• Impact of converting to IFRS (in the future)
• Keep some discretion

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Additional Considerations

• What is International Financial Reporting
  Standards (IFRS)?
• The momentum for a global GAAP (including global
  movement towards IFRS) has significant
  implications from an HR perspective, especially
  as it relates to equity based compensation,
  pensions and employee benefits
• Conversion to IFRS 2 may have a compounding
  impact on the current performance-based LTI plan
  metrics (e.g., revenue or operating income)
• Companies will need to re-evaluate the impact of
  granting performance-based options/shares under
  IFRS 2 and consider re-designing
  performance-based programs
• Other tax and accounting considerations

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• Conclusion

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Conclusion

• Keys to designing an effective performance-based
  LTI plan
• Keep them as simple as possible
• Limit initial plan eligibility, consider
  expansion once plan is successful
• Consider shorter measurement periods for
  companies of high growth or acquisitive
  industries
• Select appropriate performance metric(s)
• Ensure the plan aligns with the companys
  business strategy
• Develop an appropriate performance/payout scale
• Understand the financial implications of such a
  plan
• Discuss how to address unexpected financial
  circumstances
• Start slowly consider consecutive cycles and
  using performance metrics with only a portion of
  the LTI award

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Questions
For more information, please contact
Melissa L. Means Pearl Meyer Partners 132
Turnpike Road, Suite 300 Southborough, MA
01772 [phone] melissa.means_at_pearlmeyer.com
OR Visit our website www.pearlmeyer.com Click
on Our Knowledge then Presentations and Speeches
David G. Johnson Ernst Young LLP 925 Euclid
Avenue, Suite 1300 Cleveland, Oh 44115 (216)
583-2196 david.johnson2_at_ey.com OR Visit our
website www.ey.com