Be bold with wealth incentives.

• Author: O'Byrne, Stephen
• Position: Compensation

The history of LBOs and the entrepreneurs who leave big companies to start small ones is largely a history of inadequate wealth incentives. Big companies largely follow competitive pay strategies, and those strategies ensure that management wealth is largely independent of changes in shareholder wealth. Directors must realize that strong wealth incentives are incompatible with a commitment to competitive pay, and can only be achieved when a company is willing to make difficult trade-offs.

The directors of a public company must ensure that the company's total compensation strategy balances four conflicting objectives:

Alignment: Giving management an incentive to choose strategies and investments that maximize shareholder value.

Leverage: Giving management sufficient incentive compensation to motivate them to work long hours, take risks, and make unpleasant decisions, such as closing a plant or laying off stall to maximize shareholder value.

Retention: Giving managers sufficient total compensation to retain them, particularly during periods of poor performance due to market and industry factors.

Shareholder Cost: Limiting the cost of management compensation to levels that will maximize the wealth of current shareholders.

The Dominant Strategy

The most common -- but fatally flawed -- approach to balancing these four objectives is a total compensation strategy based on two key principles: annual recalibration to a competitive position target, and the maintenance of a substantial proportion of pay at risk.

Under this strategy, the company adopts a competitive position target -- for example, 75th percentile total compensation -- and each year recalibrates its salaries, bonus plan targets, and option grant shares to provide a total compensation opportunity at the targeted percentile. Base salary and cash compensation may be targeted at the same percentile as total compensation or, more commonly, targeted at lower percentiles to provide higher leverage and a mix of pay that is more attractive to management and the directors than the market mix.

The company's total compensation strategy can be, and often is, summarized in a table, such as the one illustrated on the following page, that expresses the company's target compensation percentiles and target pay mix.

Most companies and directors believe that this strategy provides a reasonable balance between the four conflicting objectives of executive compensation:

* It provides alignment because bonus and stock compensation is tied to operating and market measures of shareholder...