Innovation has long been critical to a company’s sustained success. Yet many companies fail to innovate meaningfully and consistently—and compensation programs may be partly to blame for many firms’ failures.
In our experience, the compensation programs within larger corporations are typically not structured to appropriately reward entrepreneurial teams that are starting innovative ventures. For example, metrics are often wrong, measurement periods are frequently too short, and the size of the rewards are rarely commensurate with the incremental value they create. We know of three executives who were instrumental in launching $100 million-plus businesses. Despite the huge incremental value all three created for their corporations, their compensation plans failed to adequately reward them for creating such explosive growth. Although they received large bonuses and public recognition, they and their teams received only a tiny fraction of the value that they created. Sadly, all three of these executives left their companies to work in smaller, more entrepreneurial firms.
Well-considered special incentives can be helpful—even mission-critical—in launching new businesses. These incentives can be tailored to fit the specific facts, circumstances, and expectations for a new business much more naturally than the regular, ongoing incentive programs of the parent company.
These special incentive plans—designed to help launch new businesses—are generally guided by five key principles:
Provide appropriate motivation and reward for a successful launch.
Ensure a fair allocation of the value created between the new business team and the company.
Reflect the “real” economics of the business. For example, business financials should include:
All costs of the new incentive plans;
Parent company overhead costs attributable to the new business, where feasible; and
All capital requirements of the new business.
Deliver an appropriate risk and reward tradeoff for participants to provide upside opportunity beyond traditional caps (perhaps even allowing uncapped rewards), balanced with no incentive payout if the new business fails.
Ensure an adequate time horizon to gauge business success or failure.
Such incentives have three key benefits:
Greater ability to attract outside talent to new startups, which can carry significant career risk
Improved likelihood of retaining key talent after a successful launch
More incentive to advance the ideas for startups in the first place
One such approach is illustrated by the design of a new business compensation plan for a startup within an established direct marketing company. The plan was requested by the company’s board in response to a proposal by a group of managers who wanted to launch a new line of business. Importantly, the board wanted a compensation plan that provided significant upside to the entrepreneurial manager group, and, at the same time, protected the broader business. The final design had the following features:
To recognize the increased risk and to give the plan an entrepreneurial character, a risk premium was added to the compensation package that was also provided to company executives of a similar pay grade, and the long-term incentive opportunity was left uncapped. However, on the downside, if the launch was not successful, payouts were essentially limited to salary and a small short-term bonus.
Part of the compensation was paid along the way through a short-term bonus with payments based on the achievement of key financial and nonfinancial milestones that were critical to a successful launch. Given the difficulty in predicting the exact timing of things, incentive payments were milestone-based, rather than tied to finite time periods. But, all milestones had to be achieved within a three-year period – a negotiated test period, balancing expectations for the new business and the board’s risk tolerance. Additionally, milestone bonuses were back-end loaded, with no more than 50% of the total opportunity paid within the three-year launch window.
The bulk of the compensation was delivered through a long-term incentive that was specific to the business unit and was tied to the value created by the business unit over a seven-year period, less all costs incurred by the parent company including capital invested, corporate overhead attributable to business, and all compensation costs. Importantly, this approach ensured the incentive program was self-funded —an important protection for the board. Value was determined using a multiple of earnings derived from the parent’s historical financials.The upshot: the business had a promising start, but it faltered against latter-stage milestones and was shuttered in its first three years. The payout to the entrepreneurs was limited to salary and a single milestone-based bonus payment. Although there was a big upside opportunity, the company’s ultimate compensation exposure was very limited. Importantly, failure was not rewarded, as had been the case with prior plans.
Seymour Burchman is a retired managing director at Semler Brossy. Burchman, who has been an executive compensation consultant for over 30 years, has consulted on executive pay and leadership performance for over 40 S&P 500 companies. He may be contacted at firstname.lastname@example.org.
Barry Sullivan is a managing director at Semler Brossy. Sullivan supports boards and management teams on issues of executive pay and company performance. He may be contacted at email@example.com.
NACD and Marsh & McLennan Companies will host a Board Committee Forum on Strategy and Risk at the upcoming 2017 Global Board Leaders’ Summit. This forum will explore converging risk and strategy issues facing boards as companies respond to digitization and artificial intelligence.
Business and society at large are in the midst of a remarkable change not seen since the Industrial Revolution. Boards and the C-Suite must understand the fundamental scope and impact of the changes to guide their organization through the next ten years.
There are two ways companies can view this change. From one perspective, it’s time to play defense. Automation is expected to rapidly erode job security for entire categories of workers. Increasing transparency will melt away the ties that bind together vertically integrated businesses. Scale-driven manufacturers will see 3D printing create decentralized and fragmented production, making many traditional factories obsolete. Virtually no conventional business will be spared by this exponentially accelerating change.
But there’s another perspective—and a wholly optimistic one. Just as there has never been this degree of change, there has never been this degree of possibility for innovation. But what will it take to win customers in this new world of extreme connectivity and automation?
To answer this question, Lippincott has worked extensively across industries to predict the changes ahead. The six fundamental shifts below offer a picture of the customer of the future and the world for which companies need to prepare.
1. A life flow. New models of work, platforms for sharing information, and constant connectivity that technology provideswill upend the traditional concepts of one job, one house, and singular ownership of things. Optionality will be what provides stability in a world that prioritizes access over ownership and experiences over possessions.
Companies that are able to move with their customers in a de-centralized, independent fashion will undoubtedly do well in the future. Convenience and flexibility will become crucial selling points. The acts of hailing a cab, visiting the grocery store, or stopping at the bank have already been streamlined to a swipe of a finger. Even the most minor interruptions will stand out.
2. A transparent existence. The amount of data created by these technologies will explode, as everything and everyone increasingly becomes tracked and scored. Tracking each facet of life presents companies with enormous opportunities—but also accountability to customers who will demand transparency around how their data is being managed. This heightened visibility will lead to a rise of ratings, and every brand we consider will have a score. Companies will need to be more transparent than ever, opening up their customer experience for full accountability. Those hiding anything will quickly be exposed.
3. The rise of the omnipotent individual. Products offered on digital platforms will be modular, customized, and democratized. As a result, customers will wield god-like power over each component of their lives, from their homes to their genes. In response, the production of products will become flexible and dispersed, customized to the unique wants of these empowered consumers.
Companies will need to give their customers the power to unbundle, customize, make, modulate and mix. They’ll need to go beyond a “one size fits all” approach and grant customers the power to control their own unique experiences. Those that master this will be rewarded handsomely for it.
4. An on-demand world. Technology makes the world more immediate. On-demand access and automated task completion will serve appetites for instantaneous results, and customers will reward the fastest solutions with their dollars and data. While customers will have less to do, they will have more to manage. For companies, it’s incredibly important to keep up with customers’ ever-increasing expectations for immediacy and efficiency throughout every aspect of the customer experience.
5. Exponential intelligence. Consumers will have more access to information than ever before, shifting who and how they trust. As a result, their decision-making processes will change from being a personal deliberation to a collaborative and connected feedback loop. Lippincott’s research shows that 62 percent of consumers would rather make decisions based on intelligent apps and crowdsourced information than on the advice of family and friends. Companies should strive to provide their customers with as much knowledge about their business and its products as possible.
6. Synthetic reality. Virtual reality and the real world will overlap, expanding consumer perspectives and opening up new possibilities in information access, communication, how people shape their personal identity, and the monetization and gamification of products and commodities. The companies that help their customers navigate between the two worlds with ease will open up new channels to connect, creating a business differentiator in the process.
As these six shifts unfold, they’ll yield a bounty of new innovations and value propositions. Companies and their boards need to think deeply and strategically about what these changes portend for the fundamental underpinnings of their business designs and value add to the customer of the future. And for those that do, something great is just beginning.
To read Lippincott’s full report on these six shifts, click here.
John Marshall is the chief strategy and innovation officer at Lippincott.
To learn more about strategy and risk, attend the 2017 Global Board Leaders’ Summitwhere you will have the opportunity to explore emerging risk issues with peers. A detailed agenda of NACD and Marsh & McLennan’s Board Committee Forum on strategy and risk, can be found here.
In April 2017, the U.S. Securities and Exchange Commission’s (SEC’s) Division of Corporate Finance announced it will not recommend enforcement action for companies that disclose, but do not further investigate usage of conflict minerals which may be from the Democratic Republic of Congo (DRC). Any company manufacturing or contracting to manufacture products using such minerals had previously been required to conduct extensive due diligence on its supply chain and make this diligence publicly known with a note that its products contained minerals which “have not been found to be ‘DRC conflict free.’” However, following a series of partial losses in court, the SEC appears to be backing off the rule—for now.
The Conflict Minerals Rule and Disclosure Requirements
A provision in the Dodd-Frank Act aims to cut off funding sources for armed rebel groups in the DRC and surrounding countries in central Africa. It requires companies manufacturing products containing certain minerals to conduct supply chain audits and disclose if those minerals were known to have originated in the DRC or adjoining countries. The SEC, as the enforcer of this provision, issued a rule requiring issuers of securities who filed reports with the SEC under Sections 13(a) or 15(d) of the Securities Exchange Act of 1934 and who manufactured or contracted to manufacture a product in which the defined conflict minerals were a necessary part, to file a separate special disclosure form, Form SD. Although these obligations were placed on manufacturing issuers, in practice, the diligence requirement was imposed on others in the supply chain because many manufacturers required their supply chain partners to certify origin of minerals and compliance with the rule.
When Form SD was first issued, items 101(a) and (b) required companies using conflict minerals to attempt to identify the country of origin of those minerals. If after conducting a “reasonable country of origin inquiry” the company determined that the country of origin was neither the DRC nor an adjacent country, it had to disclose this finding (and a description of the country of origin inquiry conducted) on its website as well as to the SEC. Per item 101(c) of Form SD, if a company’s minerals may have originated in either the DRC or its neighboring countries, the company was required to conduct additional, more extensive due diligence, and then file and publish a conflict minerals report. This report had to include a description of the company’s due diligence efforts, certified results of an independent private audit, and a list of planned changes as a result of the audit. In the report and on its website, companies also had to describe which products had “not been found to be ‘DRC conflict free,’” although for the first two years of enforcement they could use the label “DRC conflict undeterminable.”
The National Association for Manufacturers challenged these regulations on both procedural and constitutional grounds. After the district court granted the SEC summary judgment, the Association appealed to the DC Circuit of Appeals. Ultimately, the appeals court found that forcing companies to note whether or not their products are DRC conflict free was unconstitutional under the First Amendment. The case was remanded to the U.S. District Court for the District of Columbia, which issued its final judgment in April 2017 and set aside the part of the rule that requires companies to add language that their products are “DRC conflict free” or “have not been found to be ‘DRC conflict free.’” Citing both the court decision and the unclear efficacy of the rule, SEC Chair Michael Piwowar reopened comments and the SEC stayed the compliance portions of the rule pending the conclusion of litigation. The SEC announced it would not pursue enforcement actions against companies who only complete Form SD items 101(a) and (b) and do not pursue more extensive diligence on sourcing or secure an independent audit. The SEC has taken the view that the purpose of item 101(c) of Form SD and the related conflict minerals reports was to determine the status of conflict minerals by requiring the “conflict free” or “not conflict free” labels, and that these measures and the requirements for more detailed due diligence are in need of re-evaluation and clarification given recent court rulings on this matter.
Although companies are not currently expected to conduct the extensive due diligence envisioned by item 101(c) of Form SD, they are still expected to conduct in good faith a reasonable country of origin inquiry and disclose this information to the SEC and the public. Companies and boards still need to ensure there are effective diligence programs in place that allow reasonable inquiry into supply chain partners and components, particularly if conflict minerals are necessary to any product the company manufactures. By statute, the SEC is required to issue a rule relating to due diligence for conflict minerals. Although the “conflict free” labeling requirement has been eliminated, the question remains whether conflict minerals reports, in their current form, are otherwise valid. The SEC is currently developing its future enforcement recommendations with respect to the rule.
In the interim, companies should continue to ensure effective supply chain diligence mechanisms are in place that allow them to confirm where components, particularly conflict minerals, are sourced. To the extent that auditing or diligence measures had already been put into place prior to the final judgment and SEC announcement, companies may want to continue to implement these measures given the lingering uncertainty about future application of the rule. Companies also have the ability to submit comments on the rule to the SEC and should make their views known to influence future enforcement on this issue.
At Baker & McKenzie, Joan Meyer is a partner and chairs the North America Compliance, Investigations & Government Enforcement Practice Group. Reagan Demas is a partner and Maria McMahon is a professional support lawyer in the North America Compliance, Investigations & Government Enforcement Practice Group in Washington, DC.
To learn more about strategy and risk, attend the 2017 Global Board Leaders’ Summit where you will have the opportunity to explore emerging risk issues with peers. A detailed agenda of NACD and Marsh & McLennan’s Board Committee Forum on strategy and risk, can be found here.