75% of S&P 500 constituent changes in 2016 were as result of corporate transactions
Whether it’s mergers & acquisitions (M&A), initial public offerings (IPO), divestitures or spin-offs, there is a great deal of activity on the strategic business development front. We see several factors in the global economy that now make corporate deal making an attractive way to achieve greater shareholder returns, such as:
- buildup of cash reserves,
- positive market conditions,
- industry transformation opportunities, and
- the anticipated loosening of federal regulations.
All of which make the climate for corporate transactions favorable.
What does all this mean for compensation executives?
Regardless of the type of corporate transaction you might face, your compensation programs will play a key role in helping the organization through the change. One of the most important objectives in any transaction is for the organization to deliver an intact workforce to its new shareholders. But that doesn’t replace the steady-state objectives that were already in place to meet specific business objectives. Employees at every level need to stay focused on achieving results for the ongoing operations, but they will now face additional challenges because of changes in corporate structure.
As a compensation leader, you will be responsible for ensuring your pay programs achieve those objectives, before, during and after a corporate transaction.
In our executive compensation consulting practice, we find the best approach to having ‘transaction-ready’ pay programs is to be ready for a change long before the need arises. You won’t be able to solve for every possible contingency, but having a thoughtful approach ahead of time will prove beneficial if (when) your organization is faced with an opportunity to engage in a business deal. Trying to implement changes while in the midst of a transaction is distracting to executives and proves to be less effective and more costly.
You need your business leaders focused on running the organization’s operations while at the same time trying to close the deal. You can design transaction-ready compensation plans in a way that does not take away from either of these activities. Structuring a solid compensation program today may eliminate the need to implement targeted transaction programs in the middle of a deal. Or, at the very least, sets a solid foundation for both transaction and post-transaction related programs.
We like to think of assessing compensation programs based on a continuum of readiness to handle a potential transaction. Transaction ready programs are competitive and deliver a retained workforce through carefully crafted compensation arrangements. Plans at the other end of the continuum are poorly equipped to handle a transaction since they tend to be less competitive and/or have little long-term retention value.
Three Phases to Assessing Transaction-Ready Pay Plans
When we assess pay plans related to corporate transaction, we think about them in three distinct phases.
- Phase 1 - Pre-transaction: The Company’s “normal course” pay programs
- Phase 2 - Transaction-related programs: Programs specifically designed for retention and incentivizing a successful transaction
- Phase 3 - Post-transaction: Plans that will be in place after the close, (i.e., the “new normal”)
Phase 1: Pre-transaction
The most successful transactions occur when the “normal course” pay programs are already delivering on the key tenants of compensation program design—attract, retain, motivate. Well-functioning pay plans provide a strong foundation upon which to work through change. Here are some of the best practices we see in this phase:
Competitive pay enhances retention
One of the most critical levers for enhancing of retention is the ongoing competitiveness of your total compensation programs. The Total Compensation Measurement® (TCM) suite of surveys provides you with comprehensive benchmarking data to ensure you stay on track.
Assess ‘flight risk’ by analyzing realizable pay
For a more in-depth assessment of your retention risks of your senior executives, we use tally sheets to conduct analysis of their realized and realizable pay. This analysis goes beyond just looking at the competitiveness of pay at a snapshot in time. We determine the value of all un-vested equity awarded over time (typically past 3 years). Realized and realizable pay analyses take into account the company’s operational, financial, and share price performance to understand the value of outstanding equity. When you do this type of analysis, you can better assess not only the level of pay, but also the mix of equity vehicles, program leverage, performance and vesting conditions, etc.
Plan now for Change-in-Control
The contemporary approach to equity plan design is to ensure there is a “double trigger” in the event of a change in control. A double trigger arrangement accelerates the equity only if two events occur: 1) change in control (the first trigger); 2) qualifying termination within a specified post-transaction timeframe (the second trigger). Double trigger arrangements allow equity awards to survive a transaction, extending the retention value of awards beyond the transaction. Proxy advisors and institutional investors now expect this type of design as it is the best way to ensure that you are delivering an intact leadership team in the event of a corporate transaction.
Implement competitive severance plans
Severance plans are crucial to help mitigate the distraction (and negotiation) of arrangements during the deal process. You can use individual employment contracts or a broader company program, but by building in change in control severance arrangements, you will keep the executive focused on the critical business at hand—to close the deal—rather than worrying about finding their next job.
Phase 2: Transaction-related programs
When companies announce a transaction, employees may see only uncertainty and seek more stable employment elsewhere. Properly designed pay programs provide a foundation for retention, but you should plan for additional actions that you may need to take while the transaction is underway.
Use Severance as an inexpensive first defense
If executives did not have change in control protection prior to the transaction, you can establish transaction-specific severance program. You may also want to extend the reach of that program deeper into the organization to keep other critical talent in place during the transition.
Severance only becomes an actual cost in the event of job loss. This makes it a relatively inexpensive way to improve retention.
Plan for selective use of retention incentives
Deals that take longer to complete, i.e., more than three to six months, typically create undo strain on critical talent. Executives and other key individuals face unusually high workloads for prolonged periods. The risk to the organization is much higher if they opt to leave in this crunch time.
Organizations may decide to use retention awards of cash, equity or a combination of both to ensure critical talent stays and fulfills their accountabilities. However, we caution our clients to use these programs selectively. Retention programs can be expensive with costs ranging from one-half to four percent of the total deal value depending on the size of the acquisition.
Reward success of transaction when additional leverage is needed
In instances where the leadership team has limited (or no) equity interests in the company, you may want to consider using transaction incentives. These types of plans reward the executive talent in much the same that an equity stake would have otherwise rewarded them. When a leadership team drives the increase in enterprise value through a successful deal closing, they earn a transaction incentive payment.
Prepare to adjust competitive benchmarks during IPOs and spin-offs
Senior management of a company that is completing a traditional IPO or being spun out will have increased responsibilities at the close of the transaction. These leaders will now face a litany of new issues related to: institutional shareholders, public financial disclosure, exchange-related requirements, governance agencies, and media scrutiny.
As a result, you should plan for reassessing your market pricing efforts. Have the jobs materially changed and warrant new job matches? Are the scope cuts you used in the past still appropriate? You should understand how the leadership team’s pay stacks up against the new relevant labor market and plan for how you will transition. Normally, we see only modest changes needed to cash compensation, but there could be material differences in equity compensation. Often times, companies find that the un-vested portion of pre-IPO equity grants—the primary driver of retention—is below competitive levels, leading to the need to re-stock equity at the time of the IPO.
Phase 3: Post-transaction
After the transaction, the compensation focus will shift from bridging the transaction to designing and communicating the “new normal” in pay. You should pay special attention to the new pay programs after the transaction to:
- account for potential differences in employee culture of a new acquisition,
- align to the interests of the new shareholders, and
- establish compensation plan features that are appropriate for a new organization
We’ve highlighted below some post-transaction considerations for three types of deals: acquisition, IPO, and spin.
Post-acquisition, don’t assume business as usual
An organization’s culture cannot be undervalued. It is often a key attribute to a company’s ability to retain employees. You should consider unique attributes of the acquired organization before simply putting into the parent organization’s structure. This is increasingly important today as traditionally general industry companies target technology companies or vice-versa. Just think of the cultural differences in play with Amazon’s acquisition of Whole Foods.
Public governance requires alternative thinking after an IPO
The seismic shift in compensation for pre- and post-IPO companies are to their long-term incentive plans. The pre-IPO megagrants of highly leveraged equity become a thing of the past. Post-IPO, organization needs shift from ‘growing enterprise value at all costs’ to targeting a mix that focuses on:
- growing profitability,
- protecting and growing the company’s brand, and
- balancing risk through the adoption of good governance controls.
This new realty leads most companies to transition their LTI programs to include a greater focus on financial performance-based plans.
Post-spin programs need not be the same as the prior parent
Spinoff organizations too often rely on what they know: the structure of their prior parent’s pay programs. Instead, we think spinoff companies should take the time in the post-transaction phase to conduct a holistic review of what compensation programs are appropriate for the new company. You need to take an independent view of the business as a separate entity from the former parent and design the programs that fit with the new, stand-alone structure.
Corporate transactions are an ever-present reality. Each scenario is different, but as we have shown here, there are plenty of challenges and opportunities for you as a compensation leader to help deliver an intact workforce, which is necessary for a successful transaction. Fortunately, our executive compensation consultants have the skill, experience and data needed to help you prepare for and execute during a change. Contact us for more information on how we can help.