Performance-based Compensation

Introduction

Intuitively, it is natural to expect that the performance of an employee and the company affect managerial compensation. However, it is essential to understand that choosing the correct composition of the compensation package should be made while taking into account the existing risk associated with holding the company's shares, the current composition of the employee's equity holdings, and the degree of the employee's risk-aversion, which could be affected by his domestic situation, wealth, and lifestyle.

Compensation in the form of options assumes that the employee has a direct impact on the company's performance and on its market price. Compensation in the form of bonuses, however, is based on the actual performance of the employee, the officer, the division, or any other business unit influenced by the employee. The targets which the employee or officer have to meet are usually either set at the beginning of the period or result from a periodic performance assessment made by the employee's managers.

In most cases, the higher the employee's rank, the more explicitly will his targets be defined, either at the beginning of the period or even upon signing of the employment contract. The targets have to be based on a financial activity level, a market share, the profits of the division, or the employee, and so forth. The bonus itself may take the form of shares, options, or cash and can be conditional upon the targets having been met (i.e., a binary bonus that is either earned or not earned), or, alternatively, can be a function of the actual performance. For instance, if profits exceed $100 million, the CEO will receive 0.1% of the residual profits, up to a profit of $500 million (which will result in a bonus of $400,000).

The Financial Leverage of Compensation Packages

It is important to understand that the total economic value of the compensation package includes the current value of the shares and options already held by the employee, in addition to the net present value of expected salaries, bonuses, options, and the company's contributions to the employee's pension fund.

It is always important to examine the total financial leverage of compensation packages, namely, the degree of sensitivity of the value of the package to fluctuations in the price of the share. For instance, the financial leverage is 1 if the value of the total compensation package changes by 1% with every 1% fluctuation in the price of the share.

Calculating an employee's compensation leverage is complicated since the compensation package includes, on the one hand, components with a leverage that is close to 0 (for instance, the salary component, which is fixed) and, on the other hand, bonus and option components, whose leverage is greater than 1. The leverage of options changes in accordance with the price of the share, the date of expiration of the option, and the relationship between the exercise price and the share price. The higher the exercise price is above the price of the share, the higher its leverage on the value of the option. However, the leverage of most employee stock options is close to 1, since the exercise price is usually identical to the price of the share at the time of allotment of the options.

Since the salary is usually a dominant element in the compensation package, the leverage of the total package is usually lower than 1. In other words, the target of achieving an alignment of interests between the employees and the shareholders is not necessarily reached. An interesting method of achieving such alignment of interests is by giving performance-based bonuses that are credited to the employee's account in a "compensation bank" of sorts, which can be redeemed over a period of time. Bonuses can be calculated by using various formulas. One such customary formula is measuring performance by a decision on the operating unit to be measured, determining a cost of capital for that unit, in accordance with the unit's risk profile and comparing the division's operating profit to the equity "charge" resulting from multiplication of the unit's cost of capital, multiplied by the unit's capital base.

Performance Evaluation

Chapter 9, in which valuations are discussed, reviews the discounted residual income method which may be applied to the measurement of periodic performance, as illustrated above. In principle, it measures the residual income of the business unit, i.e., its operating profit after deducing the cost of any capital used by the business unit.

Performance evaluation may be made on the basis of the business results, reported in accordance with the company's reporting rules. It can also be based, however, on modified statements that reflect the activity of the business unit more realistically. For instance, the perceptible performance of a business unit which invests in R&D could be prejudiced due to accounting rules that require an investment in R&D to be recorded as a periodic expense. In such cases, R&D expenses should be treated, for the purpose of this calculation, as an investment in assets, depreciating over several periods. However, treating an investment as an asset increases the business unit's asset base, and hence the charge for the usage of capital. In some cases, adjustments are made to the rates of depreciation of the investment in the first few years. For instance, the investment may only be included in the basis in the assets two years after the investment is made, when it starts yielding fruit.

With the computerized systems that are now available for financial reporting, it is easy to make the required adjustments for different divisions, or even to measure the performance of different employees within each division. It is important to understand that the economic principles of performance evaluation are similar for different employees and different companies, but that their manner of implementation has to be adjusted to the circumstances of the evaluation. For instance, changes in the compensation parameters that depend on the residual income of the department managed by the employee will have a different impact on the behavior of a manager who has a large portfolio of company stock compared to the manager of a similar business unit who does not hold a similar package.

Types of Performance-based Compensation

• Bonuses Bonuses are the most common method of performance-based employee compensation. If the bonus is based on performance that is measured by the residual income method, then typically the bonus components are a linear function of the residual income up to a certain maximum income. In some companies, the part of the bonus that corresponds to any residual income beyond this maximum is credited to the employee but cannot be fully redeemed in the same year. This "compensation bank" enables the fining of employees in subsequent years if they do not meet the targets fixed for such years. Thus, the employees' interests become identical to those of the shareholders even if the company's performance declines. The compensation gradients of officers should also be adapted to their other compensation parameters, as well as to the relationship between the changes in the residual income and the changes in share value.

• Phantom shares Phantom shares are not actual shares, and are, in practice, an arrangement for monetary reward that is based on a direct change in the value of the company. Since it is a payment arrangement, it can be employed not only in listed companies but also in closely held companies. The price per share for the purpose of the calculation may be determined according to a formula that is based on the company's latest investment round or its financial results. For instance, it may be determined that the value of the company for the purpose of the formula will be fifty times the company's profits in that year. Phantom shares usually confer no rights other than those related to the payment arrangement. The payment may be performed quarterly, annually, or only after a predetermined period such as three years or a predetermined event (such as an IPO).

Weighing the Relative Performance of the Business Unit

Almost every organization constantly debates the relative weights that should be applied for the benchmarks when calculating employees' compensation, namely, to what extent the performance evaluation should be based on the performance of the employee's business unit, and to what extent it should be based on the result of the organization as a whole. In many cases, the compensation is affected only by the performance of the business unit, and in other cases upward of 30% of the bonus is affected by the performance of the company as a whole. Obviously, the different weights given to the compensation components should depend on the position occupied by the employee. A bonus given to senior employees should have a larger component that is based on the performance of the company as a whole. However, such systems sometimes create motivational problems, since the performance of the business unit is often affected conversely to the performance of the company as a whole. Various methods of pricing intra-organizational business activities may solve such problems, but such methods lie beyond the scope of this book.