The best part of ESOP as a compensation strategy is that it offers freedom to link employee reward with individual performance and companys performance
When cash is scarce and stock is readily available, ESOPs are a popular choice as seen by start-ups who use them as their primary tool to reward their strategic and key talent
HR Committees (in some companies, Compensation Committees) are the norm as per law today. They are expected to formulate and mandate HR strategies for the company and ensure that compensation works in harmony with other practices to implement the organization’s overall people agenda. Collectively, the HR Committee is responsible to oversee all HR aspects including Rewards. From the top, the eagles on the Committee have a “Board’s eye view” of the Company.
So when it comes to Rewards, what do they look at?
From my experience, the Board and the HR Committee looks at nine aspects which are also symbolically presented for easy recall. Let us examine each one of them.
1. The big picture, the trends… “Omega”
A major revolution is occurring in the way organizations are being managed. This is driven by technologies as well as social, economic and political changes. The Internet, e-commerce as well as mobile platforms are posing grave risks to traditional set-ups, but they are also offering huge opportunities to innovative start-ups. Lowering of barriers to capital flows has increased the power of institutional shareholders who have a huge influence on companies. Economic challenges are leading to enormous performance pressures that have never been seen before. People are now referred to as human capital. This is valued as high as physical assets, and brands. Boards have the responsibility to invest in human capital, raiseits economic value and manage efficiencies. In today’s brutal VUCA world, the quality of top and senior management has never been socritical to business success as we perceive today. Start-ups have not only redefined business models, they have also redefined reward models!
If you link all these variables to the reward systems, you are probably looking at three powerful drivers - rewards
- For success
- For excellence including knowledge and skills
- For innovation
In a way, these three outcomes also represent the past, present and future.That is the nature and composition of Rewards today. If you are wondering why the “Omega” symbol, this Greek alphabet stands for “mega”, which is the big picture of the market.
2. Beating performance expectations vs. market … "Alpha"
The Boards of today are primarily concerned with developing a deep understanding of the company’s performance management systems. The HR Committee approves the performance targets of the top executives, guided by the expected marketmovements. Every Board wants the company to perform ahead of its competitionand beat the market. Typical market related measures are – volume market shares,value market share, share of high value segments, share of high growth segments,share of industry profit pool, and so on. Many Boards also insist on Relative Total Shareholder Returns, benchmarked with bellwether stocks or indices. Commodity companies are usually benchmarked with the sectoral indices. Boards spend a lot of their quality time understanding the company’s differentialperformance versus market. They fundamentally believe that this kind of performance management comparison infuses a spirit of competition and ambition without which complacence could set in.For this, I use the Greek alphabet “Alpha”. In the financial markets,analysts use the term “alpha” to measure the excess returns of a fundrelative to the performance of a benchmark! I do think Alpha is a very appropriate angle for a Board’s eye view!
3. Managing volatility …. "Beta"
VUCA – volatility, uncertainty, complexity and ambiguity is the new normal today. But in this environment,what then is the way forward? How do Boards look at rewards in the context of wildswings in performance? In such challenging situations, Boards have a difficult job tounderstand the extent of volatility and its impact on company’s performance. Over the years, Boards have gotten used to dealing with this subject and most of them resort to measuring relative performance with the rest of the market. This is not straight forward. It does require a lot of delayering to understand underlying performance. This can be quite intensive for the Boards. Here, I use the second Greek alphabet “Beta”. In financial parlance, beta is a measure of the volatility or systemic risk of a security or portfolio in comparison to themarket as a whole! And indeed very relevant for the Board’s eye view as well!
4. Growth, growth and growth…"Delta"
Growth is the only thing which is constant today. Boards and HR Committees seek to understand what and how much growth will occur in the company’s performance, both absolute and relative. You rarely witness discussions in Boards and Committees of managements going in to sustain current levels of performance.Instead, the debate is all about how much growth and how many parameters ofgrowth. The usual questions asked at the Board and Committees are – what are the CEO’s growth targets? What about the next line? And, is there a robust and transparent process of cascading these growth targets? The Greek alphabet “delta” is now very English. Made popular by mathematicians and statisticians, delta stands for the measure of change either in absolute numbers or percentages. Needless to say, this is an angle Boards want to examine in depth!
5. Hedge the risks since there are several probabilities of outcomes…"Gamma"
In this volatile world, every stakeholder seeks to hedge risks. HR Committees have the onerous task of hedging the risks for both the company and employees. From a company view point, it is important to minimize the risks by fixing floors for performance, below which incentives do not apply. From the executive’s perspective,the risks are mitigated by ensuring they are “in the money” through fixed components of rewards. How many components to “be in the money” or “out of the money” is a constant balancing challenge for HR Committees. How many fortune stories of millionaires has one heard over the years! At one time, these were headlines. Today, they are perceived as common and mere disclosures to investors. Incentives and options are only on paper, the listing is quite far away, there is no visibility of monetization, and so on.When we hire from start-ups, we are constantly faced with valuation challenges especially when they produce option letters with several zeroes. Below water today, but there is a probability of going above water in a few years, so they believe. That is the ‘big promise’ shown to them. But, what is the probability? These are the same questions asked and discussed in Boards and Committees. And, finally, what matters in all such discussions is management conviction in businessplans, visibility of profits and positive cash flows, and in some cases, well-established benchmarks of valuations supported by pricing and IPOs. I use the Greek alphabet “Gamma” to number this point. In the financial world, gamma is a measure of the option’s price in relation to how in or out of the money the option is! Whenever we face “in money” or “out of money” situations in Rewards, it is nothing but a Gamma problem!
6. Leverage for superior performance … "Lambda"
The mirror side of risk is opportunity. Boards and HR Committees are predominantly looking for ways to incentivize superior performance. HR Committees are expected to approve reward plans with upsides for employees, who expect disproportionate multipliers for superior performance. How steep can the incentive curve go and at which level can it capped is for the HR Committee to deliberate and approve. There is a view point which says there should not be any cap for upside. Why should anyone be given an impression that there is a limit to superior performance and the rewards accompanying it? The contrary view is that without caps on upsides, volatility sets in, and the period-to-period variations become very pronounced. Boards are conscious of such behaviors, and they have sought to balance the equation through the stock options route. By definition, share prices tend to follow performance, and hence the price discovery mechanism of the share market is the best way to provide the reward leverage. Financial wizards use the Greek alphabet “Lambda” to represent leverage! Lambda is defined as the percentage change in option price divided by the percentage change in the underlying price. Given my finance leanings, I have always applied the Lambda to analyze upsides and downsides!
7. Aggregation or disaggregation … "Sigma"
This is a new debate which is raising its head in recent times. Traditionally, reward policies are applied to derive actual quantum of rewards for individuals and the aggregation of the individual rewards is the budget required. As performance pressures increase, Boards are asking company managements to turn the arithmetic upside down. They would rather have management first decide the actual amount of the reward pool based on principles such as performance multipliers, market benchmark, percentage of revenues or profits, minimum and maximum, etc. Once the total reward budget is decided, then distribution principles are applied to disaggregate the budget into individual rewards. Boards and HR Committees are toggling between aggregation and disaggregation approaches. Finally, what helps them decide on the final approach is the Board’s reward philosophy of bottom-up or top-down. The Greek alphabet “sigma” is very popular. It simply denotes the summation of individual scores. The question for Boards is – sigma or de-sigma! Personally, I find this metric very fascinating in the way it can be applied in Rewards – should we Sigma or, should we de-Sigma?
8. Time value of money …. "Theta"
Time is an important criterion for rewards. Boards and HR Committees want to increasingly link rewards with sustained, long term performance.Hence, they push for long term incentive plans. Deferred bonuses, longer periods of vesting for stock options, retirement plans, etc. are all indicators of the Board’s desire to ringfence the key executives and reward over a period of time. In a hot talentmarket, companies deploy several retention tools, and deferred payouts are one such tool. However, for the employee, time value of money is a very important factor. The more you defer the benefits, the employee tends to discount the value. In addition to time discounting, with deferred amounts at risk, employees find it tricky to navigate through pay discussions with a new employer if they want to switch jobs. In finance lingo, “theta” is a measure of the rate of decline in the value of an option due to passage of time! And how relevant for Rewards strategy as well!
9. Keep testing your reward hypothesis… "Chi"
Finally, Boards keep asking managements for their hypothesis on what is working and what is not. Different reward schemes are designed and deployed to achieve multiple objectives, such as motivation, retention, employee satisfaction, wealth creation and so on. Boards and HR Committees do ask for regular testing of such hypotheses, to decide what is better for the times ahead. But, establishing correlations between rewards and outcomes are not always easy. Companies use empirical data along with employee feedback surveys to test effectiveness of rewards. Another litmus test is – how effective or difficult is it to attract new talent? Are there aspects of the company’s reward mechanism which are making it uncompetitive to attract the right talent? A smart Rewards team is always alert to all these signals, and is able to conduct testing of hypotheses much better than a team which is out of sync with internal and external realities. The Greek alphabet “chi” is used in the “chi squared test for independence” which is performed to test hypothesis! Some call it the test of “goodness of fit”, and to my mind, there is no other angle more appropriate for Rewards!
In conclusion, what are the expectations of the Board? What are their frustrations? Boards have to blend two aspects – on one hand, they want to apply the objectivity of performance management and scientific reward mechanisms. On the other, the Board has to get comfortable with the dynamics injected by the VUCA world and the web of human aspirations and motivation. What then is the way forward? The answer is – the Board’s eye view! This top down view however needs to be complemented by a bottom-up view of what the pros and cons are of the various Reward approaches.