ADVANCING EXEMPLARY BOARD LEADERSHIP

Age of Alignment Part III: Moving From Theory to Practice

Compensation Series

May 14, 2015

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Meet The Presenters

Robert Galford (moderator) is a Managing Partner of the Center for

Leading Organizations and is on the teaching faculty of the NACD.

He is a member of the Board of Directors of Forrester Research.

Jim Heim is a managing director in the Boston office of Pearl

Meyer & Partners

Theo Sharp is a managing director in the Boston office of Pearl

Meyer & Partners.

Deborah Lifshey is a Managing Director in the New York office of

Pearl Meyer & Partners

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Click the buttons below to access additional resources

Housekeeping

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Housekeeping

Click below for a copy of the slides.

Slides are also available at

pearlmeyer.com/ageofalignmentpartIII

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You will automatically receive 1 NACD skill-specific

credit for your participation.

Credit may be applied to NACD Fellowship

programs. Contact Fellowships@NACDonline.org

for more details.

The replay and slides will also be available early

next week at NACDonline.org/webinars and

pearlmeyer.com

Housekeeping

Today’s Discussion

• Breaking News: The SEC’s Proposed Pay-versus-Performance Rules in

a Nutshell

• Review key points from Parts I and II in the Age of Alignment series

• How to set the framework for incentive design analyses

• How to integrate market/industry practice, optics, performance

alignment and business/industry reality

• What to do when the numbers don’t tell the whole story

• Weighting subjective strategic goals over objective financial goals

• In practice: case studies

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The SEC’s Proposed Pay v. Performance Rules

• Time Period: Past 5 years (phase in over 3 years)

• All NEOs Included

- Each CEO for the year, with multiple CEOs aggregated

- All NEOs averaged

• “Actual” Compensation

- Equity in year of vesting

- Service cost of pensions only

• Performance = Total Shareholder Returns (TSR) for Each Year

- Also includes Peer Group TSR for each year (published industry/index/CD&A peers) weighted

based on market cap at beginning of period

• Exemptions

- Emerging Growth Companies, Foreign Private Issuers, Registered Investment Companies

- Smaller Reporting Companies

• Scaled Disclosure (3 years, 3 NEOs, no pensions, no Peer TSR)

• Interactive Data Tagging - XBRL

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DFA 953(a): Disclosure of “the relationship between executive compensation actually paid and the financial

performance of the company taking into account any change in value of the shares of stock and dividends of

the company and any distributions”

The SEC’s Proposed Pay v. Performance Rules

• Disclosure Requirement

- PVP Table

Pay Versus Performance Table (New Item 402(v))

- Description of Two Relationships

• Actual Compensation vs. Company TSR

• Company TSR vs. Peer Group TSR

- Narratives, Graphics, Supplemental Disclosure Permitted

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Year SCT

Total

Compensation

CEO

Compensation

Actually Paid

CEO

Average SCT

Total for Other

NEOs

Average

Compensation

Actually Paid to

Other NEOs

Company Total

Shareholder

Return

Peer Group

Total

Shareholder

Return

2011

2012

2013

2014

2015

Strategy and Incentives (AOA I)

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• Through a rigorous strategy development

process where management and the Board

are involved

- Key performance drivers are identified

- Priorities are established

- Key areas to incentivize can be targeted

• Easy to fall back on pure numbers to drive

incentive design but Strategy should play an

integral role

- Signals to employees the importance of the chosen

strategy

- Reinforces employee understanding and acceptance

of the strategy

- Creates a virtuous cycle where increased

understanding drives aligned actions which helps

accomplish the chosen strategy

Revenue

Growth

Value

Creation

Economic

Profit

Market Share

Return on Invested Capital

New Products

Cost of Capital

Capital

Efficiency

Quality

New Markets

Operating

Margin

Capital

Deployed

Innovation

R&DDistribution

Costs

Working

CapitalPricing

Performance Measures are a Critical Link Betweena Stated Business Strategy and ManagementExecution (AOA II)

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In most cases, the strategy can be

well supported by financial analysis

• Maximize shareholder value

• Company-specific path to value-

creation taking into account

- Market economic; competitive position

- Company strengths, weaknesses,

opportunities and risks

• Specific/relevant financial

measures, balancing growth and

returns

• Operational measures tied to

business strategy

Goal

Centerpiece

Financial Measures

Corporate Processes

Operating Decisions

Incentives Planning &

Resource AllocationReporting

Strategy

Driver Measures

Strategy is Sometimes Not Best Represented Solely by Financial Indicators

• Some situations call for short-term or even long-term

decisions that don’t produce immediate financial results

- Turnarounds

- Industry disruption

- Bankruptcies

- Innovation

• Strategy can be affected by corporate culture and internal

change

- CEO changes

- M&A

- Employee values

• Outside influencers should be understood, but sometimes

intentionally ignored

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Protocol for Designing Incentives

• To be sure that the overall strategy is well supported by

compensation plans, each year the Compensation

Committee should evaluate:

1. The state of the business:

- Strategic imperatives

- Financial imperatives

- Company cultural imperatives

2. The industry:

- Change drivers

- Technological momentum

- Competitive landscape

3. External forces:

- ISS

- Activist shareholders

- Media12

Evaluate

Balance

Adjust

Protocol for Designing Incentives (cont.)

• Determine the balance of the imperatives

• Emerging companies:

- Focus is on product development/launch

- Strategic imperatives take precedence

• Growth companies:

- Focus shifts to expansion of market

- Even weighting between financial & strategic imperatives

• Mature companies:

- Focus shifts to maintenance

- Financial imperatives take precedence

• Turnaround / Industry disruption:

- Focus on efficiency and responsiveness to shifting market

- Strategic imperatives take precedence

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Evaluate

Balance

Adjust

Protocol for Designing Incentives (cont.)

• Adjust the balance for the time horizon

• Short-term incentives should have a different focus than

long-term incentives – avoid redundancy!

• Short-term can include product milestones or market share

growth – encapsulate the short-term priorities!

• Long-term will most often reflect financial imperatives such

as margin improvement or better returns – but could also

contemplate strategic imperatives such as a product phase-

out!

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Evaluate

Balance

Adjust

Case Study #1

Midcap Technology Company

1) Profile:

- Strategic imperatives:

• Shifting business from low-margin hardware to high-margin software

• New product development and introduction

• Need to maintain legacy business to fund R&D

• Change customer mix

- Financial imperatives:

• Maintain positive cash flow

• Hold margin on legacy products

- Cultural imperatives:

• Change executive skill sets to software

• Recognize that long-time employees may feel threatened

• Likely short-term stock-price stagnation (at best) may cause erosion of equity incentives

and negative outlook toward compensation

- Industry imperatives:

• Legacy products were becoming extinct with technological advancement forcing the

entire industry to change 15

Case Study #1

Midcap Technology Company

2) Conclusion:

- Annual bonus program:

• Weighted mix of metrics to strategic goals

- Product introduction

- Major account wins

• Increased weight of MBO metric to 25%

• Kept profitability/loss goal, but decreased weight to 25%

• Any bonuses paid in shares

- Long-term incentives:

• Eliminated performance-based restricted stock

• Weighted grants to stock options

• Included time-based restricted stock for retention

• Planned to re-introduce performance-based restricted stock as business stabilized into

new model

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Case Study #2

Large industrial manufacturer

1) Profile:

- Strategic imperatives:

• Maintain leading position in its core manufacturing business

• Drive discipline around capital investment

• Improve efficiency

- Financial imperatives:

• Provide returns in excess of cost of capital

• Grow stock price (currently underperforming)

- Cultural imperatives:

• History of paying maximum bonuses each year

• Executives undervalue equity grants

• High profile Board is cognizant of shareholder optics

• Economic value added (EVA) concepts drive decision making

- Industry imperatives:

• Cyclical business

• Commodity prices impact customer buying behavior 17

Case Study #2

Large industrial manufacturer

2) Conclusion:

- Annual bonus program:

• Metrics heavily weighted towards ROA to reinforce capital investment discipline

• Goal-setting considers business cycle and peer historic performance

• New addition is emphasis on revenue from new sources (geographic regions, new

products) to encourage top line growth

- Three-year cash bonus program:

• EVA as metric

- LTIP:

• TSR and sales growth

• Performance measured on relative basis

• New addition is re-introduction of stock options to both underscore growth imperative

and provide equity vehicle with greater leverage in cyclical business climate

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Case Study #3

Large Cap Distributor

1) Profile:

- Strategic imperatives:

• Maintain and expand diverse product offerings

• Expand geographic footprint

• Growth through acquisition

- Financial imperatives:

• +10% annual growth

• Increase dividends

- Cultural imperatives:

• Loyal, long-tenured executive team

• Highly team-focused

• Succession planning is ongoing

- Industry imperatives:

• Consolidation is abundant

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Case Studies

Large Cap Distributor

2) Conclusion:

- LTIP reflects long-term growth imperative (PSUs, with performance

assessed vs. 10% EPS growth goal), but also includes RSUs to foster

management continuity

- Bonus program is mix of financial and strategic imperatives

• Corporate financial performance

• Business unit financial performance

• Individual strategic measures

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ADVANCING EXEMPLARY BOARD LEADERSHIP

Questions

Don’t Miss Our Upcoming Webinar

Join NACD and Pearl Meyer & Partners for the next program in our Compensation Series on August 6, 2015.

To register or check out the archives of earlier webinars in this series, visit NACDonline.org/webinars.

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ADVANCING EXEMPLARY BOARD LEADERSHIP

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