November 6, 2020
November 6, 2020
Suppose I approached you and offered you the chance to play a game. Here are the rules and the stakes.
Will you play this game?
The answer is really a function of your decision model and your risk appetite but the expected payoff to you is: ($100/2) – ($5/2) = $47.50.
At these stakes, most rational decision makers would play the game. But what if the coin lands tails-up and you owe me $5? Did you make a bad decision? Not at all. But you did have a bad outcome.
Decisions are made in the face of uncertainty with an array of possible outcomes; outcomes are certain and ex post facto. On the other hand, if the bet was that there would be 20 tosses of the coin with the same stakes, it is almost certain that you would be a winner. Your decision to play would be supported by the outcome.
Boards and compensation committees are challenged every year to assess the performance of management. Did management make the right decisions? Did they quantify the risks they expected to confront? For example, did they assess business, financial, regulatory, or activist risks?
In an optimal world, the compensation committee would evaluate the quality of the decisions made by management. And to some extent, through analyzing the materials prepared by management and asking questions, boards do assess the decision. But in the end, board members base much of their assessments of performance-based compensation on outcomes, whether these outcomes are based on Generally Accepted Accounting Principles (GAAP) metrics, such as total shareholder return, or non-GAAP measures such as earnings before interest, taxes, depreciation, and amortization (EBITDA).
But with an emphasis on outcomes, we lose a focus on the decisions themselves.
As with the multiple coin-toss game, boards have observed management’s performance over many quarters. They usually know if management has a propensity to underestimate the EBITDA by a penny or two a share, or overestimate sales. And, through observing management over multiple months and quarters, the outcomes become a valid proxy for the decision.
Not so in 2020. The decisions made by management to address the impact of COVID-19 are not unlike the one-time coin toss. When companies prepared their 2020 calendar year forecasts, very few were aware of the coronavirus. Revenue and cost estimates made in late 2019 were, for a majority of companies, irrelevant three months later. The conventional outcomes that have been used to assess performance in prior years are not relevant for 2020.
The challenge for compensation committees in 2020 is to assess actual decisions made when COVID-19 struck, instead of the outcomes. Did management act decisively? To what extent did management appreciate the magnitude of the pandemic?
COVID-19 demanded that management make a number of decisions quickly, under duress, and with only partial information at best. To better assess the quality of management’s decisions, boards should ask the following questions with the early days of the pandemic in mind:
Human Capital and Facilities
Customers and Clients
Performance-based compensation is a critical part of most companies’ reward structures. Done well, it can motivate and build not only a strong culture but also loyalty. Without doubt, one of the greatest challenges boards must confront in 2020 is evaluating the decisions management made in the face of an unprecedented pandemic and unforeseen market volatility—not necessarily the outcomes experienced.
David A. Wilson is lead independent director and a member of the compensation and audit committees of CoreSite Realty Corp. He is also chair of the audit committee and a member of the corporate governance and nominating committee of Barnes & Noble Education.
NACD: Tools and resources to help guide you in unpredictable times.