Conventional wisdom says compensation should follow a company’s strategy: a company develops its strategy and then aligns its organization, talent and compensation accordingly. However, sometimes—quite surprisingly—the process works in reverse, and compensation discussions uncover gaps in underlying premises, leading to important and deep discussions that clarify strategic intent. In the first of this three-part series, we examine three case studies that show how executive compensation discussions catalyze value creation by highlighting misalignment or unsubstantiated assumptions. In the process, they initiate conversations that engage management and the board in reshaping and better articulating the strategy. In the second publication, we’ll explore how compensation impacts talent decisions. The third edition will focus on compensation’s impact on changing how work is done.
These moments when pay “wags the dog” can initially feel jarring, but when fully played out, they present opportunities for the board to coalesce around business priorities and direct companies towards discovering substantial economic value.
As compensation committee advisors, we’ve seen firsthand how these discussions can profoundly impact an organization. These discussions provide an opportunity for boards to pause, delve deeper into strategic assumptions and communicate intended messages through the compensation program. Left alone in the absence of conversation, the compensation design could compromise strategic achievement. Once revisited, pay program messaging can fundamentally reshape an organization.
Signal Strength: Refocusing Compensation for Strategic Alignment
A communications company had a straight-forward, “middle of the road” long-term incentive plan focused on profit growth and relative Total Shareholder Return. In a short period, the company incurred substantial capital investment to ensure the relevance of its product offering. Belatedly, board members began discussing adding Return on Invested Capital (ROIC) as a key long-term measure to validate the efficacy of the large investment. Others suggested focusing on free cash flow to ensure the debt levels associated with the investment could be paid down in due course. Further study provided a key insight: there was no way to earn satisfactory returns on the investment without meaningful growth in new customers. Management had initially proposed a large spend to maintain product parity with competitors, but the investment had to drive share growth and be supported by new revenue streams to earn it back. This insight drove a re-alignment of the organization to focus on growth. Rather than measuring ROIC or free cash flow (two measures best understood by the small number of executives involved in capital allocation decisions), the company pivoted its incentives to focus on revenue growth—a measure with broad application among virtually all of those participating. The “tail” of pay design led to both organizational changes and a sharpening of strategic intent.
Healthcare Hustle to Healthy Margins: Compensation Revamp Sparks Process Improvement
A healthcare company undergoing a transition had developed an activity- and milestone-based annual incentive program aligned with the priorities in the strategic plan. The activities engaged the full organization and were all important markers. However, the company’s financial state was not improving fast enough. As the board approached the incentive plan’s annual approval, they realized the plan skirted the issue of profitability, and without that focus, no level of activity would save the company. As the conversation progressed, it became clear that there was insufficient clarity in their strategic planning discussions on how the activities could be coordinated to achieve profitability. The renewed focus led to discussions about how the company could improve its processes, including claims, membership enrollment and provider interactions, to reduce costs, improve payments and increase profitability. It also led to productive discussions about where to focus new membership growth and how to integrate new members into the organization to drive higher margins. The compensation program became the catalyst for renewed substantive discussion and analysis of what it would take to prevail.
Metrics in Motion: Redefining Value Creation Drives Profitable Growth
At a logistics company, an activist investor joined a board discussion with the compensation committee and reviewed the compensation program that management wanted to maintain. The investor highlighted that the program didn’t appropriately reflect how the company would create value in a cyclical industry where goal setting is challenging. The activist investor believed that one business unit was the primary driver of value creation and wanted the enterprise-wide plan to focus on performance in that business unit only. After several discussions and extensive analysis of different business units’ contributions, the board and management developed a plan that focused primarily on one business unit. They included measures for other divisions that management believed would complement the company’s overall value proposition and drive growth. This new incentive plan incorporated an alternative top-line metric, as the new analysis of value drivers revealed that revenue did not accurately reflect industry growth. The compensation program sparked questions from the activist investor, leading to new insights into where value in the business was created.
Conclusion
Strategy and compensation have a symbiotic relationship. When compensation doesn’t follow strategy, missed opportunities are likely. Sometimes inadvertently, compensation can ‘wag the dog’ and highlight the need to revisit key business assumptions. When this happens, boards will benefit from embracing the process, taking the time to run additional analyses and having deep discussions that will drive greater strategic clarity and redirection, as warranted. These discussions can also open up opportunities for refining organizational models and renewing leadership commitment. Overall, compensation can create a call to clarity to signal what’s important to the organization and drive strong performance outcomes.
