When Strategy Changes, Should Incentives Change Too?

Jake: Kicking off our annual Top Five series, where we examine five topics likely to be on compensation committee agendas as they head into fall planning meetings. In this first episode, Mark and Aalap are joined by managing directors Steve Van Putten and Will Cockle to discuss how executive incentive plans can support business transformation while still maintaining accountability for financial performance.

Steve has advised board comp committees for more than 30 years, with deep expertise in aligning executive incentives with company performance. Will advises tech companies on executive compensation, equity strategy, and corporate governance across the company lifecycle. Together, they discuss how committees can think about transformation-related priorities such as AI, portfolio repositioning, M&A, and new market growth, and how incentive designs can evolve to recognize meaningful progress without adding unnecessary complexity or weakening financial discipline. Let's listen in.

Mark: Steve and Will, so excited to have you on the podcast today. This is a really interesting topic that I think is applicable to many of our clients.

Steve: Great to be here, Mark. Thanks for having us both on board.

Will: Yeah, thanks, Mark. Great to be here again.

Aalap: Yeah, great to have you both, Steve and Will. I mean, clearly there's been a good amount of activity happening in the AI sector, IPOs, M&As. So I think it's really important for committees to think about how these macro activities are impacting their incentive design. So, would love to hear from you, when companies are going through a transformation, what do you actually mean by a business transformation?

Steve: I would say, first off, Aalap, there's no such thing as a business being on autopilot all the time. Businesses are always changing, always responding to competitive pressures and changing market dynamics. So business strategy is typically flexible and evolves as the company evolves, and typically you would see incentive programs evolve along with that.

But at certain junctures, companies may pursue a more transformative strategic shift, and it could be due to a variety of factors. You could have a new CEO on board who has their own particular strategy that they're trying to pursue. You could be confronted externally with an activist investor, creating pressure to enhance value, or confronted with changing market dynamics, and you have a lagging competitive position and stock price. So, there are a lot of factors. 

One basic example would be a company could be pursuing a business portfolio optimization. You could be divesting non-core, low-growth businesses and then use that cash flow to fund an acquisition strategy. So you're taking that money, you're investing in higher-growth or higher-margin businesses. So that's a more transformative type of an event. We’re hearing a lot now about AI initiatives, and I think Will could speak to that.

Will: Yeah, I think on the AI initiatives, what we're seeing is there are companies that may have been relatively stagnant for years that are suddenly becoming strategically important because of the AI buildout. You see that in parts of the semiconductor and digital infrastructure ecosystems, and even in areas like quantum computing. That can materially change the company's valuation. We've seen companies go from a few billion to ten plus billion market cap. 

The transformation isn't always management deciding to change the business. Sometimes the market changes around you and forces that transformation. So, from an incentive perspective, the challenge is timing. Management may be investing heavily in that technology, talent, infrastructure system today, while the financial benefit may still take a couple years to show up.

Mark: So why does that suggest that we need to have different metrics, or do we need to have different metrics? What's wrong with maintaining the same pretty tried-and-proven metrics, cash flow, financial-based incentives? They're traditional and they've worked over time.

Steve: Yeah, Mark, we certainly don't want to suggest that traditional financial incentive metrics are no longer appropriate. You think about traditional metrics such as profitable growth, cash generation, return on capital, shareholder value creation. Those are foundational to most executive incentive plans. Your directors will expect to see them. They often get uncomfortable with more squishy-type metrics. They're objective, they're understood by your management team, investors are aligned with them. So we think it would be a mistake to go away from those traditional metrics. But we also have to recognize those are often lag metrics. They reflect the business as it exists today. So the revenue, the profit that your existing business, your services throw off. Whereas, you may want to consider more lead metrics. Lead metrics would be more aligned with strategic efforts to lead to future value creation and may be appropriate to consider.

The other point is strategic investments often involve significant cost, and you may not see the benefits from those investments until some point down the road. So that could put pressure on the existing traditional financial metrics.

Aalap: Steve, I think you're touching on an important point there. When you have these transformation metrics that are lead metrics, how do you avoid the problem of using a way to hedge against deteriorating financial performance?

Steve: Yeah, that's the challenge for compensation committees. They have to balance two equally important objectives. They need to hold management accountable for delivering near-term financial results. That's expected from Wall Street and from your directors. At the same time, you also have to encourage the strategic decisions that are going to position the company for future success and create long-term shareholder value. So this could mean, from an incentive standpoint, that you adapt the short-term incentive program by maybe including a more strategic scorecard component. It doesn't have to have a significant weighting, but it would signal internally and externally the importance of these strategic initiatives. And then maybe you adjust the long-term incentive metric to reflect a return-on-investment metric or a margin expansion metric that is aligned with what you're trying to do with your transformation efforts.

Aalap: When you're trying to balance all of these metrics, I think the thing that we always talk about with boards, as well as management teams, is that we don't want to overcomplicate the incentive design. Is the incorporation of some of these additional metrics doing that, or how do we avoid that?

Will: So, yeah, it can make it more complicated, but what we advise is for boards to be cautious about creating a new transformation metric just to align with that transformation or, in the AI context, creating an AI-specific metric simply because it's strategically important.

You want to start with what the transformation is actually going to accomplish, or is expected to accomplish, and go from there. So that doesn't necessarily mean adding a new metric. Sometimes the better answer is changing the emphasis on the existing measures that you already have as the economics of that transformation changes. So maybe early in the process, deployment or adoption is more important. And as the business matures, it's looking at margin expansion, cash generation, or returns. Among our clients that are in the AI space, it starts with, did we implement it? And then, what actually did it produce?

For an AI product, that could be progressing from launching the product to customer adoption to revenue contribution. For an AI-enabled operator, it might progress from workforce adoption to productivity to operating leverage. So the goal isn't necessarily more metrics; it's making sure the measures evolve from implementation toward impact while keeping those durable financial measures at the core.

Steve: An additional point related to that, thinking about those durable financial measures, is that committees also need to consider how these significant transformation-related costs are treated for incentive calculation purposes. We know typically incentive goals are set at the beginning of the year based on budget. The budget reflects expectations in terms of near-term revenue generation and expenses for the coming year. But in some situations, those one-time investments, you may not be able to accurately forecast it, and it may make it difficult to evaluate the underlying operating performance against those goals when you get to the year. So when you're unable to forecast it, committees may determine that it'd be appropriate to exclude certain board-approved transformation costs from incentive calculation. And that will provide a more meaningful assessment of how management performed during the year. 

When you do consider adjustments, you should consider it through the lens of, first, is it material? Are we comfortable disclosing the adjustment? Because you'd have to disclose it, and it could be separate from your non-GAAP results. And then ultimately, how do we ensure management is being held accountable over the long term for generating return on those investments? So if you're going to benefit from revenue creation, we need to make sure they're held accountable for that. And committees should get a quarterly update on potential adjustments throughout the year.

Mark: But how do you think about those adjustments in the annual plan versus the long-term plan? Because if I'm adjusting them out, and I hate to use the term "adjust" because were they reasonably contemplated when you started the year? So let's just say that we exclude them because they're appropriate investments. How do we think about the annual plan versus the long-term plan and the value that ultimately is created, or in some cases, not up to the expectations?

Steve: Yeah, it's an excellent point, Mark. It's certainly something that needs to be considered. It's something I was trying to touch on in terms of when you set these long-term metrics, you need to build into them the expectation that you're going to benefit over that period of time from investments you're making in the near term. So maybe you set more stretch objectives. Maybe you extend the performance award slope on the upside. Maybe you consider relative metrics. Maybe you simplify with total shareholder return. There are a variety of things that you can do to take into consideration the fact that you're getting the benefit in the short term through an adjustment, but you don't want to just necessarily be benefited in the long-term incentive program from the results of those investments.

Mark: But how do we avoid the potential for short-term improvements in the stock price that might—some would refer to it as "hype"—but to increase the stock price prior to the fundamentals being delivered? How do we balance that?

Steve: Yeah, I mean, you always have the bulk of executive incentives tied towards long-term incentives. So the impact on the short-term incentive program, while it may be positive, if you don't deliver the returns on the long-term incentive program, the executive team is going to be more adversely affected through that, given the overweighting on long-term incentives.

Mark: So the vesting is going to carry you through when the value should be delivered. It's long term, you're not just capturing that short term.

Aalap: Yeah, because you have to have the sustained stock price. So even if the short term is a momentary blip up in the stock price, you have the long-term vesting. 

Will: Yeah, I think what I've seen there, this applies to companies in the AI-adjacent space, the semiconductor and quantum computing where the underlying business hasn't changed, but the demand for their products has significantly increased and the stock price has shot up. And those companies are concerned with the multiple of their valuation to the underlying financials. And what they'll think about is, let's look at this group from a relative perspective for the long-term incentive plan and think about our relative TSR performance to the semiconductor industry or the companies that are dealing with the same external market pressures, and then focus that annual plan on what we believe as a company is truly important for this year to achieve.

Aalap: And so, how should a committee decide whether a transformation objective belongs in the annual incentive plan versus the long-term incentive plan?

Steve: Transformation-based incentives can belong in both the annual and the long-term incentive program. For the annual incentive program, it's important to create that balance in terms of delivering on the traditional financial metrics that investors expect to see. Those are lag-type metrics. You may want to consider a small component tied to strategic initiatives and be as objective and quantifiable as you can, recognizing folks generally don't like soft, subjective-type measures. And I think, importantly, there should be some tie to the long-term incentive program that reflects the purpose of why you're making these investments. If you're expected to outgrow the industry through these investments or expand your margins or your PE multiple, that needs to be reflected in the long-term incentive metrics, either through changing the metrics to reflect margin expansion or relative TSR outperformance, or changing the goals or the performance award slope to create more upside and more leverage to the incentive program.

Mark: Yeah, I'm hearing a "Did we do it?" versus "What did it produce?" And that's ultimately the direction you guys are suggesting we move towards.

Steve: Right. Exactly.

Will: Yeah, the annual plan certainly can be a better place to recognize those near-term execution milestones, like Steve mentioned, potentially having a strategic component, putting some concrete, milestone-based goals in that annual plan, but then ultimately having the long-term plan to hold management accountable to what those near-term actions ultimately produce, whether it's increased revenue generation or greater margin expansion.

Aalap: So, Steve and Will, I mean, some great points here for committees to discuss. Wanted to close out with, what do you see as the biggest mistakes companies make when trying to align incentives with a major transformation?

Steve: Well, first of all, you have to make changes to your incentive programs. You get what you pay for. So if you just go with your status quo incentives and you don't meaningfully modify that approach, then you're going to continue to get expected performance.

Will: I think what I've seen where companies are challenged is when they try to create a new metric and be really creative with the approach, where what we really push the company to think about is, what is this transformation trying to achieve and what are the financial outcomes that are going to come from it? And working backwards from there to use some of the existing financials as the backbone of the incentive plan but adjusting the weighting or the performance criteria to get there versus coming up with something truly unique.

Steve: And anytime you make a change to your incentive program, communication is probably the most important thing, internally as well as externally. Your employees currently understand the existing incentives. They understand it really well. Externally, they understand it really well. You need to make a concerted effort to communicate why we're making the change, how the change aligns with what we're trying to create in terms of future value creation, and how your actual pay will reflect on those efforts.

Will: That's a great point, Steve. I think with transformations, there's a lot going on, and it can be really unclear what the incentives are. So having that crystal clear and communicated throughout the year on how you're progressing versus that incentive metric can be really important.

Mark: Well, guys, I've heard a bunch of great things, like the goal isn't more metrics; it's better alignment. And I know that oftentimes we get involved and people just want to add another metric to solve for something. But ultimately, don't just reward management for transforming the business. Hold them accountable for creating that value through the transformation. So, guys, this has just been a great conversation. I appreciate your time.

Will: Thanks so much.

Aalap: Yeah, really appreciate it, Will and Steve. Thank you.

Steve: Great, thank you.

Jake: Our thanks to Steve and Will for walking us through the complexities involved in adapting executive incentive plans during a time of business transformation. In our next episode, we'll turn our attention to CEO succession. Two of Pearl Meyer's leadership experts, Peter Thies and Susan Sandlund, will join Mark and Aalap to discuss why boards need to move beyond simply identifying a potential CEO successor and focus more deliberately on whether the organization is truly ready for a leadership transition.

Until then, you can find all of our Unscripted episodes on Spotify, Apple Podcasts, pearlmeyer.com, or wherever you get your podcasts. Thanks, as always, for listening, and we'll meet you back here next week.