Category: Risk Management

Preparing an Organization for an Economic Downturn

Published by
Jim DeLoach

Jim DeLoach

There is no better time to prepare for an economic downturn than when times are good. With the memory of the severity of the 2007–2008 financial crisis still fresh in the minds of many directors and executives, how should companies prepare for a downturn in the cool of the day, rather than reacting in crisis mode?

Most business plans do not currently anticipate economic downturns; however, a contingency plan makes good business sense because it positions companies to act decisively when recessionary storm clouds loom on the horizon.

Organizations develop contingency plans to address market opportunities should they arise and document specific action steps that are triggered if certain events occur. Such events might include natural disasters, cybersecurity breaches, terrorist attacks, fire, fraud, theft, or embezzlement. These perils may never occur, but the plan nonetheless stands ready with a response team organized to implement it.

The focus of this discussion is how to prepare for an economic recession that causes revenues to decline below a predefined threshold. It is virtually irrefutable that a recession will occur, which is why it’s wise to create a contingency plan to (a) mitigate the financial impact of a severe economic downturn on earnings and share price and (b) position the company to gain market share during the recovery.

In preparing a contingency plan to accomplish these two objectives, action steps are sequenced, prioritized, and grouped by corporate function and operating unit so that ownership of each step is clear. Targeted cost savings in the current and subsequent projection years should also accompany each action step. Key plan elements for most companies include.

  • Headcount and hiring changes. Distressed operating environments present a time for shepherding the talent most critical to retain. Focused retention, objectively determined workforce reductions, and changing hiring practices are often important components of a contingency plan.
  • Compensation, benefit, and incentive plan adjust­ments. Temporary revisions to compensation, benefit, and incentive plans may be necessary to stabilize the firm’s financial condition. Vetting the economic realities of a declining top line and the need for adjustments to the reward system with key personnel before a downturn creates a broader support base for the plan when it is implemented.
  • Asset divestitures. Manage­ment should categorize the company’s assets—underperforming versus high-performing, strategic versus nonstrategic—so that a plan can be developed for each asset category. The plan should consider the timing and the immediate and long-term financial impact of asset sales, and the need for such sales as signs of extreme economic scenarios appear. Timing can be a critical factor due to the difficulty of selling assets in a depressed market. Sale-leaseback transactions for certain facilities are also an option for raising capital.
  • Selling, general and administrative (SG&A) expense cutbacks. SG&A offers many cost reduction opportunities. In the context of a contingency plan, the objec­tive is to adjust the cost structure to support stabilization and preservation of the enterprise.
  • Consider other options. Other steps a company can take include:
    • Hedge raw material costs and lock in sales prices, thereby stabilizing margins — at least for a time;
    • Consider outsourcing non-core activities that are not strategic to the business, if it will reduce costs such as certain human resources support, accounting, manufacturing and transportation activities;
    • Focus marketing on sustaining brand awareness during a recession;
    • Discontinue underperforming operations; and
    • Address the impact of upstream and downstream interconnectivity within the value chain, e.g., what steps would the company take if a major supplier were to go under due to the downturn?
  • Hierarchy for cost-savings initiatives. Management should outline a comprehensive menu of prioritized cost-savings initiatives that could be implemented either in part or in its entirety, depending on the severity of the downturn.
  • Communications plan. In times of economic uncertainty, timely and open communications are vital to preserving morale so that employees know where they stand, and how they and the organization can get through the crisis. Straight talk and transparency are important because, from an employee perspective, no news does not necessarily mean good news.

An effective plan should determine the metrics to be managed against the enterprise’s specified targets such as net operating income percentage, gross margin percentage, acceptable variance from budget, earnings per share, minimum cash reserves, and maximum debt levels. With targets identified, a financial forecast over an appropriate period should be prepared to establish a baseline. Considering different scenarios—revenue declines of, say, 10 and 20 percent— the costs and expected benefits from the various elements mentioned above should be considered to ascertain specific actions management should take under the circumstances.

Once completed, the plan should be reviewed with and approved by the board. The company then resumes its growth strategy with full knowledge that the contingency plan is ready when the time comes—and, unfortunately, it will come. A vetted, actionable contingency plan saves precious time during a crisis because there is a broader base of support for its execution. Preparedness leads to decisiveness under fire.

Management should review the plan on a regular basis to ensure it remains current and apprise the board of any significant changes made to the plan. Going forward, management should monitor the external and internal economic indicators appropriate to the company, and periodically review the analysis with the board. Once the plan is initiated, a project management office should be designated to drive its imple­mentation. The project management office monitors the achievement of the assigned initiatives and provides status reports to senior executives and the board.

Developing a response plan under sunny skies rather than when the recessionary storm breaks  would demonstrate a board’s due care and sound business judgment in discharging its oversight respon­sibilities to address a credible threat. Further, entering a distressed operating environment without a thoughtful, compre­hensive plan can lead to hasty decisions, inefficiencies and costly delays. An organization’s stakeholders deserve better.

Launching a New Business Requires Something Special

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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.

Seymour Burchman

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.

Barry Sullivan

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:

  1. Provide appropriate motivation and reward for a successful launch.
  2. Ensure a fair allocation of the value created between the new business team and the company.
  3. 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.
  4. 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.
  5. Ensure an adequate time horizon to gauge business success or failure.

Such incentives have three key benefits:

  1. Greater ability to attract outside talent to new startups, which can carry significant career risk
  2. Improved likelihood of retaining key talent after a successful launch
  3. 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 sburchman@semlerbrossy.com.

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 bsullivan@semlerbrossy.com. 

The Strategic-Asset General Counsel

Published by
Kimberly Simpson

Kimberly Simpson

In June, NACD convened general counsels (GCs) from across the country for a one-day meeting in New York City on the role of the GC in supporting boards of directors. Program panels consisted of directors, GCs, and subject-matter experts on legal issues affecting board decision making.

The Evolving Role of the GC

According to Richard D. Buchband, senior vice president, GC, and secretary for ManpowerGroup, the GC must clear the way for the board to focus on strategic matters. Though each company is different, long past are the days when the GC’s role was to take minutes in the corner of the boardroom.

A clue to how a general counsel will be perceived in any given company may be found in the interview process, when a candidate should take note of whether board members participate. Also, in assessing how the board will utilize the GC, a candidate or sitting GC should be aware of whether board members hail from countries in which the GC traditionally takes a smaller role, reporting not to the CEO but to the CFO, according to Yvonne E. Schlaeppi, director for Stallergenes Greer and former GC for several companies, including Johnson Controls Europe.

Once connected to the board, the general counsel can be of value for many facets of the enterprise, leveraging his or her unique position in the organization to assimilate information and data from across the business. Several suggested that the general counsel should always offer a recommendation when providing input to the board. In fact, judgment is a critical part of what a GC offers the board. “The crux of a GC being a strategic advisor to the board is having your good judgment on the complex mix of puzzles which general counsels deal with all the time—including commercial, legal, and people challenges—recognized and valued,” said Schlaeppi.

Further, the career of Robert Bostrom, senior vice president, GC, and corporate secretary for Abercrombie & Fitch Co., illustrates how the general counsel can be the glue for an organization in turmoil. During a prior role as general counsel at Freddie Mac, he saw several CEOs and CFOs come and go around the time of the 2008 financial crisis and when the government appointed a conservator. Today, Bostrom co-chairs Abercrombie’s enterprise risk management group and leads the organization’s crisis management team, taking point on risks affecting the company’s reputation.

Moving the Board Forward

Of course, given that the GC is often the most knowledgeable person about issues of corporate governance, the GC brings tremendous value by providing advice and counseling on governance matters. Gillian A. Hobson, partner, capital markets and mergers & acquisitions at Vinson & Elkins, pointed out that such governance matters include issues such as independence, diversity, proxy access and others outlined in Commonsense Corporate Governance Principles, published in 2016 by a group of leading executives and investors. In addition, in order to move a board forward, the general counsel has a number of specific tools at his or her disposal. The general counsel can:

  • Suggest formats for a board evaluation and skills matrix;
  • Bring outside information (such as NACD’s Blue Ribbon Commission Reports) and outside perspectives (such as those from ISS, BlackRock and others) to the board; or
  • Develop relationships with board members, including board leadership and more progressive board members.

William E. McCracken, director for MDU Resources Group and for NACD, suggested that when boards get “stuck,” the GC is in a “unique position to lift the board’s vision up to see what else is happening out there.” Steven Epstein, corporate partner and co-head of mergers and acquisitions at Fried Frank, agreed. “The GC will be up to speed on the general M&A landscape and the latest thinking of the courts and will be well-positioned to combine that knowledge with the business objectives of the company, which is extremely valuable to the board.”

No Surprises and Keep It Short

Several times throughout the day, panelists espoused the best practice of imparting “no surprises” to the CEO or the board. For example, if the GC sets up lunch with a board member, Buchband suggests a check in with the CEO after the meeting is set but before the lunch takes place. “I ask the CEO if there are any issues he would like me to raise or discuss,” said Buchband. Keeping the board informed on matters affecting governance is equally important.

Also, all panelists reiterated how important it is for the GC to keep materials short and topline for the board. “We can be victims of our own desire to be thorough,” noted Buchband.

Enterprise Risk Management and Compliance Make the GC’s Job Easier

The role of risk assessment is not to avoid all risk, but rather to identify and manage risk, said George J. Terwilliger III, partner at McGuire Woods. In fact, Bostrom noted that enterprise risk management at Abercrombie helps him and the company prioritize risks. If a risk rises to the top, then a cross-functional, high-level team has agreed that it should be there, and he doesn’t have to champion the cause as a lone voice.

Daniel Trujillo, senior vice president and chief ethics and compliance officer for Wal-Mart International, stressed that a culture of compliance must start at the top. A program must then be implemented that is effective, consistent, data driven, efficient and sustainable. Terwilliger echoed that compliance has to be part of the fabric of the company, with the compliance council acting as a convener rather than as “internal police.” Today, predictive analytics help his team spot trouble early at Walmart, at the country or even the store level.

Consider Cross-Border Complexities

Just as Wal-Mart operates globally, so too do companies like Abercrombie. David H. Kistenbroker, global co-head of white collar and securities litigation at Dechert, reminded the audience to consider cross-border complexities when advising the board. Long-arm statutes in the United States and United Kingdom can impact deals all over the world. Due to such complexities, the GC is in a unique position to be a strategic asset to companies operating globally, especially where board members are all based in in the United States.

NACD would like to thank the panelists for sharing their experiences with attendees, and for these generous sponsors for their support of the event: Dechert, Fried Frank, KPMG, and Vinson & Elkins.


Kimberly Simpson is an NACD regional director, providing strategic support to NACD chapters in the Capital Area, Atlanta, Florida, the Carolinas, North Texas and the Research Triangle. Simpson, a former general counsel, was a U.S. Marshall Memorial Fellow to Europe in 2005.