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The New Standards: Methods for Linking Business Performance and Executive Incentive Pay

ISBN: 978-0-470-55989-5
336 pages
April 2010
The New Standards: Methods for Linking Business Performance and Executive Incentive Pay (0470559896) cover image
Make the most of the new standards

Every year companies spend millions of dollars on executive incentives. All too often, however, these programs provide a very weak link between pay and performance, with executives potentially rewarded as much for bad decisions as they are for good ones.

Packed with examples, The New Standards insightfully discusses:

  • How to link pay with business results that create long-term value

  • Why incentive structures can discourage management from reasonable risk-taking, in some cases, and can enocourage imprudent risks in others

  • The full range of inputs that should guide proper incentive policy

  • Why performance measures must reflect both the quality and quantity of earnings

  • Risk, executive behavior, and the cost of capital

  • How to use valuation criteria when choosing metrics

  • The pros and cons of common approaches to stock-based incentive pay

Written by noted compensation expert Richard Ericson, this innovative book is a must-read for directors and management concerned with executive compensation design or financial performance measurement and forecasting. Get the guidance and concrete solutions you need to thoroughly reexamine your executive compensation policies and practices with the principles and financial maxims found in The New Standards.

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Preface ix

Acknowledgements xv

Chapter 1 To the CEO 1

Well-Designed Incentives Are Governance Defined 3

Old School 6

Act Now 7

You Do Not Run Your Company 9

The New Standards 10

It Is Not about You 14

Last Things First 16

Bottom Lines 17

Chapter 2 Business Valuation and Incentive Policy 19

The Rosetta Stone 20

Stealing the Playbook of Business Valuation 21

Incentives and Value Creation 25

Value is a Function of the Quality and Quantity of Earnings 28

Cost of Capital and Expected Returns 30

As Long as We’re at it 32

What Are We Paying For? 34

Total Business Return 37

The DCF Model Serves as a Proxy for Other Valuation Methods 40

Free Cash flow 43

FCF and the Irrelevance of Accounting Choices 45

Income and Capital: FCF’s Drivers Should Be the Main Incentive Drivers 46

The Shape of Things to Come 47

Quando, Quando, Quando 49

The Past is Relevant Only as Prologue 50

Valuation Perspective: Operational Results, Debt, and Capital Structure 52

Chapter 3 Market Practices in Incentive Pay 59

How Much Are We Paying for Management Incentives? 64

Variable Pay versus Incentive Pay 67

Mismatch Makers 74

Other Market-Based Considerations of Market-Based Consideration 75

Market Practices and Presumptions 77

Chapter 4 The New Standards 83

Common Sense 91

Bias is the Boil Weevil of Value Creation 92

Get Cynical 93

Incentivization and its Discontents 95

Leading Chartcter 97

Guidelines for Incentive Design 99

Chapter 5 Risk and Executive Incentive Pay 107

Risk Management Policy and Incentives 108

Sheep in Wolves’ Clothing 113

Investors versus Management 113

The Risk Trade 115

Risk and Incentive Calibration 119

The Wages of risk: Estimating the Cost of Capital 121

Beta Coefficients and the Capital Asset Pricing Model 121

Financial Leverage and the Cost of Capital 123

Other Methods and Evidence for Attaching a Cost to Capital 125

Chapter 6 Motive, Means, and Method: Evaluating Incentive Performance Metrics 131

Role of Individual Performance in Incentive Pay 132

Nonfinancial Goals 133

Evaluating Financial Metrics 137

Revenue, Volume, and Gross Margin 138

Using Valuation Criteria to Choose Metrics 141

Context for Evaluating Financial Metrics 142

Operating Income, EBIT, and Return on Invested Capital 143

Two Wrongs Can Make a Right 146

On the Importance of Being Earnest 149

Pretax Income, Net Income, EPS, and ROE 149

Debt, Share Repurchases, EPS, and Stock Price Gains 150

Remedying Issues with Pretax Income, Net Income, EPS, and ROE 154

Cash flow Metrics 155

Indexation and Immunity 158

Overall Perspectives 160

Chapter 7 Value-Based Performance Measures 163

Value-Based Measurement 165

Economic Profit or Economic Value Added 167

Use the Metric, Lose the Rest 169

Total Business Return 170

Shareholder Value Added 174

Cash Value Added 174

Cash Flow Return on Investment 175

Real Value Added 177

Common Values 179

Metric Adjustments and Business Governance 180

Metric Adjustments: Compulsories Only 185

Risk-Based Capital Requirements and Return on Economic Capital 188

How Not to choose Among Value-Based Metrics 191

Chapter 8 Ownership, Not Gamesmanship: Setting Targets and Ranges for Performance-Based Plans 195

Best of Both Worlds 196

Trifold guide to Benchmarks 197

The Past is Prologue 198

Not to Insult Chimpanzees 203

Interpreting the Oracle 205

Multiple Personalities 206

Full Reconciliation to Market Value 209

Setting Targets Based on Total Business Return 215

Run Away! 219

Range and Domain: setting Intervals for Performance and Pay 222

Weightings, Award Leverage, and Participant Influence 227

Incentive Risks, Calibration, and Testing 228

Chapter 9 Business Units and Private Companies, Phantom Stock and Performance Plans 231

Private Companies 233

Phantom Stock and Subsidiary Equity 234

Phantom Stock Plan Example Using Total Business Return 235

TBR Phantom Stock Grant Structure and Leverage 239

Dilution Guidelines and Competitive Award Levels 241

Valuation Approaches for the Phantom Stock Plan 242

Market Valuation Techniques 243

Discounts for Lack of Marketability and Control 244

Valuation Accuracy versus Incentive Efficacy 245

Reconciling and Funding Market Value and Formula Value 246

Market-Indexed and Performance-Based Valuation formulas 248

EBITDA as a Valuation Yardstick 251

Equity-Based Incentive Plans Based on Book Value 252

Tale of Three Cities 252

Adjusting Valuation Results 253

Performance Plans 254

Value-Based Incentives versus Private Equity Incentives 259

Where the Rubber Hits the Road 262

Chapter 10 Using Stock to Create Effective Incentives 265

From the Top 266

Off to the Races 269

Pros and Cons of Major Approaches to Stock-Based Incentive Design 271

All-In-One 273

Let Them Eat Risk 275

Purely Stock-Based LTI Approaches 278

Keeping the Horses in the Barn 280

Granting and Leverage 282

Equity-Based Incentives in Venture-Stage Companies 284

Ownership Effects 287

A Whole New Ball Game 287

Chapter 11 The Medium Is the Message 289

Incentive and Financial Governance 290

Human Resource Perspectives 293

Glossary 301

Index 305

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Richard N. Ericson is an expert in executive compensation with Towers Watson. He has more than twenty-five years of experience in business valuation, performance standard setting, incentive design, and general executive pay consulting. Mr. Ericson holds an M.B.A. in finance from the University of Chicago.
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