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DESIGN A SUCCESSFUL COMPENSATION SYSTEM

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December 7, 2004 TODAY S DISCUSSION Compensation Philosophy What is a comp philosophy? Why do we need one? How to develop one for your company Compensation Systems ... – PowerPoint PPT presentation

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Title: DESIGN A SUCCESSFUL COMPENSATION SYSTEM


1
DESIGN A SUCCESSFUL COMPENSATION SYSTEM
  • December 7, 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 Type I
15
BASE SALARY
Example Salary Structure Type II
16
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

17
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

18
BASE SALARY
  • Example Merit Increase Matrix

19
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

20
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

21
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

22
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
23
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
24
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

25
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

26
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

27
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
28
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
29
LONG-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?

30
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

31
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

32
LONG-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

33
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

34
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.

35
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.

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)
  • 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

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
  • 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

41
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.

42
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

43
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

44
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

45
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

46
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

47
QUESTIONS?
48
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
  • (415) 438-3403
  • brooke_at_presidiopay.com

49
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 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

50
APPENDIX 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.

51
APPENDIX 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

52
APPENDIX 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

53
APPENDIX 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
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