Creating Space for Non-Financial Metrics

Transcript

Jake George: Has your compensation committee talked about modifiers or weighted metrics? That's up next on Pearl Meyer Unscripted. Hi, I'm Jake George, CMO at Pearl Meyer. Today, my colleagues Mark Rosen and Aalap Shah explore some difficult territory in the form of non-financial metrics and when it might make sense to weave these into your incentive plan.

Aalap: Hey Mark.

Mark: Hey.

Aalap: A director who I've known for a long time just took on a new board role and was noodling on their incentive program, which by the way is 100% based on financial metrics in both the short-term and the long-term plan. Her main question was, is there a place for non-financial metrics that align to future value creation? If I read between the lines, I think she believes non-financial metric can be helpful but doesn't want to take away from the alignment that 100% financial metrics-based program brings. What do you think?

Mark: Well, you know, there's a lot of directors out there who really are skeptical of having non-financial metrics in the annual plan. And those are the same people that never put it in the long-term plan.

Aalap: Yeah, I don't know her board yet, but I suspect there are some members the committee and maybe even the broader board that probably have that view. But one of the things that immediately came to mind was that if there is that healthy skepticism, maybe there is a non-financial metric that could be used for a modifier.

Mark: Yeah, that's a good way to sort of bring the concept in while still only really paying if you hit your financial metrics.

Aalap: I think just to be complete with the director, I'd really love to pick your brain about the modifier approach, which I think we both agree is a good alternative for them to consider. But also if she wants to go a little bit stronger and suggest a weighted metric that doesn't have to be the same percentage, but is on par with a financial metric. So when you think about a metric and then put in that frame, do you have significant concerns?

Mark: Well, you know, I think it's very company specific and it's also very industry specific because you see some industries clearly having these non-financial metrics in them and some are weighted, rather heavily weighted. Oftentimes we'll see anywhere between 10 and 30% having a weighted metric, but sometimes it's even greater. And so it really depends, for example, in some cyclical industries I work with, they have higher percentages of weighted non-financial metrics in order to reduce that volatility in the payouts of the plans. Because I find that when you have a non-financial metric, and of course it depends on what it is, but when you have a non-financial metric, you often end up paying near target. You almost never pay maximum and you almost never pay zero.

Aalap: That does become a concern. I mean, I think there are structures where if your non-financial metric in field and administration replicates a financial metric, then it can be very helpful. For instance, I think the sector that uses non-financial metrics the most is life sciences. And what I've seen with those is that you could have certain threshold target and superior link to how long it takes to develop a therapeutic area. And so if it takes longer, then you're getting a threshold payout. And if it's a shorter duration, then you're getting something closer to superior because it allows the go-to-market and revenue generation to become processed quicker.

Mark: Yeah, but that's a company that would have a very high percent of the annual incentive in the form of a non-financial metric. From a prevalence perspective, I would suggest that they're actually quite common in companies in, for example, safety. Most manufacturers, extractive industries, utilities, they're going to have a safety metric. Not everybody will have a safety metric. And that's another example of you tend not to pay maximum because the targets are set as close as you can get to zero incidents, which is impossible just because we're all human. But striving for it is a great goal. And then we've seen all of this ESG over the last few years, but while the DE&I may not make it much further. In today's environment, clearly safety emissions, carbon reduction is still highly prevalent for those industries with a lot of, I don't want to call pollution, but emissions. That's a really important metric. I'm not so sure how carbon reduction it works in biotech, but it certainly is important even for some of the larger tech companies.

Aalap: Oh no, absolutely. I think focusing on some of those types of metrics. I think it's definitely something that I tend to bring up with this director because there is, when you think about, as you mentioned, carbon emissions, there is definitely a threshold and target and superior framework I could see happening based on how you set yourself up on the goals for the annual incentive program. So, you know, to me, that's one of those metrics that can be structured akin to a financial metric. But there is a whole host in that ESG bucket. There is a whole host of metrics that I think that do lend itself. I think the question will be is that if her goal is to have something that really increases the value and supports the value creation of the organization, is ESG the right sort of bucket to put that in? And I don't know the answer to this for this particular company, but I want to keep in mind that we don't want to introduce something as a weighted metric that's going to take away from the financial metrics that are already closely aligned to value creation.

Mark: Yeah, a couple of thoughts there. Don't forget that some of reasons for these ESG is because we're sending a message and we're sending a message not just to the participants in the plan, but we're sending a message to the entire population of our employee population, but we're also sending an external message that says, Hey, in the event, in the example of safety, this is really important to us carbon reduction is really important to this. So we're measuring and we're paying people. I'm not so sure that some of these metrics have much of an impact on behavior. I think that something that is only worth less than 5% of your overall incentive isn't going to grab your attention every day that you get out of bed and say, I'm going to reduce carbon today. But I think it sends the message that overall, this is an important value of our organization and we're going to strive towards it.

Aalap: Absolutely. I think you know that you're absolutely right, because this is age old question that we've been having with that on ESG is that how much does this need to be a metric versus how much is this, you know, just cultural and how you, you know, set up your organization and the values that you bring to the table. So outside of ESG, I mean, another metric that I was thinking about was an efficiency metric. So not exactly profitability, but you know, having a efficiency metric, this is essentially a non-financial metric, but I could see that being really value creative to an organization if they were to select the right one.

Mark: Oh yeah, we see that pretty commonly in certain manufacturing environments and chemicals, for example, especially commodity chemicals. We like to see if we can't run a planet, the nameplate are better. How efficient can we be because obviously the greater utilization of your assets, the more profitable you're going to be. So there are all sorts of things like that. I think about hospitality and you're always looking at this combination, hotels use RedPar, and so you're always looking at what your rate per room is, but you're also looking at how many rooms are rented, sealed. Just like in the airlines, if you have an empty seat, you you lost money and you're never going to get it back. So there are all sorts of these efficiency, for lack of better term, metrics that are really important in certain industries. But you talked about value creation. I think it's very situational, but I had a client that put in a value creation plan that was based on ideas that were generated by the employee population. And we looked at what the run rate was for whether cost savings or new projects that were identified that would increase EBITDA. It was really kind of cool.

Aalap: Oh yeah, no, I love that sort of granular look and because I think those are the leading metrics that go into a financial metric, so going more granular and the concept of having that bubble up from the employee population sounds fantastic. I think more companies should probably do that. And the other thing I was thinking about that I've seen in the technology space that is essentially a non-financial metric, but it's very important, is two other concepts, churn and new client acquisition, so new client logos. So those particular are very important for a technology company that has a SaaS-based model. So again, to me, those are very value-creative and could be used. Unfortunately, this company is not, the answer isn't that easy for this particular company because it isn't a software company. But that was just another one that I've seen, you know, very industry specific and prevalent.

Mark:  Have you talked to her about individual performance? Sometimes that's a modifier, but sometimes it's just a weighted metric.

Aalap: That's a good point. And I guess the concern there is that if they've been for years just using 100% financial metrics, I wonder if they have the appropriate performance management system. But I think I'll ask the question because it didn't occur to me to think about that, I was thinking about sort of more corporate, you know, higher level metrics, but you're right. I mean, doing this on an individual metric basis, could lead to the same result, but they just have to have that performance management and monitoring in the right place.

Mark: Well, you absolutely have to have a robust performance management system. And I'm also a little skeptical of it. It works best for the general population as we get towards the executive level. It does have a little bit of hair on it because we need to be careful. Companies never like to disclose when participants who will be disclosed in the proxy will perform poorly. And we want to have a zero or a negative impact on their incentive. So for example, they don't hit target, they hit 75% of target on individual performance. Now, the more robust the metrics within that individual performance, the easier it is to say, well, they didn't achieve this particular target and it's not them individually. But the closer you get towards their actual individual rating, the less likely it is that you'll see it below target performance level. You don't want to say that your executives haven't performed well, but what happens is typically when they don't perform well, they're gone.

Aalap: Right. Yeah, exactly and this is a public company, so that proxy disclosure can be quite problematic. I mean, you mentioned something earlier about these tend not to pay out above target, and I tend to agree with that. But I think the other thing, when I've these conversations before, the other question that oftentimes comes up is would this non-financial metric be a way to have lower accountability on the financial metrics, meaning that our financial metrics are paying at 85% of target, but now the non-financial metrics paying at 100% target. So it's uplifting the actual financial result. Do you think that's a true concern or is that just something that is on top of mind but doesn't in practice really matter as much.

Mark: Well, I think you're always going to get some pushback from shareholders whenever you have a below target financial result and a target or above non-financial. But there are ways to deal with that. One is to retain overall discretion to reduce. The second is to have a gate that says if we don't at least hit threshold or oftentimes I'll put it below threshold financial performance, if we don't at least hit that level of performance, we're not paying out anything on the non-financial. And that protects the shareholder, that protects the cash flow. But frankly, having the non-financial pay at, let's say target, when the financial is paying between target and threshold actually is what we want to have happen in some cyclical industries because you don't really know when you're going to go into that down cycle and when you do, it's often very difficult to get to threshold. So paying the employee population, especially the non-executives, something for what they're doing is important.

Aalap: Yeah, that's been my point. And even outside a cyclical type of company is that if we had a robust performance selection process and a robust goal setting process, then should we really be concerned that the non-financial is paying out a little bit higher than the financial? Now, if that was happening on a consistent basis, that's where I would question more. So if it happens one year, but then it happens three years in a row, then I think there's something probably off in how we're selecting metrics and setting the goals for...

Mark: Or they're just a really high performing company.

Aalap: That's true. That's true. 

Mark:  Let's not forget that happens.

Aalap: Yeah, no, absolutely. And there's definitely ways to test that. But again, I think the point is I wouldn't start getting concerned over that until repeatable thing and then investigate that further.

Mark: Have you started thinking about the applicability to long-term incentives?

Aalap: Mark you know, my favorite topic is to talk about equity incentives. So if we could, you know, maybe table that for another time, I just about to run onto a committee call.

Mark: Oh yeah, that works great. Just give me a shout when you get a chance.

Aalap: All right, thanks Mark. Take care.

Aalap: You too, bye.

Jake: That brings us to the end of part one of this two-part conversation. Join us next week as Mark and Aalap close out this first season of Pearl Meyer Unscripted with some incentive plan disclosure and communication guidance. Be sure to look for us on Spotify, Pearlmeyer.com, or wherever you get your podcasts. Thanks for listening and we'll meet you back here next week.