Setting shareholder-focused performance targets: setting executive compensation targets has changed. The process now reflects the new environment of heightened shareholder activism, increased disclosure requirements and overall market skepticism.

• Author: Turner, Matt
• Position: COMPENSATION

Until recently, setting performance targets for executive incentive compensation plans was too often a perfunctory and one-way process. Typically, Corporate Finance would prepare the annual operating plan and determine "planned" performance with respect to standard financial performance measures such as revenue and earnings per share.

These figures (or a set of related Street "commit" numbers) were then reported to the Compensation Committee and plugged into the annual incentive plan. Threshold and superior levels of performance might be set based on a fixed percentage above or below target for each metric. The process was similar for a cash-based long-term plan, possibly with a nod toward longer-term "required" performance.

Those days are over. Heightened shareholder activism, increased disclosure requirements and an overall market skepticism regarding "pay-for-performance" requires that companies embrace a more rigorous, shareholder-focused approach to ensuring that both performance measures and targets are appropriate and effective. The goals of engaging in a more systematic and thoughtful approach include:

* Validating the performance measures used in incentive compensation plans;

* Grounding the target-setting process in a clear understanding of shareholder expectations; and

* Involving all of the relevant people in the process--early and often.

Validate the Performance Measures

Most financial performance measures baked into annual incentive plans are based on a combination of historical usage, industry practice and compatibility with analysts' coverage of the company. While intended to reflect shareholder value, too many companies fail to ever validate whether or not performance against such measures will actually create shareholder value.

Validating performance measures need not be rocket science, but should involve at least some statistical analysis. The analytic process starts with a strong understanding of the economics of the relevant industry, along with a command of the company's specific business strategy and value chain. One can then identify what specific performance measures might best correlate to long-term value creation for the company, using regression and time-series analyses to test that value link.

However, relying on regression analysis to the exclusion of other factors that impact the link between pay and performance is never sufficient. The review also needs a critical evaluation of the analysis in light of knowledge that is specific to the company and industry.

For...