Setting Bonus Measures and Goals in an Uncertain Environment

At this time, many boards are focusing on the annual operating plan (AOP) for 2023. Projecting financial performance may be difficult given continuing supply chain issues and market volatility, inflation, and a tight labor market in certain sectors. For private companies, there is added pressure to get the AOP right. Private companies often use the AOP as the target for the annual bonus plan and for shareholder distributions. Here's how private companies can structure the appropriate bonus program and goals for 2023.

Selecting Measures

As compensation committees evaluate bonus measures for 2023, they could consider whether measures reflect the health of the business and how the business needs to respond given the economic uncertainty. Most private companies use one to three measures for their bonus plans. Common financial metrics include revenue, earnings, return, and cash flow. In addition, companies also use operational and customer metrics such as efficiency and satisfaction. In terms of environmental, social, and governance impact measures, quality, customer satisfaction, and safety are the most popular.

In selecting measures, businesses should ensure that they reflect not only financial results but also how the business may need to respond in the short- and long-term. For example, during the COVID-pandemic, many companies considered qualitative measures, the ability to shift strategy, and customer and employee health and safety. For 2023, some of the key issues will be the impact of inflation and higher interest rates, pessimistic consumer attitudes and a cutback in spending, and increased pay transparency and other diversity, equity, and inclusion initiatives. Compensation committees will have to consider the appropriate mix of quantitative and qualitative measures to address these issues. Care should be taken that any perceived "soft" metrics are meaningful and measurable, and not overly discretionary in nature or intended to be a buffer against poor financial results.

Setting Goals

Compensation committees can also evaluate how bonus goals are set. For many companies, the bonus target goal is set at the AOP budget (for example, the 2023 budgeted EBITDA). Committees may find it helpful to evaluate the target goal through various lenses, such as the following:

• Relative to prior year(s) bonus targets. The board can review the goals over time and ascertain if there is pay for performance, or if, on the other hand, bonuses are paid for the same level of performance every year. This analysis may be illuminating. For example, one company established sales goals based on budget. A longitudinal analysis showed the budgeted sales goals had not increased as much as the overall target bonus pool.

• Comparing actual versus budgeted performance. Have goals historically been too hard or too easy? Boards can review historical actual to budgeted performance to help answer that question. If there is consistent overachievement (that is, actual performance always or often exceeds budget), perhaps goal setting is too easy. If there is consistent underachievement, goal setting is too aggressive. On average, bonus plans should pay at target over the long term. In some years, performance and bonus exceed target; in other years, they fall below target. Average payouts should be around target.

• Relative to external benchmarks. Private companies can evaluate their actual performance against the external benchmarks. While data from specific comparable private companies may be difficult to come by, industry associations and publicly traded companies in the same industry can provide useful data. External operating and financial metrics help the board and owners understand the competitive performance expectations.

• Relative to shareholder objectives. For most private companies, shareholders have an expectation of a minimum return on their capital. As compensation committees establish the goals for threshold, target, and maximum bonus payouts, they should consider whether such payouts are aligned with shareholder distributions. For instance, shareholders may question whether it is appropriate for management to receive bonus payouts if there is no shareholder distribution.

• Accounting for different external scenarios. Compensation committees could consider scenario-based goals based on certain fact patterns. For instance, for a financial services company, bonus goals differ based on the interest rate scenario. One set of goals applies in a lower interest rate environment while another set of goals applies in a higher interest rate environment.

Using Discretion

Unlike publicly traded companies, private companies and their compensation committees are not precluded from applying discretion to calculated bonus awards. We recommend that compensation committees establish the approach to using discretion well before such discretion is needed. To help establish this approach, boards can ask the following questions:

• What is the philosophy for adjusting for external factors? For some companies, there is no adjustment as management is expected to handle externalities. Externalities can cause a windfall in some years, and losses in others. Over time, the effect of externalities averages out. For other companies, there is a strong desire to soften the effect of externalities on bonus payouts.

• What is the philosophy for below-threshold performance? For some companies, below-threshold performance means no bonus. Other companies establish a reserve pool (e.g., up to 20 percent of target bonus) with specified criteria for awards to selectively reward high performers (i.e., not spread thinly across the organization).

Protecting the Company

Compensation committees should also consider whether any protective mechanisms are appropriate. For some companies, the pandemic created demand spikes that generated outsized and unintended bonus award payouts, especially for companies with uncapped bonus plans. Boards can consider whether award caps or achievement of minimum cash flow or shareholder distribution requirements are appropriate.

As boards evaluate the AOP, it is an opportune time for the compensation committee to evaluate the bonus plan. There is still time to ensure that the 2023 bonus structure, measures, and goals reflect company and shareholder objectives and be flexible given the uncertain economic environment.

Bertha Masuda is a partner at Compensation Advisory Partners.