DESIGN A SUCCESSFUL COMPENSATION SYSTEM

1
DESIGN A SUCCESSFUL COMPENSATION SYSTEM

• August 25, 2004

2
TODAYS DISCUSSION

• Compensation Philosophy
• What is a comp philosophy?
• Why do we need one?
• How to develop one for your company
• Compensation Systems
• What makes them successful?
• Four fundamental components
• Program design examples
• After the Design Whats Next
• Tips for effective administration
• Managing change

3
COMPENSATION PHILOSOPHY

• What is a compensation philosophy?
• Articulates what the company believes about how
  its employees should be treated financially
• Provides guiding principles for designing
  cohesive compensation programs
• Lays out what is important to the company
• Communicates a consistent and clear message
• Should be backed up by the companys actions

4
COMPENSATION PHILOSOPHY

• Your stated philosophy should reflect the
  companys intentions and set expectations for
  employees. Example statements
• Efforts will be recognized, but results will be
  rewarded.
• Employees with the greatest level of sustained
  performance receive the greatest rewards in pay.
• Solid performers will be targeted at 50th
  percentile. Top performers will be targeted at
  75th percentile.
• By linking pay opportunities to clearly outlined
  individual performance objectives, we offer every
  employee an equal chance to succeed.
• All employees should share in the financial
  success of the company.
• Our compensation programs are globally focused,
  locally competitive.
• We want all employees to think like owners, which
  is why we award stock options to every employee.

5
COMPENSATION PHILOSOPHY

• Why do you need an explicit compensation
  philosophy?
• Managers might be making compensation decisions
  that are not in the best interests of the company
  as a whole
• There may be an implicit philosophy that isnt
  consistent across the company
• Look at employee communications over the years
• Informally survey top managers of the company
• What do the current compensation programs look
  like and what do they say about the companys
  beliefs?
• Does the corporate culture offer any clues?

6
COMPENSATION PHILOSOPHY

• How do we develop a compensation philosophy?
• Interview senior management and Board of
  Directors
• Business objectives, current and future
• Desired employee behaviors to accomplish those
  objectives
• Competitive environment and desired positioning
• Recruiting or retention issues
• Pay elements and desired mix
• Outline current rewards programs
• Where are we now?
• Where do we want to be?
• How do we get there?

7
COMPENSATION PHILOSOPHY

• Example Comp Philosophy Worksheet

8
COMPENSATION PHILOSOPHY

• When might your compensation philosophy change?
• Leaving start-up phase
• Major change in your business model
• Business and headcount growth that outpaces
  expectations
• Following a merger or major acquisition

9
COMPENSATION SYSTEMS

• What is a successful compensation system?
• Supports the companys compensation philosophy
• Enables the company to compete for the talent it
  needs to be successful
• Provides sustainable compensation programs
• Allows the company to meet its financial goals
• Flexible enough to accommodate changes in the
  company or marketplace
• Motivates and rewards complementary objectives
  over the short and long term

10
COMPENSATION SYSTEMS

• Four fundamental reward categories make up the
  typical compensation system
• Base Salary
• Annual Incentives
• Long-Term Incentives
• Benefits Perquisites

Base Salaries
Benefits Perquisites
Total Rewards
Annual Incentives
Long-Term Incentives
11
BASE SALARY

• Being Competitive
• What does competitive mean?
• Winning the talent contest
• Winning the business contest
• How do you know if your company is competitive?
• Surveys of compensation for your particular
  industry
• Association websites or studies
• Outside offers made to employees
• Making counter-offers
• Exit interviews
• New hire salary history

12
BASE SALARY

• Being Competitive
• When is it okay to pay above competitive?
• Check your companys performance
• Losing mission critical employees or prospects
• Remember, base salary decisions are difficult to
  undo
• What if you cant afford competitive base
  salaries?
• This is where a bonus plan can make a difference
• Do you have any kind of equity compensation to
  offer?
• What about other rewards?
• Quality-of-life flex time or every other Friday
  off
• Career development training or education
  allowance
• Corporate culture and work atmosphere

13
BASE SALARY

• Staying On Target
• Put some structure around salaries
• Group jobs together with similar market salaries
  and internal value
• Set a minimum, midpoint, maximum range for each
  grouping
• Low end of range inexperienced or newly promoted
  employees
• Middle of range fully-competent employees with
  consistent performance
• Upper end of range superstars who are experts at
  their job and show sustained overachievement

14
BASE SALARY
Example Salary Structure
15
BASE SALARY

• Staying On Target
• Conduct an annual review of base salaries
• Ensures we stay on the mark for our desired
  positioning
• Helps us win the talent we need to be successful
• Credibly reassure employees that salaries are
  keeping up with the market
• Credibly reassure management that we are
  responsibly managing our compensation dollars

16
BASE SALARY

• Staying On Target
• Systematic merit and promotional increases
• Links individual performance review to salary
  progress
• Enables precise management of increase budgets
  less guesswork
• Gives managers tools to assess trade-off
  decisions
• Minimizes abuse of promotions

17
BASE SALARY

• Example Merit Increase Matrix

18
ANNUAL INCENTIVES

• Types of incentives
• Performance-based plans
• Generate awards based on financial performance
  relative to pre-established targets
• May incorporate individual, team, division, and
  company metrics
• Threshold performance level set for funding of
  plan
• Milestone or project incentives
• Typical in newly formed companies without
  steady-state operating history
• Milestones can be for overall company, functional
  area, or team-based
• Profit sharing plans
• Usually includes all employees, with a minimum
  service requirement
• Awards based on company, not individual
  performance

19
ANNUAL INCENTIVES

• Types of incentives
• Discretionary bonus
• Not based on pre-established formulas or
  performance objectives
• Can be administered by guidelines, although
  recipients unaware
• Usually not for entire employee population
• Spot bonus or special recognition programs
• Cash, stock options, gift certificates, trips or
  travel vouchers, e-awards
• Examples of behaviors that might be rewarded
• Development of a new product or process idea
• Exceptional or sustained productivity
• Working exceptionally long hours to achieve
  critical goals
• On-time, successful completion of a highly
  strategic project

20
ANNUAL INCENTIVES

• A well-designed annual incentive plan should meet
  several objectives
• Provide a systematic approach to incentive pay
  that links company and individual (or
  team/department) performance
• Allow employees to benefit financially when
  company meets or exceeds its short-term goals
• Support and reinforce the financial planning and
  goal setting process
• Strengthen and support the individual performance
  management system
• Use companys cash wisely
• Not a fixed cost like base salaries
• Provides cash awards only when company performs
  well
• Limits cash payments when company does not
  perform well

21
ANNUAL INCENTIVES

• Example Annual Incentive Plan
• Here is an example of a simple, three-step annual
  incentive plan. For this plan, there are three
  things that determine annual bonus payouts.
• Lets walk through the mechanics of a plan like
  this.

Distribute Bonuses Based on Individual Performance
Evaluate Company Performance
Establish Total Company Bonus Pool
1
2
3
22
ANNUAL INCENTIVES

• Example Annual Incentive Plan
• Establish target incentive levels for
  participants
• Each participant is assigned a target incentive
  award expressed as a percent of base salary.
• If base salaries are below competitive, we might
  use incentive targets that are higher than
  competitive.
• For private companies that dont have stock
  options to offer, we might also use higher than
  competitive incentive targets.
• Incentive targets for illustration only

Position Level Target Incentive ( of Salary)
Executives 50
Directors 25
Managers 15
Professional Staff 10
Non-Exempt 5
23
ANNUAL INCENTIVES

• Example Annual Incentive Plan
• Define company performance objectives
• Two key measures used to create an award payout
  matrix
• Net income or net income growth year-over-year
• Revenue or revenue growth year-over-year
• Pre-tax profits
• New or repeat customers
• Payout matrix defines the relationship between
  the performance targets and the resulting bonus
  pool funding
• Determine minimum company performance required to
  fund the bonus pool, the target performance
  level, and the maximum or cap

24
ANNUAL INCENTIVES

• Example Annual Incentive Plan
• Define company performance objectives
• A hypothetical payout schedule is shown below.
• At target company performance, the bonus pool
  will be funded at 100 of each participants
  target incentive percentage.
• To reach the minimum performance threshold, this
  company needs to achieve 80 percent of both
  targeted revenue growth and pre-tax profits.
• Payout schedule for illustration only

25
ANNUAL INCENTIVES

• Example Annual Incentive Plan
• Determine bonus pool
• Once the company has assessed its overall
  performance at the end of the plan year, target
  incentives are adjusted upward or downward using
  the matrix.
• If this company achieves 95 of its profit goal
  and 105 of its revenue goal, the initial
  incentive awards will be funded at 95.3 of
  target.
• Payout schedule for illustration only

26
ANNUAL INCENTIVES

• Example Annual Incentive Plan
• Assess individual performance
• Early in the year, managers and employees set
  three to five performance objectives for the
  employee (or team/department).
• To be eligible for an award at the end of the
  year, employees must perform at a level equal to
  or greater than Meets Objectives.
• Poor performers dont receive an award, even if
  company meets goals.
• Each level of performance has an associated
  multiplier that is used in the final award
  calculation.

Exceeds Objectives Highest level of performance that can be reasonably expected.
Meets Objectives Level of performance the company expects for the position. Corresponds to the 100 of target level.
Below Objectives Performance falls below the minimum acceptable level.
?
THRESHOLD
27
ANNUAL INCENTIVES

• Example Annual Incentive Plan
• Calculate incentive awards

100,000 x 20 x 110 x 1.05 23,100
Base Salary Target Incentive Award Company Performance Factor Individual Performance Multiplier Individual Incentive Award
28
LONG-TERM INCENTIVES

• The goal is to design a well-balanced set of
  programs that motivate and reward complementary
  objectives over both the short term (one year)
  and long term (three-to-five years).
• Two categories of long-term incentives
• Cash-Based
• LTI cash
• Performance units
• Stock appreciation rights
• Equity-Based
• Stock options
• Restricted stock
• Stock appreciation rights

29
LONG-TERM INCENTIVES

• Cash-Based Incentives
• Require ability to set long-term company and
  individual goals (3 to 5 years)
• Goals are often expressed relative to industry or
  peer company performance on various measures
• Growth
• Revenues
• Profitability
• Total return to shareholders
• Good performance linkage, but potential drain on
  cash flow
• Provide a retention hook longer than the annual
  incentive plan
• Enable private companies to compete with stock
  option grants

30
LONG-TERM INCENTIVES

• LTI Cash Plans
• Long-term cash-based plan, designed to pay out
  after 2-3 years based on attainment of
  performance measures.
• Plans generally have overlapping cycles, which
  maintains the retention value of the plan from
  year to year and does not create a "down year"
  after the first 3-year period, as payouts are
  made each year after the first plan cycle is
  complete.
• Year 1 Plan Cycle 1 starts.
• Year 2 Plan Cycle 2 starts, Plan Cycle 1
  continues.
• Year 3 Plan Cycle 3 starts, Plan Cycle 2
  continues, Plan Cycle 1 pays out.
• The plans can use internal metrics, external
  metrics, or both to determine payouts.

31
LONG-TERM INCENTIVES

• LTI Cash Plans
• Setting performance goals three years in advance
  can be difficult.
• These plans typically require a cash outlay,
  which can be intimidating for companies with
  limited cash. However, the cash impact can be
  managed by
• Designing self-funding plans with payout
  contingent upon earnings, among other performance
  measures.
• Discounting the value delivered to reflect the
  lack of market risk to the employee.
• Paying the awards in stock (typically net of
  taxes) rather than cash.

32
LONG-TERM INCENTIVES

• Performance Unit Plan
• Long-term performance plan denominated in units
  and paid in cash.
• Employees earn units based on the attainment of
  company defined performance goals over a given
  performance period.
• Either the value of the units or the number of
  units to be granted is determined prior to start
  of the performance period.
• Performance period is generally greater than 2
  years and less than 5 years.
• Eligible employees must remain with the company
  for the duration of the performance period to
  earn the units.
• Employee is taxed when the units are earned and
  the company receives an equivalent value tax
  deduction.

33
LONG-TERM INCENTIVES

• Performance Unit Plan
• Example
• Target award of 10,000 units dependent on 3 year
  profit and revenue growth versus goal
• Actual award can range from 0 to 20,000 units
  depending on performance
• Unit value is fixed at 10.00
• Performance exceeds the goals at the end of the
  period, and the employee earns 15,000 units
• At a 10 per unit value, the employee receives
  150,000 in cash

34
LONG-TERM INCENTIVES

• Performance Unit Plan
• Advantages
• Links company and employee performance with
  long-term payouts
• Can pay out in cash or shares
• Disadvantages
• These are generally complex plans and
  communication may be difficult
• A weak performance review process may create a
  sense of ambiguity on vesting conditions

35
LONG-TERM INCENTIVES

• Stock Appreciation Rights
• Right to receive appreciation of stock price over
  specified base price, paid in either cash or
  stock. Like options, except that rather than
  paying to exercise the option, the participant is
  paid the gain in either cash or stock.
• Advantages
• Can mimic options without using shares
• For employees in countries with significant
  regulatory or tax burdens on options
• Accounting charge equals only the appreciation in
  the stocks value
• Disadvantages
• May involve cash cost to company, if gain is paid
  in cash rather than shares
• Relatively complex and may be difficult to
  communicate to employees

36
LONG-TERM INCENTIVES

• Equity-Based Incentives
• Allow employees to benefit financially from the
  creation of long-term value in the company
• Opportunity for significant cash gains
• Provide a retention hook for key employees
• Another way to reward employees who contribute to
  the company over the long term
• Can get employees thinking like shareholders
• Challenging to link individual performance
  directly to stock price

37
LONG-TERM INCENTIVES

• Stock Options
• New accounting pronouncements regarding stock
  options are causing companies to rethink their
  equity compensation strategies.
• Financial Accounting Standards Board (FASB)
• Released long-awaited exposure draft on equity
  compensation
• If adopted, effective date for most companies
  would be next year
• Companies would recognize an accounting expense
  for stock options on their income statements
• Now determining how companies would calculate
  that expense
• Black-Scholes model currently most common method
• Lattice models FASBs preference

38
LONG-TERM INCENTIVES

• Stock Options
• The results of Presidio Pays recent Pulse Survey
  suggest a delay in making decisions.
• Majority of the companies have not made any
  changes to their equity compensation practices
• None of the surveyed companies are planning on
  expensing stock options prior to FASBs deadline
• Many companies anticipate eventually making some
  changes, such as
• Reducing stock option grants across all employee
  groups
• Limiting participation in equity incentives below
  the manager level
• Attaching performance criteria to vesting
  conditions
• Granting some form of restricted stock

39
LONG-TERM INCENTIVES

• Stock Options
• Before making decisions about future stock option
  usage, look at the big picture.
• Why did we start giving employees stock options
  in the first place?
• Create an ownership culture
• Deliver compensation or create wealth
• Recruit and retain employees
• What are the challenges associated with
  expensing?
• Achieving the original goals of the option plan
• Reducing the impact on company financials
• Are options still practical?
• Can you accomplish your goals with fewer stock
  options?
• If not, is a complete change in the type of
  equity incentive feasible?

40
LONG-TERM INCENTIVES

• Company Considerations
• Financial modeling
• Multi-year economic impact of various equity
  incentives
• Compare various valuation methodologies, using a
  variety of vesting and stock price performance
  scenarios
• Project overhang, run-rate, and share usage over
  a three to five year period
• Detailed review of plan documents
• Make sure current or proposed plans provide
  sufficient share reserves and allow necessary
  plan features to implement desired strategy
• Reaction by the Board of Directors
• Compensation Committees are becoming much more
  involved in the broad based compensation strategy

41
LONG-TERM INCENTIVES

• Employee Considerations
• Understand how new programs or changes to
  existing programs will impact employees
• Are you accomplishing your intended goals for
  your employees?
• Review the effect various equity incentives will
  have on specific employees compensation levels
  relative to historical and/or competitive pay
  levels
• Review tax burdens that may be imposed on
  employees
• Remember the perception issue
• Programs should be consistent with the
  communicated compensation philosophy
• Communicate well in advance of implementation,
  providing details on why changes were made

42
LONG-TERM INCENTIVES

• Restricted Stock
• Grant of stock that is restricted from sale until
  it is vested. If vesting requirements are not
  met, stock is forfeited.
• Why to use
• No cost to the employee
• Stock retains some value even if the stock price
  declines
• Fixed and precise accounting cost no estimates
• Need less shares than options to satisfy total
  value delivered
• Why not to use
• Retention tool with little incentive value (pay
  for pulse)
• Employee taxed at vesting
• No risk to employee

43
LONG-TERM INCENTIVES

• Example Restricted Stock
• The following chart illustrates the impact to the
  employee of replacing stock options with
  restricted shares. Given the assumptions and
  methodology for determining an equivalent value,
  replacing 7,500 stock options with 2,000
  restricted shares would provide an employee with
  the same value after four years.

44
LONG-TERM INCENTIVES

• Example Restricted Stock
• The final outcome of this exercise leads to a
  number of conclusions.
• Company
• Expense on restricted stock grant less than
  expense on stock options
• Using fewer shares will reduce dilution
• Turnover from underwater stock options disappears
• Employee
• Employee receives same value at the end of four
  years given moderate stock price growth
• Maintains the ownership mentality that options
  provided
• Time-based vesting creates an incentive to stay
  with company
• Option value will eventually surpass the
  restricted stock value if the stock price shoots
  way up, but the risk is much lower

45
BENEFITS PERQUISITES

• Benefits Perquisites
• This is one area of missed HR marketing
  opportunity. Few employees know the actual dollar
  cost to the company of their benefits, which
  typically add another 30 in value to the total
  rewards package.
• Health and welfare protection
• Helps attract employees, especially those looking
  to cover family members
• Most companies subsidize the cost of health
  insurance
• Retirement programs
• Assist employees in saving for retirement
• Provide a current tax benefit
• 401(k) plans are the predominate retirement
  vehicle
• ESPP
• Profit sharing

46
BENEFITS PERQUISITES

• Benefits Perquisites
• Miscellaneous perks
• Not just for executives
• Car allowances
• Gym membership or subsidy
• Free or discounted company product
• Employee cafeteria or snack room goodies
• Flexible schedules
• Telecommuting
• Nursing mothers room

47
AFTER THE DESIGN

• Tips for effective administration
• Articulate career paths
• Helps retain key employees by demonstrating clear
  opportunities for growth and financial
  progression
• Establish consistent titling criteria to
  accurately reflect expected contribution (and
  compensation) levels within the company
• Acknowledges levels of contribution
• Rewards exceptional performers with meaningful
  titles
• Give managers tools and training they need
• Manager buy-in is the key to positive employee
  perception
• Believing you are treated fairly and consistently
  is as important as believing you are paid well

48
AFTER THE DESIGN

• Managing Change
• Mergers Acquisitions
• Start now, because deals move fast and sometimes
  HR is the last to know
• Make sure salary structures are current
• Think about how to integrate annual incentive
  plans
• Update equity plan projections overhang,
  run-rate, projected share usage
• Executive change-in-control agreements
• Business Model Changes
• Shift in jobs overseas
• Moving from growth company to mature market

49
QUESTIONS?
50
BRANDON CHERRY

• Brandon Cherry is a Principal and Consultant with
  Presidio Pay Advisors, where he assists clients
  with the design and implementation of cash
  incentives, equity based incentives, group
  incentives and executive pay strategies. He also
  has experience helping employers deliver
  competitive benefit and perquisite packages to
  employees and executives.
• Prior to co-founding Presidio Pay Advisors,
  Brandon worked for PricewaterhouseCoopers LLP in
  Global Human Resources Solutions, working with
  clients to design and implement global
  compensation and equity solutions for domestic
  and international employees.
• Brandon received a Bachelor of Arts in economics
  from Stanford University and is a member of the
  Bay Area Compensation Association.
• Brandon Cherry
• [phone]
• brandon_at_presidiopay.com

51
BROOKE GREEN

• Brooke Green is a Principal and Consultant with
  Presidio Pay Advisors, where she provides
  consulting advice and implementation assistance
  to clients with compensation support needs. Her
  particular focus is on the design, communication,
  and execution of broad-based compensation
  programs within public, private and non-profit
  organizations.
• Prior to co-founding Presidio Pay Advisors,
  Brooke was an independent consultant offering
  on-site compensation program design and launch
  assistance to Bay Area companies. Previously, she
  was a consultant for WestWard Pay Strategies in
  San Francisco, where she specialized in the
  evaluation and design of executive compensation
  and broad-based employee programs. She has served
  as an internal consultant to HR executives in
  telecommunications, technology, financial
  services, and non-profit organizations.
• Brooke received an M.B.A. from the Cox School of
  Business at Southern Methodist University. She
  also holds a Bachelor of Arts from the University
  of Texas at Austin.
• Brooke Green
• [phone]
• brooke_at_presidiopay.com