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Data effective: June 15, 2020

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For questions or more information, please contact: Ryan Colucci Senior Associate ryan.colucci@capartners.com 646-486-9745 or Joshua Hovden Senior Analyst joshua.hovden@capartners.com 646-512-9135.

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The CAP 120 Company Research consists of companies from ten industries, selected to provide a broad representation of market practice among large U.S. public companies. In this report, CAP reviewed Pay Strategies, Annual Incentives, Long-Term Incentives, Perquisites, and Stock Ownership Guideline Requirement Provisions of these companies in order to gauge general market practices and trends.

Characteristics of the CAP 120 Company Research Sample

The CAP 120 Research Study consists of companies selected from ten industries intended to provide a broad representation of market practice among large U.S. public companies. The fiscal year revenues of the companies in our sample range from approximately $3 billion to $500 billion (median revenue of $32.7B) and are summarized in the following exhibits.

9%12%13%9%10%8%9%10%10%10%IndustriesAutomotiveConsumer GoodsFinancial ServicesHealth CareInsuranceManufacturingOil and GasPharmaceuticalRetailTechnology
Financial Summary ($M) Cumulative Total Shareholder Return Ending on 12/31/2018
Percentile Revenue Net Income Assets Market Cap 1-Year 3-Year 5-Year
75th $67,103 $6,804 $172,979 $99,181 4% 50% 73%
Median $32,716 $3,183 $61,495 $43,956 -12% 21% 33%
25th $18,762 $1,654 $25,487 $21,535 -23% -4% 1%

Pay Strategy

Among companies in CAP’s 120 Research, 97% disclose using a peer group for pay benchmarking purposes. The median number of companies in a peer group is 18.

Consistent with last year, approximately one-third (31%) of the companies with a peer group use more than one peer group. Companies with multiple peer groups either use two peer groups for pay benchmarking (e.g., an industry specific peer group and a general industry peer group) or use one peer group for pay benchmarking and another peer group for relative performance comparisons.

Peer Group (n = 116)
% of companies with a disclosed peer group % of companies with more than one peer group (among companies with a peer group) Median # of companies in peer group
97% 31% 18

While use of a peer group is almost universal among large cap companies, many use a peer group as a reference point when setting pay and do not disclose targeting a specific pay position relative to market. Only half of the companies in our study disclose a target pay philosophy for total compensation. Of these companies, only 7% target total compensation above median.

Target Pay Philosophy (n = 56)
Element Base Bonus Cash Long-Term Incentives Total Compensation
% Disclosing 32% 22% 22% 24% 47%
% Target Below Median Pay 8%
% Target Median Pay 87% 96% 96% 97% 93%
% Target Above Median Pay 5% 4% 4% 3% 7%

Annual Incentive

Annual Incentive Plan Metrics

A majority of CAP 120 companies (90%) fund their annual incentive plans using two or more metrics. Only 10% of companies use 1 metric, reflecting a decrease from 2009, as companies try to balance overall plan funding. Use of multiple performance metrics allows for annual incentive payouts to be reflective of broader company performance.

10%35%55%18%25%57%1 Metric2 Metrics3+ MetricsNumber of Annual Incentive Metrics2018 (n=110)2009 (n=76)

Operating Income (including EBIT, Pre-tax Income and EBITDA), Revenue, EPS, and Cash Flow are the most common metrics used in annual incentive plans. Since our first study, the use of Operating Income and Revenue has been generally consistent. Over this period, the use of EPS, Return Metrics and Net Income has decreased (by 11, 10 and 6 percentage points, respectively).

47%45%41%36%31%15%10%5%46%47%35%47%n/a25%16%n/aOp. Income/EBIT / Pre-taxIncome / EBITDARevenueStrategic / Non-Financial GoalsEPSCash FlowReturn MeasuresNet IncomeOp. MarginAnnual Incentive Metric Prevalence2018 (n=110)2009 (n=76)

Note: In the chart above, n/a = not available. Percentages add to greater than 100% due to multiple responses disclosed by many of the companies. Return measures category is comprised of the following metrics: ROE, ROI, ROIC, and ROA.

More companies are incorporating non-financial measures in the annual incentive plan as they are unique to a company’s strategy. Overall, approximately 40% of companies in our study use strategic and other non-financial measures, with certain industries (e.g., Health Care and Oil and Gas) having more of an emphasis on these measures. An emerging trend is to incorporate ESG (environmental, social and governance) metrics in the annual incentive program. Overall, 14 companies (12%) in our study disclosed such measures; environmental measures are most prevalent (8 companies) followed by diversity and inclusion (6 companies).

The chart below shows the three most common metrics by industry in 2018:

Industry Metrics
Metric #1 Metric #2 Metric #3
Automotive (n=11) Cash Flow (73%) Op. income / EBIT / EBITDA (64%) Revenue (36%)
Consumer Goods (n=14) Revenue (71%) EPS (57%) Op. income / EBIT (50%)
Financial Services (n=7) EPS (68%) Return Metrics (43%) Strategic Goals (43%)
Health Care (n=11) Strategic Goals (64%) Op. income / Pre-tax Income (55%) EPS (45%)
Insurance (n=12) Op. Income (58%) Op. EPS (33%) Op. ROE (25%)
Manufacturing (n=10) Cash Flow (60%) EPS (50%) Op. Income (20%)
Oil and Gas (n=11) Strategic Goals (64%) Op. Income / EBITDA (55%) ROIC (36%)
Pharmaceuticals (n=11) Revenue (73%) Pipeline / R&D (73%) EPS (64%)
Retail (n=11) Revenue (82%) Op. Income / EBIT / Pre-tax Income (82%) Strategic Goals (27%)
Technology (n=12) Revenue (67%) Cash Flow (50%) Op. income / Pre-tax Income (50%)

Note: Percentages reflect the prevalence of companies disclosing the metric.

Award Leverage

CAP reviewed proxy disclosures to understand how companies establish annual incentive payout ranges (i.e., threshold payout and maximum payout expressed as a percentage of the target award). 45% of companies in our study disclose a threshold annual incentive payout at a defined level other than zero. The most common threshold payout for these companies is 50% of target. Other companies start at a 0% payout for threshold performance with payout levels progressing to target.

A majority of companies (84%) disclose a maximum annual incentive opportunity. Most of these companies (74%) have a maximum bonus opportunity of 200% of the target award; only a handful of companies (7) have a maximum payout above 200% of target. We continue to see a decline in the number of companies with a maximum payout above 200% of target (8 companies in 2017 and 11 companies in 2016).

Threshold Payout as a % of Target (n = 54)
Range % of Cos.
< 25% 24%
25% to < 50% 26%
50% 48%
> 50% to < 100% 2%
Maximum Payout as a % of Target (n = 101)
Range % of Cos.
> 100% to < 150% 5%
150% to < 200% 14%
200% 74%
> 200% to < 250% 6%
250% or more 1%

Long-Term Incentives

Long-Term Incentive Vehicle Prevalence

A vast majority of companies in our study (84%) use multiple long-term incentive vehicles for the most senior executives. Slightly more than half of the companies (55%) use two long-term incentive vehicles, typically delivered through either a long-term performance plan and time-based restricted stock/units (an uptick this year to 58%) or a long-term performance plan and stock options.

The next most common approach is to use three vehicles (29% of companies). A small percentage of companies in our study (16%) use only one vehicle and it is most typically delivered in the form of a long-term performance plan (84%).

16%55%29%Number of LTI Vehicles1 Vehicle2 Vehicles3 Vehicles

Performance-based LTI awards for senior executives is used nearly universally among large cap companies (95%) and the use of stock options has declined to 51% of companies. This contrasts our first study when the use of stock options and performance-based LTI was fairly balanced (79% used performance-based LTI and 73% used stock options). The prevalence of time-based restricted stock/units has remained flat.

95%51%62%79%73%62%Performance-Based LTIStock OptionsTime-Based RS/RSULong-Term Incentive Vehicle Prevalence2018 (n=120)2009 (n=85)

LTI Award Mix

Performance-based LTI reflects the largest portion of the LTI mix for the CEO. For the first time in our large cap company study, time-based restricted stock reflects a larger portion of the total LTI mix than stock options. The decrease in the value delivered in stock options has shifted to performance-based LTI in the overall LTI mix. The value delivered in time-based restricted stock/units has been generally flat since 2011.

46%62%34%16%20%22%20112018CEO Average Long-Term Incentive Vehicle MixPerformance-based LTIStock OptionsTime-based RS/RSUs

Restricted Stock / Units (RS/RSU) and Stock Option Provisions

The majority of companies use ratable vesting over a period of three years for time-based RS/RSU awards. Approximately 30% of companies use a vesting schedule of four years or more.

68%28%4%Time-based RS/RSUVesting ApproachRatableCliffPerf-Based72%17%11%Time-based RS/RSUVesting Years3 Years4 Years>4 Years

For stock options, most companies use 3-year ratable vesting with a 10-year term.

Stock Options
Vesting Approach Vesting (Years) Term (Years)
Ratable Perf-Based Cliff 3 4 > 4 10 < 10
82% 2% 16% 69% 26% 5% 92% 8%

Performance-Based Award Provisions

The payout curve for performance-based LTI awards with upside and downside leverage mirrors the payout curve for annual incentive awards; the most common threshold payout is 50% of target and the most common maximum payout is 200% of target. Unlike annual incentive awards, a large number of companies (41% for long-term plans vs. 26% for annual incentive plans) disclose a threshold payout between 25% – 50% of the target award.

Threshold Payout as a % of Target (n=74)
Range % of Cos.
< 25% 11%
25% to < 50% 41%
50% 46%
> 50% to < 100% 3%
Maximum Payout as a % of Target (n=106)
Range % of Cos.
100% 1%
> 100% to < 200% 32%
200% 62%
> 200% to < 250% 1%
250% or more 4%

Performance Metrics

Total Shareholder Return (TSR) continues to be the most prevalent performance metric in long-term performance plans; 63% of companies use it as a measure in the performance-based LTI plan. Return metrics are the second most common measure (51% of companies) followed by EPS (31%) and Revenue (23%).

In CAP’s first study, EPS was the most common measure followed by TSR. The rise in the use of TSR can be linked to the influence of proxy advisors who have increasingly used TSR as a proxy for performance since our first study (conducted prior to the adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act which mandated the shareholder Say on Pay vote). Of the companies that use TSR, approximately 30% disclose using it as an award modifier instead of a weighted metric.

The decline in the use of EPS in performance-based LTI plans is consistent with the decline of EPS use in annual incentive plans. Interestingly, the use of return measures has increased significantly from our first study (51% in 2018 vs. 20% in 2009) as companies are aligning executive long-term pay with profitable growth and operational efficiency. Return metrics are also often favored by institutional shareholders.

63%51%31%23%13%35%20%42%22%11%TotalShareholderReturnReturnMeasuresEPSRevenueCash FlowPerformance-based LTI Metrics2018 (n = 115)2009 (n = 65)

Note: Percentages add to greater than 100% due to multiple responses disclosed by many of the companies. Return measures category is comprised of the following metrics: ROE, ROI, ROIC, and ROA.

Performance Measurement – Absolute vs. Relative

A majority of companies in our study balance absolute financial performance goals (based on budget) with relative metrics. This balanced approach has increased substantially since our first study. Today, 52% of companies use both absolute and relative metrics vs. 25% of companies in 2009. This increase is tied to the increase use of relative TSR as a long-term metric.

In our most recent study, only 11% of companies use relative performance metrics only (down from 26% in 2009) and 37% of companies use absolute metrics only (down from 49% in 2009).

60%87%11%52%37%51%74%26%25%49%RelativeMetricsAbsoluteMetricsRelative Metrics OnlyRelative and AbsoluteMetricsAbsolute Metrics OnlyPerformance-based LTI: Absolute vs. Relative Metrics2018 (n = 115)2009 (n = 65)

Perquisites

A majority of companies in our study (87%) provide perquisites to their CEO. Most companies (69%) also provide perquisites to the CFO. These findings are consistent with our study last year.

Personal use of aircraft, personal security, financial planning and automobile allowance continue to be the most common CEO perquisites. Even though the percentage of companies providing perquisites to the CEO has been relatively flat, the percentage of companies providing the most common perks has increased suggesting that when companies are providing perks to their CEO, it is likely a combination of the four most common categories.

69%45%41%38%56%29%24%31%Personal Use of AircraftPersonal SecurityFinancial PlanningAutomobile AllowanceCEO Perquisite Prevalence20182014

The median value of perquisites delivered to the CEO in 2018 ($125,000) is lower than the value five years ago ($143,000). There was nearly a 30% increase however, in the median perquisite value for the CFO in 2018 ($32,000) compared with 2014 ($25,000).

$125$32$143$25CEOCFOMedian CEO and CFO Perquisites Value ($000s)20182014

Stock Ownership Requirement Provisions

Stock ownership guidelines are very common in publicly traded companies and are viewed favorably from a governance perspective. 95% of companies in our sample have requirements in place for the NEOs. For the CEO, the median guideline (expressed as a multiple of base salary) is 6x and for other NEOs it is 3x.

Stock Ownership

Guideline

Median Multiple of Base Salary
CEO CFO Other NEO
95% 6x 3x 3x

Many companies (52%) have a stock holding requirement in place in addition to the stock ownership guideline requirement for senior executives. It continues to be less common for companies to have stock holding policies that are independent of stock ownership guidelines, or that apply after the ownership requirement has been achieved. These holding policies require executives to hold net shares received from equity awards for periods ranging from one year (most common) to post-retirement. These are generally viewed as shareholder friendly, yet their prevalence has remained fairly consistent over the past few years.

Holding Requirement Until SOG is Met Holding Requirement Separate from or After SOG is Met Holding Period for Separate/Post-SOG Requirements (n=26)
1 Year 5 Years Until Retirement Post Retirement
52% 22% 54% 4% 23% 19%

For questions or more information, please contact:

Melissa Burek Partner
melissa.burek@capartners.com 212-921-9354

Lauren Peek Principal
lauren.peek@capartners.com 212-921-9374

CAP’s Industry Report summarizes 2016 Chief Executive Officer (CEO) compensation relative to 2016 company performance, as well as incentive compensation practices, for a sample of 19 large U.S.-based Consumer Product companies.

2016 Company Performance

2016 was a mixed performance year for the companies in CAP’s Consumer Products sample. While profitability improved, total shareholder return (TSR) underperformed the broader market.

GAAP revenue for CAP’s sample decreased -1% at median during 2016, following a -2% decrease in 2015. The continued strengthening of the U.S. dollar has contributed to FX headwinds for the companies in CAP’s sample, as they have significant international exposure – on a consolidated basis, 45% of fiscal 2016 revenue was generated overseas. Adjusted revenue, a common incentive plan performance metric, which is generally reported on an FX-neutral basis, increased +3% and +4% at median in 2016 and 2015, respectively.

Operating margin (defined as earnings before interest and taxes, or EBIT, divided by revenue) and earnings per share (EPS) growth improved year-over-year on both a GAAP and adjusted basis. Continued focus on cost savings and productivity has helped to boost profitability among companies in CAP’s Consumer Products sample. Industry consolidation and improvements in product mix have also contributed to margin expansion.

For the full year 2016, median TSR for companies in CAP’s Consumer Products sample was +5%, below the median TSR for the S&P 500 of +13%. Companies in CAP’s sample did not experience the same post-election stock price rally enjoyed by the broader market. Through November 8, 2016, the median TSR for CAP’s sample kept pace with the median TSR for the S&P 500 +10% to +8%, respectively. During the remainder of the year, however, median TSR for CAP’s sample was -1%, while the median TSR for the S&P 500 was +4%.

Year Median Financial Performance for CAP’s Consumer Products Sample
Revenue Growth Operating Margin EPS Growth
GAAP Adjusted GAAP Adjusted GAAP Adjusted
2016 -1% +3% 16% 18% +8% +12%
2015 -2% +4% 15% 16% +4% +4%
Y/Y Change +1% pts -1% pts +1% pts +2% pts +4% pts +8% pts
Group Median TSR – CAP’s Consumer Products Sample vs. S&P 500
2015 2016
1/1 to 11/8 11/9 to 12/31 Full Year
CAP’s Consumer Products Sample +17% +10% -1% +5%
S&P 500 +1% +8% +4% +13%

Annual Incentive Payouts for CEOs

At median, annual incentives for 2016 performance paid out at 117% of target, essentially unchanged from 2015 (118%). 75th percentile payouts were similarly flat – 140% for 2016, compared to 147% for 2015. However, payouts increased dramatically at the low end of the range, as the 25th percentile payout jumped from a below-target 74% for 2015, to an above-target 109% for 2016. More than a quarter of the companies in CAP’s Consumer Products sample paid an above-target bonus for 2016, after paying a below-target bonus for 2015.

Summary Statistic CEO Annual Incentive Payouts as a Percent of Target
2015 2016
75th Percentile 147% 140%
Median 118% 117%
25th Percentile 74% 109%
CEO Annual Incentive Payouts as a Percent of Target(Prevalence among CAP's Consumer Products Sample) 5% 32% 21% 42% 58% 21% 21% 2015 2016 ≥ 150% of Target 100% > 150% 50% > 100% < 50%

Consistent with the year-over-year trend in payouts as a percent of target, 2016 payouts on a dollar value basis were unchanged from 2015, which is generally aligned with adjusted financial performance which was unchanged year-over-year.

Changes in CEO Target Compensation

The median change in target total direct compensation (defined as the sum of base salary, target annual incentive, and long-term incentives) was 5% from 2015 to 2016, driven primarily by increases in variable compensation: the median increase in long-term incentive award values was 5% and the median increase in target annual incentive award values was 3%.

For 2016, just over half of the CEOs in CAP’s Consumer Products sample received a base salary increase. The median increase was 2%.

In reaction to external pressure, boards of directors are increasing CEOs’ accountability for sustained performance. To that end, boards are turning to long-term incentives to reward executives, often in lieu of increases to annual incentives and base salaries.

Compensation Element 2015-16 Median Change in CEO Compensation
Base Salary 2%
Target Annual Incentive Award Value 3%
Long-Term Incentive Award Value 5%
Target Total Direct Compensation 5%

Incentive Compensation Practices: Annual and Long-Term Incentives

85% to 90% of target total direct compensation for CEOs of large U.S.-based companies comprises variable compensation (i.e., annual and long-term incentives). Among the companies in CAP’s Consumer Products sample, variable compensation accounts for 89% of target total direct compensation, on average.

11 % 22 % 19 % 78 % 70 % VariableCompensationMix TargetCompensationMix Compensation Mix(Average among CAP's Consumer Products Sample) Base Salary Annual Incentive Long-Term Incentives

Annual Incentives

Annual incentives encourage and reward successful performance against short-term company and/or individual objectives. For the companies in CAP’s Consumer Products sample, annual incentives make up 19% of target total direct compensation, on average.

Performance Metrics

The objectives underlying annual incentive plans are often associated with short-term growth and profitability. Accordingly, among the companies in CAP’s Consumer Products sample, revenue, operating income (or EPS), and net income (or EPS) are the most common financial performance metrics – 100% of companies use at least one of these metrics, and nearly 75% of companies balance the use of a “top-line” revenue metric with one or more “bottom-line” income metrics.

Revenue and income are typically measured on an adjusted, as opposed to GAAP, basis. For instance, two-thirds of the companies in CAP’s sample that use revenue growth as an annual incentive performance metric use FX-neutral revenue growth. Other common adjustments to revenue and/or income include the exclusion of results from businesses acquired or divested during the performance year, as well as one-time gains or charges, such as those related to corporate restructuring.

Annual incentive metrics measuring performance against strategic objectives are also common among companies in CAP’s Consumer Products sample. Workplace diversity is considered by more than half of the companies that use strategic metrics. Innovation, cost savings, and market share are also prevalent strategic metrics; each are used by approximately one third of the companies that use strategic metrics.

58% of the companies in CAP’s Consumer Products sample consider individual performance in the determination of the CEO’s annual incentive award. Among these companies, the way in which individual performance impacts the annual incentive award is mixed. Some companies include individual performance as a discrete additive component in the annual incentive formula. Others use individual performance to modify awards; this can be done objectively, using a “multiplicative modifier,” or on a more subjective, discretionary basis.

79% 58% 53% 26% 21% 58% 58% 0% 25% 50% 75% 100% Revenue Financial Performance Metrics OperatingIncome/EPS NetIncome/EPS Cash Flow Return onInvestment StrategicObjectives IndividualObjectives Annual Incentive Performance Metrics (Prevalence among CAP's Consumer Products Sample)

Long-Term Incentives

Long-term incentives tie executive compensation to performance against the company’s longer-term objectives. Awards are typically delivered using equity-based vehicles with multi-year vesting periods; this helps to align the interests of executives with those of shareholders, and serves as a retention incentive. For the companies in CAP’s Consumer Products sample, long-term incentives make up 70% of target total direct compensation, on average.

26% 12% 62% Long-Term Incentive Vehicle Mix(Average among CAP's Consumer Products Sample) Time-Vested Restricted Shares Time-Vested Stock Options Performance Plan

Vehicle Mix

Long-term incentive vehicles can be bucketed into three broad categories: (1) time-vested restricted shares (or units); (2) time-vested stock options (or stock appreciation rights); and (3) performance plans. Performance plans include performance shares (or units), performance-vested stock options, and performance-based cash compensation with multi-year performance criteria.

All of the companies in CAP’s Consumer Products sample use a performance plan to deliver long-term incentives to the CEO. However, the use of a performance plan as the exclusive long-term incentive vehicle is uncommon: 44% and 11% of companies in CAP’s sample mix a performance plan with time-vested stock options and time-vested restricted shares, respectively. 28% of companies use all three vehicles.

17% 11% 44% 28% 0% 10% 20% 30% 40% 50% Perf. Plan(LTPP) RS + LTPP SO + LTPP RS + SO+ LTPP Long-Term Incentive Vehicles(Prevalence among CAP's Consumer Products Sample)

Performance Metrics

While annual incentives emphasize short-term growth and profitability, long-term incentives generally encourage and reward long-term value creation. Approximately four-fifths of the companies in CAP’s Consumer Products sample use one or more return metrics in the long-term incentive plan: TSR is used by 50% of companies, return on investment is used by 33% of companies, and economic profit is used by 11% of companies. All of the companies that use TSR measure performance on a relative basis against a company-defined peer group or broad-market index. Among the companies that use relative TSR, 67% use one or more additional absolute performance metrics.

50% 44% 44% 33% 17% 11% 11% 0% 25% 50% 75% 100% TSR Revenue Net Income/EPS Return onInvestment Cash Flow EconomicProft/EVA OperatingIncome/EPS Long-Term Incentive Performance Metrics(Prevalence among CAP's Consumer Products Sample)

Conclusion

Similar to other industries, Consumer Product companies are not immune to macroeconomic factors and external challenges impacting their businesses. Between taxes on soda, competition from store brands / smaller upstarts, battle for shelf space and health conscious consumers, consumer product companies are facing a decrease in sales volume and market share. The shift in shopper preferences has continued in 2017 and will force these companies to find new ways to increase profitability and market share.

As a result of this competition, companies are balancing strategic objectives and individual performance with top-line growth and bottom-line performance in their incentive plan design. Boards and management will need to continue to reinforce the emphasis on pay and performance and ensure that the appropriate behaviors and results are being rewarded, performance targets are reflective of the long-term strategy and incentive plan design supports current business needs.

Boards and management need to be mindful that as incentive plan metrics are tied to adjusted financials, proxy advisory firms will be using GAAP metrics when calculating the pay for performance relationship, which can vary greatly from the adjusted metrics. This may impact the pay for performance alignment and impact the Say on Pay vote if the proxy advisory firm recommends Against Say on Pay.


For questions or more information, please contact:

Dan Laddin Partner daniel.laddin@capartners.com 212-921-9353

Shaun Bisman Principal shaun.bisman@capartners.com 212-921-9365

Kyle Eastman Associate kyle.eastman@capartners.com 212-921-9362

Ryan Colucci Associate ryan.colucci@capartners.com 646-486-9745

Kyle Clemenza and Rebecca Wertman provided research assistance for this report.


CAP’s Consumer Products Sample

Altria Group, Inc.
Avon Products, Inc.
Campbell Soup Company
The Clorox Company
The Coca-Cola Company
Colgate-Palmolive Company
Conagra Brands, Inc.
The Estée Lauder Companies Inc.
General Mills, Inc.
The J. M. Smucker Company
Kellogg Company
Kimberly-Clark Corporation
Mondelēz International, Inc.
Newell Brands Inc.
NIKE, Inc.
Pepsico, Inc.
The Procter & Gamble Company
Starbucks Corporation

Christopher Y. Clark, publisher of NACD Directorship Magazine, hosts this edition of NACD BoardVision with guest Melissa Burek, partner at Compensation Advisory Partners. The discussion centers around the obvious and no so obvious results from say on pay voting, how performance fits into the results, and what surprises could be ahead in 2014.

Companies use annual bonuses as a tool to reward executives for achieving short-term financial and strategic goals. Setting appropriate annual performance goals is essential to establishing a link between pay and performance. Goals should achieve a balance between rigor and attainability to motivate and reward executives for driving company performance and creating returns for shareholders.

Key Takeaways:

  • Based on our analysis of actual incentive payouts over the past 6 years, the degree of difficulty, or “stretch”, embedded in annual performance goals translates to:
    • A 95% chance of achieving at least Threshold performance
    • A 75% chance of achieving at least Target performance
    • A 15% chance of achieving Maximum performance
  • This pattern indicates that target performance goals are challenging, but attainable, and maximum goals are achievable through highly superior performance
  • The majority of companies use two or more metrics when assessing annual performance
  • Annual incentive payouts have been directionally linked with earnings growth over the past 6 years

Summary of Findings

Plan Design

For the purposes of this study, we categorized annual incentive plans as either goal attainment or discretionary. Companies with goal attainment plans define and disclose threshold, target and maximum performance goals and corresponding payout opportunities. Alternatively, companies with discretionary plans do not define the relationship between a particular level of performance and the corresponding payout. Discretionary programs provide committees with the opportunity to determine payouts based on a retrospective review of performance results.

Annual Incentive Plan Type
Industry Sample Size Goal Attainment Discretionary
Auto n= 8 100% 0%
Consumer Discretionary n= 10 90% 10%
Consumer Staples n= 12 67% 33%
Financial Services n= 12 17% 83%
Healthcare n= 9 89% 11%
Industrials n= 14 71% 29%
Insurance n= 12 67% 33%
IT n= 12 83% 17%
Pharma n= 10 80% 20%
Total 72% 28%

Consistent with the findings from our study conducted in 2014, 72% of sample companies have goal attainment plans. Our study focuses on these companies.

Performance Metrics

Most companies (61%) use 3 or more metrics to determine bonus payouts. This reflects a shift from 2014, where 48% of companies used 3 or more metrics. Companies annually review metrics to ensure that they align with the business strategy.

Many companies use financial metrics such as revenue and profitability, which are indicators of market share growth and stock price performance. Some bonus plans also include strategic metrics, which incentivize executives to achieve goals that may contribute to long-term success, but may not be captured by short-term financial performance. Companies in the pharmaceutical industry often use strategic goals, such as pipeline development. Similarly, companies with large manufacturing operations often use quality control metrics.

  # of Metrics Used in Goal Attainment Plan  
Industry 1 Metric 2 Metrics 3 Metrics 4+ Metrics
Auto 13% 13% 25% 50%
Consumer Discretionary 11% 44% 45% 0%
Consumer Staples 0% 37% 38% 25%
Financial Services 0% 50% 50% 0%
Healthcare 0% 38% 12% 50%
Industrials 20% 40% 20% 20%
Insurance 37% 13% 25% 25%
IT 10% 30% 40% 20%
Pharma 0% 0% 63% 37%
Total 11% 28% 34% 27%

Pay and Performance Scales

Compensation committees annually approve threshold, target, and maximum performance goals, and corresponding payout opportunities, for each metric in the incentive plan. Target performance goals are typically set in line with the company’s internal business plan. Executives most often earn 50% of their target bonus opportunity for achieving threshold performance and 200% for achieving maximum performance. Actual payouts are often interpolated between threshold and target and target and maximum.

Annual Incentive Plan Payouts Relative to Goals

All Companies

Based on CAP’s analysis, companies paid annual bonuses 95% of the time. Payouts for the total sample are distributed as indicated in the following charts:

This payout distribution indicates that committees set annual performance goals with a degree of difficulty or “stretch” such that executives have:

  • A 95% chance of achieving at least Threshold performance
  • A 75% chance of achieving at least Target performance
  • A 15% chance of achieving Maximum performance

From 2010-2015, no more than 10% of companies failed to reach threshold performance in any given year. By comparison, in both 2008 and 2009, which were challenging years, approximately 15% of companies failed to reach threshold performance goals.

When looking back over 8 years (2008-2015), companies achieved at least threshold and target performance with slightly less frequency. Based on CAP’s analysis of this 8-year period, executives have:

  • A 90% chance of achieving at least Threshold performance
  • A 70% chance of achieving at least Target performance
  • A 15% chance of achieving Maximum performance

By Industry

Pharmaceutical and healthcare companies have paid at or above target more frequently than companies in any other industry over the past 6 years. Both industries have experienced significant growth over the period in part due to consolidation. The companies in the IT, Consumer Discretionary and Consumer Staples industries tend to pay below target at a higher rate. Average payouts for each industry are distributed as indicated in the following chart:

Relative to Performance

CAP reviewed the relationship between annual incentive payouts and company performance with respect to three metrics: revenue growth, earnings per share (EPS) growth and earnings before interest and taxes (EBIT) growth. While payouts were generally aligned with revenue and EPS growth, they most closely tracked with EBIT growth over the period studied (2010-2015). Companies may seek to align bonus payouts with operating measures, such as EBIT, as they capture an executive’s ability to control costs and improve operational efficiency.

The chart below depicts the relationship between median revenue, EPS, and EBIT growth and target and above annual incentive payouts among the companies studied.

Conclusion

In the first quarter of 2017, committees will certify the results and payouts for the fiscal 2016 bonus cycle and approve performance targets for fiscal 2017. Given the uncertain economic outlook following the 2016 presidential election, establishing performance targets for 2017 may be more challenging than usual. Companies may choose to use a range of performance from threshold to maximum to build flexibility into their plans given the unpredictable environment. Our study of annual bonus payouts over the past 6-8 years supports setting goals such that the degree of difficulty, or “stretch”, embedded in performance goals translates to:

  • A 90-95% chance of achieving at least Threshold performance
  • A 70-75% chance of achieving at least Target performance
  • A 15% chance of achieving Maximum performance.

Companies should continue to set target performance goals that are challenging, but attainable and maximum goals that are achievable through outperformance of internal and external expectations – therefore, establishing a bonus plan that is attractive to executives and responsible to shareholders.

Methodology

CAP’s study consisted of 100 companies from 9 industries, selected to provide a broad representation of market practice across large U.S. public companies. The revenue size of the companies in our sample ranges from $18 billion at the 25th percentile to $70 billion at the 75th percentile.

CAP analyzed the annual incentive plan payouts of the companies in the sample over the past 6-8 years to determine the distribution of incentive payments and the frequency with which executives typically achieve target payouts. In this analysis, CAP categorized actual bonus payments (as a percent of target) into one of six categories based on the following payout ranges:

Payout Category Payout Range
No Payout 0%
Threshold Up to 5% above Threshold
Threshold – Target 5% above Threshold to 5% below Target
Target +/- 5% of Target
Target – Max 5% above Target to 5% below Max
Max 5% below Max to Max

Spin-offs have been in the news for several years. Fully 60 spin-off transactions occurred in 2014, followed by another 40 spin-offs in 2015, with 13 involving S&P 500 companies.1 Spin-off activity continued to be newsworthy in 2016 with major spin-offs completed by Alcoa, Danaher, Emerson Electric, Johnson Controls, and Xerox. Spin-off activity will continue into 2017 with a number of pending transactions including major companies like Ashland, Biogen, Hilton Worldwide, and MetLife. The need to create shareholder value during a period marked by low returns from most asset classes is driving the spin-off activity. In some cases, activist shareholders have pushed companies to create value by breaking businesses into their component parts. When a business undergoes a spin-off, the human resource and executive compensation implications for executives at both the Parent Company (ParentCo) and the Spin-off Company (SpinCo) are very significant.

We have advised many companies as they worked through the spin-off process and we want to share some of what we have learned. As a starting point, we have identified four critical work streams for executive compensation in a spin-off:

  1. Establishing Transitional Compensation Arrangements (e.g., near-term retention plans)
  2. Understanding and/or Modifying Outstanding Compensation Arrangements (e.g., outstanding equity awards, severance and change in control agreements, benefit plans, etc.)
  3. Developing Going Forward Compensation Programs for SpinCo, equivalent in many ways to standing up a newly public company in an IPO
  4. Modifying Compensation Programs for ParentCo, as necessary to reflect new business focus and business scale

1. Establishing Transitional Compensation Arrangements

After deciding that a portion of the business is going to be spun-off, one of the first compensation decisions that needs to be addressed is how to structure incentive compensation programs for the company in the year of the spin-off. How complex this step is will depend on the timing of the spin-off in the fiscal year and the nature of the company’s annual and long-term incentive plans. A general principle is that if the spin-off has already been announced at the time design decisions are being made, SpinCo incentive compensation should be based primarily on SpinCo performance to provide better line-of-sight for SpinCo employees and to facilitate the transition.

Annual Incentive Plans

If the upcoming spin-off is a known event at the time that the annual incentive award is made, the transitional incentive plan can be simplified by ensuring that the annual incentive for SpinCo executives is tied 100% to SpinCo performance for the entire fiscal year. In this case, SpinCo executives will be paid an annual incentive based on SpinCo’s performance early in the fiscal year following the spin-off.

In some cases, the annual incentive award may already have been granted prior to the announcement of the spin-off. In such a situation, it is likely that the incentive plan for SpinCo employees will be based on a combination of ParentCo and SpinCo performance up to the time of the spin-off and then on SpinCo performance for the remainder of the year. This may require the company to establish SpinCo specific performance goals for the “stub period” from the completion of the spin-off to the end of the fiscal year. The performance measures for the “stub period” are typically the same performance measures used to assess SpinCo performance for the portion of the fiscal year prior to the completion of the spin-off.

Long-term Incentive Plans

Similar to the short-term incentive, if the company knows that the spin-off is going to take place during the fiscal year, there are design decisions that can help to facilitate transitioning the long-term incentive awards. For any performance-based awards (e.g., performance shares/units/cash), SpinCo employees should be granted awards that are based on multi-year performance objectives for the SpinCo. In some cases, companies will avoid making performance-based awards to SpinCo employees in the year of the transition because of the challenges in maintaining a consistent performance measurement approach before and after the spin-off.

If the spin-off is not a known event at the time that performance awards are made, there may be challenges in converting ParentCo performance awards into SpinCo performance awards at the time of the spin-off. In these cases, some companies will truncate the payout based on the ParentCo performance to date, at spin, and establish SpinCo goals for the remainder of the overall performance period. We will address this issue in greater detail in the next section on the treatment of outstanding awards following the spin-off.

Special Transition Compensation Programs

Most SpinCo employees are likely to view the spin-off as a positive event. Staff positions (e.g., finance, legal, human resources, etc.) will often have enhanced roles and responsibilities at the new company, given the stand-alone nature of the business. Line positions (e.g., business unit executives and staff) often feel that the spin-off provides them with a greater ability to impact business performance.

On the other hand, announcement of a spin-off creates uncertainty about the future prospects of the business. In addition, the SpinCo is a potential acquisition target, with the business potentially being sold rather than spun-off to shareholders. In many cases, it makes sense to review the severance protection in place for SpinCo staff in advance of announcing the spin-off. If there is a real chance that the business may be sold, enhanced severance protection may be needed to ensure that staff positions do not “jump ship”.

There may also be employee retention concerns at the ParentCo. While the spin-off is generally a positive event for SpinCo employees, spin-offs can create concerns for ParentCo employees. For ParentCo employees, a spin-off means working for a smaller company in the future, with a less complex and potentially less interesting job. In addition, the spin-off transaction will create additional work for all corporate staff positions as they set up the newly public company and continue to do their “day job”. For select ParentCo employees, a near-term retention bonus or short-term stock retention grant may provide recognition for their additional workload and focused efforts on preparing for a successful transaction, and help to keep them engaged in a stressful working environment. To the extent that certain corporate staff positions will no longer be needed following the spin-off, there may also be a need for enhanced severance for corporate staff.

2. Understanding and/or Modifying Outstanding Compensation Arrangements

As the company approaches the spin-off, a key compensation issue is how to adjust outstanding compensation arrangements to recognize that one company is breaking up into two companies. Decisions need to be made about what will happen to the company’s long-term incentive plans, as well as retirement plans and deferred compensation plans. For purposes of this discussion, we will focus on long-term incentive plans, as it is an area that is particularly critical for executive compensation.

The treatment of outstanding long-term incentives (particularly equity incentives), can be complex following a spin-off. There are several steps that need to be taken to transition awards, including review of the following:

  • What provisions are specified in the equity plan and equity award agreements?
  • Should the Committee apply discretion to modify the treatment of employees’ awards based on the circumstances of the transaction?
  • What is the preferred approach for converting ParentCo equity (i.e., ParentCo post-spin and SpinCo equity)?
  • What will be the timing of the conversion of equity?

Existing Equity Plan and Award Agreements

The first step in reviewing outstanding equity is to understand the treatment that the company’s equity plan and the individual award agreements prescribe for outstanding equity awards. A key issue to understand is what will happen to the awards held by employees of SpinCo. In many cases, the spin-off constitutes a termination of employment and, under ParentCo’s plans, unvested awards are forfeited at the spin-off.

It is important to understand the extent to which the prescribed approach impacts the bottom line of both entities. It is also important to work with internal and external counsel to ensure that there is a common understanding of the contractual rights of employees under the equity plan and award agreements.

Another key issue is whether the plan provides for the conversion of outstanding awards in a spin-off transaction. The plan document will likely include a section addressing a change in capital structure and transactions like a spin-off. In most cases, the Committee is required to convert vested awards to preserve value, but is afforded significant latitude in determining the details of the conversion.

Exercise of Compensation Committee Discretion

In our experience, most Compensation Committees do not want SpinCo employees to forfeit outstanding unvested equity as a result of a spin-off transaction. Forfeiture of previously awarded equity could have a serious impact on morale. One way to address this is to accelerate vesting in ParentCo equity or to provide for continued vesting post-spin. Alternatively, if the ParentCo’s Compensation Committee does not take action to keep SpinCo’s employees whole, then SpinCo’s Compensation Committee may need to take action following the spin-off. But it is important to keep in mind that each situation is different. If outstanding awards are underwater, the spin-off may be an opportunity to eliminate overhang on the stock.

Approaches for Conversion of ParentCo Equity

There are several approaches that are used in practice when addressing how to treat outstanding equity upon a spin-off. The following table provides an overview of the alternative approaches:

Approach

Description

Employee

Employee awards are converted to equity in the company where they are employed. The participants of the equity plan who remain employed by ParentCo retain adjusted ParentCo equity awards. The equity plan participants who are employed by SpinCo receive converted SpinCo equity awards with same terms and conditions

Shareholder

Employees are treated like shareholders. Regardless of where the participant is employed following spin-off, outstanding awards of all equity plan participants are converted into both ParentCo and SpinCo equity at the same conversion ratio as shareholders, with the same terms and conditions as the original awards

Hybrid

A combination of the “Employment” and “Shareholder” approaches based on any of the following: (i) when the equity award was granted, (ii) where the equity holder is employed post-spin, (iii) when the equity award will vest, and/or (iv) the type of equity held at spin-off

Adjustment Only, No Conversion Approach

All employees retain adjusted ParentCo equity with same terms and conditions. Continued employment with SpinCo is treated as employment with ParentCo, for purposes of continued award vesting

While several approaches to conversion are used in practice, the Employee approach is the most consistent with the goal of aligning the executives of the company with the shareholders of the entity they support following the spin-off. Other approaches (e.g., shareholder) may attempt to recognize the efforts of employees, prior to the spin, given that such efforts contribute to the future business success of both entities, post spin. The hybrid approach is sometimes used in situations where there is a significant difference in the growth prospects of the SpinCo or ParentCo. (i.e., ParentCo is expected to have modest price appreciation potential and SpinCo has strong growth prospects). And it is sometimes the case that different treatments may apply to employees within one entity. For example, if the ParentCo hires a senior executive for SpinCo from outside the company, prior to the spin, their awards may convert using the Employee approach if they have minimal service at ParentCo, yet the Shareholder approach may be used for other employees.

For outstanding long-term performance share or unit/cash plans (typically with three-year performance cycles), practice is mixed, and the conversion approach used will depend on the length of time remaining in the outstanding award cycle, the performance measures used, whether a new program is put in place in SpinCo, and the type of SpinCo company structure. In many cases, ParentCo prorates outstanding LTI awards held by employees of SpinCo to reflect their time as an employee of ParentCo. The prorated awards held by SpinCo employees are then paid out based on the original performance criteria at the time payments are made to ongoing employees of ParentCo. Once employees have transferred to SpinCo, the remaining stub periods of each outstanding award may be paid out at the target award amount, or, in cases where the Committee of SpinCo wants to preserve a performance-based focus, they may establish new performance goals based on operational or stock performance of SpinCo. There are challenges associated with setting goals for these ‘interim’ performance periods, yet many companies will do so.

Retirement Programs. Agreement on the treatment of retirement programs, non-qualified deferred compensation (“NQDC”) plans and other benefits is a critical administrative decision. If ParentCo has a defined benefit plan, it must determine whether to transfer assets and liabilities of the pension associated with SpinCo employees to SpinCo. A decision on whether any applicable grandfathering of frozen plans/plan benefits will continue is also required. Non-qualified benefit programs are often only partially funded, or unfunded, and the amounts can be significant. Typically, employee accounts in any NQDC plan of ParentCo are transferred to a SpinCo plan for employees of SpinCo. Alternatively, SpinCo could receive a payout of the NQDC applicable balances. Plan provisions will dictate the course of action. Note that distributions in connection with a spin-off are generally not compliant with Section 409A of IRC, since a spin-off is not a separation of service for employees under 409A.

Health and Welfare Benefits. Generally, SpinCo is responsible for setting up new health and welfare programs and both ParentCo and SpinCo are responsible for claims incurred against the respective plans post-spin. Certain programs such as retiree medical, however, may require a determination of how to allocate liabilities to SpinCo (e.g., for current terminated employees, or just future retirees). Decisions on allocating liabilities related to LTD payments, accrued vacation, COBRA, workers’ compensation, etc. may also need to be made depending on the programs of ParentCo.

Severance and Change in Control (“CIC) Benefits. A spin-off could trigger a CIC depending on the provisions of ParentCo’s various plans. While many benefits arising from a CIC are only paid after a “double trigger” (i.e., they are only paid or vested if a termination of employment occurs in connection with the CIC), certain benefits may be accelerated or payments may be triggered immediately. As a result, severance payments could become due to employees transferring to SpinCo. The companies need to determine if any severance obligations apply when employees transfer to SpinCo and who bears the responsibility for such obligations. Note however, that in many transactions, outstanding awards are assumed by SpinCo, in which case, payments would not be accelerated, nor would any benefits be distributed.

3. SpinCo Going Forward Compensation

Developing a going forward compensation program for the SpinCo is a critical process that often evolves over time. While the default approach may initially be to maintain compensation programs similar to those of the parent company, there may be a compelling case to make fundamental changes to the compensation program to address differences between the SpinCo and the Parent. However, depending on the time-frame for completion of the spin-off and the corporate governance structure, the timing of any such changes may be delayed.

Corporate governance of a spin-off can vary and we have seen each of the following approaches used:

  • SpinCo Board of Directors is led by ParentCo executives through time of spin-off until ParentCo no longer has majority stake
  • SpinCo has Independent Board members appointed prior to spin-off; decisions on compensation for SpinCo may be subject to Parent Company Compensation Committee approval
  • ParentCo Compensation Committee reviews and approves programs for SpinCo

Prior to a planned spin-off there is typically a designated subcommittee of the Parent company board that begins planning and making decisions related to the SpinCo’s compensation program. A Lead Director may be appointed to oversee this planning process on behalf of the new Board, working with the company’s HR or designated SpinCo CEO. Prior to the spin-off, coordinated efforts to recruit new directors, develop a compensation committee charter and a Board calendar, etc. are required.

In a one-stage spin-off, where all shares of the SpinCo are distributed to ParentCo shareholders at the time of the spin-off, the involvement of ParentCo executives and Board members in SpinCo corporate governance will cease at the time of the spin-off. In other cases, where the SpinCo is distributed in stages (e.g., partial IPO to public shareholders followed by a completion of the spin-off or incremental sale of shares in the SpinCo to the public), the parent company Board or parent company executives may continue to serve as Board members of the SpinCo up until the time that the parent company has fully distributed its interest in SpinCo.

When ParentCo Board members or executives are involved in the compensation design, they are more likely to fall back on maintaining a compensation approach that is consistent with that of the parent. They may continue to view the SpinCo as akin to a subsidiary. In these cases, the SpinCo’s compensation program may evolve from the timing of the initial spin-off through the year following the parent company fully divesting its interests in the SpinCo.

Pay Philosophy and Target Pay Levels

For the SpinCo, there is typically pre-planning around the desired compensation philosophy, including a defined market or peer group for pay and performance benchmarking. This peer group should be size and industry specific, reflective of the operating characteristics of SpinCo and may or may not include similar peers to ParentCo’s peers.

There is often extensive benchmarking conducted before the spin-off to determine competitive pay levels for executive positions at SpinCo, assuming new position roles/responsibilities as part of a standalone entity (vs. part of a business unit, prior to the spin-off). It is often the case that benchmarking for SpinCo as a standalone entity will support an increase in pay for executive positions. For example, the top finance executive of a subsidiary is a very different role than CFO of a stand-alone public company. Some adjustments to base salaries and bonus opportunities may be made prior to and/or near the spin date, but should be made within the context of an overall compensation framework to the extent possible. The desired pay mix needs to be determined, with the appropriate emphasis on long-term (equity) incentives to ensure equity ownership build up and alignment with shareholders.

Annual Incentive Program

As with any company, the ongoing bonus program is designed so that funding is based on an appropriate mix of corporate, business unit and/or individual performance. The mix depends on the company’s emphasis on line of sight unit results or overall corporate team results. Performance metrics, whether top line, bottom line, or return based, should appropriately support the company’s strategy. Some investors may initially focus on EBIT/EBITDA or cash flow, yet ultimately determine that a balanced mix of metrics is desirable.

It is worth noting that for both short and long-term incentives, based on the tax code rules (IRC Sec. 162(m), the “performance based compensation” tax exemption for select executive officers), if a company gets an annual and long-term incentive plan approved prior to the Spin by the ParentCo board, and discloses such plan documents in any S1 filing, the company is exempt from IRC Section 162(m) rules for one year. Reapproval of such plan(s) by SpinCo shareholders is required prior to Sec. 162(m) transition relief expiring, and is also required under applicable stock exchange rules. Most companies, however, will still construct their plans to conform with “performance based compensation” rules and best in class industry/market practices.

Long-term Incentives

Key objectives of the Long-term Incentive (“LTI”) program for the SpinCo are to build executive/ employee stock ownership and to create excitement, engagement and alignment with shareholder value creation.

An important first step is to determine an overall equity pool to reserve for equity grants at the SpinCo, i.e., the amount of public stock outstanding that will be shared with employees as part of the compensation program. (This amount is generally under 10% of CSO, once initial IPO, has occurred and/or upon completion of the full spin; industry norms should dictate). At the initial IPO, or at full spin-off, it is common to grant a front loaded equity award to ‘jump start’ employee ownership in the new company. Some companies make a broad-based award to employees deeper in the organization, or beyond the executive group. Stock options and restricted stock are used for this type of grant, yet use of options (vs. full value awards) should be balanced with participation, share usage and cost considerations.

The core LTI framework for SpinCo should be designed to accomplish multiple objectives. Emphasis on equity programs helps to build shareholder alignment. Stock-based performance programs are strongly recommended. Not only do they reflect prevalent practice, but they are viewed favorably by large shareholders. Performance-based equity will also serve as a tool for the new leadership team to promote a focus on specific longer term performance results.

Like any LTI program, balance is important. While some specific industries may use more restricted stock than others (e.g., energy companies), most restricted stock is granted at lower levels in the organization, or for special retention/recognition grants. As a new entity, any new design presents an opportunity to assess long term performance goals related to business strategy and those being communicated to the marketplace. Such goals should likely be incorporated into the LTI program.

Vesting, form of payout and termination provisions are also important. The spin-off event is an opportunity for the new company to re-evaluate ParentCo practices. For example, SpinCo may choose to implement somewhat more stringent award termination provisions to support longer term employment of employees. To further align with best practice, companies should include CIC provisions that provide for outstanding award vesting only upon both completion of a CIC and termination of employment for good reason (i.e., a “double trigger”).

Severance provisions should be established as part of a formal severance (CIC/non-CIC) program or through severance agreements, or less common, as part of an employment agreement. These programs should be implemented after careful consideration of potential costs and benefits to the participant and to the company. Recognize that severance benefits are a sensitive issue for many investors. Tax gross-ups for any 280(g) CIC tax liabilities are no longer common and should not be included. Non-compete and non-solicitation provisions should be put in place for the new entity, as standalone policies or as part of LTI award agreements.

Governance Practices

Certain good governance practices that are commonly in place should be implemented, as they are in the best interests of SpinCo and shareholders and have come to be expected.

Stock Ownership guidelines are now very mainstream and expected by shareholders. They should apply to the newly formed executive group. In SpinCo, it may take some time to ramp up ownership in SpinCo stock, particularly if outstanding ParentCo equity awards were converted at spin using the shareholder approach. Keep in mind there should be a phase-in period before executives are held accountable and a ‘soft’ penalty my make sense, to help facilitate ownership, such as a required holding of 50% of net shares (vested or settled), until the guideline is met.

A Clawback Policy for any awards that were based on results impacted by an accounting restatement is a matter of good governance. A majority of companies today have one, with the ability for discretionary recoupment in the case of fraud or earnings restatement. Note that potential Dodd-Frank rules may mandate a “no fault” policy if finalized.

An Anti-Hedging Policy should be in place that prohibits executives from entering into any hedging transactions related to the company’s stock or trading any instrument related to the future price of the stock.

If Dodd-Frank rules are finalized as currently expected, companies may need to modify these provisions to comply with final rules, but on their own merit, these provisions should be put in place as a baseline.

Directors Compensation. The outside directors’ compensation program of SpinCo should ultimately reflect appropriate market norms for companies of similar size and industry, in terms of the amount of pay provided, the cash/equity mix, and overall structure of board and committee service pay. The design should consider the duties required of directors, as well as the company’s executive compensation philosophy. Initially however, the structure of SpinCo’s program will often resemble the ParentCo program.

The directors equity plan, if separate, follows the same rules as executive equity plans. The ParentCo board typically approves the SpinCo plan prior to the spin-off. Shareholders of SpinCo must reapprove the plan prior to IRC Sec. 162(m) transition relief running out, and also to comply with stock exchange listing requirements.

If any directors work on SpinCo activities prior to the spin-off, special equity compensation may be awarded, or pro-rated. If board leadership includes a non-executive chair or lead director, compensation will need to reflect the expected role, responsibilities and time commitment expected at that time.

4. Modification to ParentCo Compensation Programs Post-Spin

After the spin transaction, it is a good time for the remaining ParentCo to review its own compensation programs to ensure that they reflect the company’s new size and business focus. While not inclusive, the following program components may require review and/or potential modification:

Compensation Philosophy and Competitive Market. The company should assess who the appropriate peer companies are in terms of size, business mix, customers, geographic footprint, domestic vs international business, etc. It may be that the company maintains a market median pay philosophy, but that market position means something different now. If the company’s size is significantly smaller than before, pay levels will need to be monitored for alignment with the newly defined market over time.

Annual Incentive Program. The company’s annual incentive plan, in particular, may need revision so that the performance metrics reflect key drivers of the remaining entity and adjustments to the plan should reflect the new adjustments to the plan should reflect the new organization structure as it relates to any Business Unit or Division performance components. If the remaining business has slower growth prospects and lower margins, for example, the performance metrics may need to be redefined and the weightings reallocated. It may also be the case that there is more of a role for strategic goals as ParentCo also embarks on a new business strategy.

Long-term Incentive Plans. The company should reassess the role of various LTI vehicles at ParentCo. For example, in a low growth business, stock options are not the most effective long term incentive and the company may be better served by increasing the role of a three year LTIP. Conversely, the company may want to instill renewed enthusiasm around the ParentCo’s long term stock performance and growth potential. It may be an appropriate time to emphasize the role of equity. It is also a good time to reassess equity award participation as it relates to overall cost and/or share utilization, both domestically and internationally.

From a more technical standpoint, the Parent should review its current equity plans and share reserve, in light of the recapitalization. A spin-off event itself may not necessarily require revisions to plan documents, but it is an appropriate time to review documents to ensure that appropriate terms and provisions are included. It is also a good time to review compliance with IRC Section 162(m) and 409A.

The compensation related programs and provisions that need to be addressed and acted upon in a spin-off are comprehensive. It is important to the ongoing entities that both ParentCo and SpinCo business objectives are supported by appropriate pay design. At the same time, employee perspectives need to be considered as these transactions can present uncertainty. Planning should begin well in advance of any potential or planned transaction. A cross-functional team from HR, legal, finance and possibly outside advisors, should oversee the necessary action steps. This report can be used to help guide the process and compensation decisions that an organization will need to consider in a spin-off.


1 Source: www.spinoffresearch.com

Certain compensation practices can have a potentially damaging effect on a company’s reputation, which makes determining what constitutes fair director pay no easy task. Daniel Laddin, founding partner of Compensation Advisory Partners, and Martin M. Coyne, II, Chairman and CEO of NACD’s New Jersey Chapter, offer their insights on today’s most critical compensation issues.

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