Title: DESIGN A SUCCESSFUL COMPENSATION SYSTEM
1DESIGN A SUCCESSFUL COMPENSATION SYSTEM
2TODAYS 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
3COMPENSATION 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
4COMPENSATION 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.
5COMPENSATION 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?
6COMPENSATION 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?
7COMPENSATION PHILOSOPHY
- Example Comp Philosophy Worksheet
8COMPENSATION 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
9COMPENSATION 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
10COMPENSATION 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
11BASE 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
12BASE 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
13BASE 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
14BASE SALARY
Example Salary Structure Type I
15BASE SALARY
Example Salary Structure Type II
16BASE 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
17BASE 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
18BASE SALARY
- Example Merit Increase Matrix
19ANNUAL 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
20ANNUAL 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
21ANNUAL 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
22ANNUAL 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
23ANNUAL 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
24ANNUAL 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 -
25ANNUAL 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
26ANNUAL 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
27ANNUAL 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
28ANNUAL 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
29LONG-TERM INCENTIVES
- The goal for long-term incentives should be 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). - The plan should consider
- Ownership culture and shareholder alignment
- Wealth creation
- Key employee recruiting tool
- Impact on employee turnover
- Given your past and future goals make sure stock
options are still practical - Could goals still be achieved by simply reducing
your grants or modifying certain terms? - Is a complete change in the type of equity
incentive practical?
30LONG-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
31LONG-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
32LONG-TERM INCENTIVES
- There are a number of variations of long-term
incentives. The two broad categories of
long-term incentives are - Cash-Based
- LTI cash
- Performance units
- Stock appreciation rights
- Equity-Based
- Stock options
- Restricted stock
- Stock appreciation rights
33LONG-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
34LONG-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.
35LONG-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.
36LONG-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
37LONG-TERM INCENTIVES
- Stock Options
- New accounting pronouncements regarding stock
options are causing companies to rethink their
equity compensation strategies. - Financial Accounting Standards Board (FASB)
- Currently fine tuning the exposure draft on
equity compensation - The newly proposed effective reporting date most
public companies will be the quarter ending
September 30, 2005 - Companies would recognize an accounting expense
for stock options on their income statements for
any unvested stock options - Now determining how companies would calculate
that expense - Black-Scholes model currently most common method
- Lattice models FASBs preference
38LONG-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
39LONG-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?
40LONG-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
41LONG-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.
42LONG-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
43BENEFITS 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
44BENEFITS 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
45AFTER 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
46AFTER 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
47QUESTIONS?
48BROOKE 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
- (415) 438-3403
- brooke_at_presidiopay.com
49BRANDON 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 and employee 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
- (415) 438-3402
- brandon_at_presidiopay.com
50APPENDIX I
- 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.
51APPENDIX I
- 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
52APPENDIX I
- 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
53APPENDIX I
- 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