Introduction

We published the first version of this guide in 2015 — soon after Dodd-Frank was implemented. At the time of the initial publication of the guide, the most immediate focus for compensation committees was reacting to the new environment of “Say on Pay” where companies were required to give shareholders a say (in other words a vote) on executive pay, or compensation programs. In the years following the first publication, we have seen continued heightening of the impact that shareholders and shareholder advisory firms have on the design of executive compensation programs. While the compensation committee is expected to act in the interests of shareholders, we find that more and more committees are directly engaging with shareholders to understand their specific points of view on executive compensation programs.

Serving on the compensation committee is an important responsibility. Shareholders expect the compensation committee to represent their interests and ensure that the company is using its resources responsibly. They expect the committee to pay management for performance while also holding the committee responsible for supporting the company’s efforts to attract and retain required talent. If the compensation program is viewed as too generous or the pay levels are misaligned with company performance, shareholders may vote against the company’s executive pay program in the Say on Pay vote. If the pay levels are inadequate, the company risks losing talent to competitors, compromising chances for optimal business performance.

Further complicating the environment that compensation committees operate in is that there is no uniformity of thought among the shareholders that they represent. The largest institutional shareholders each have their own governance guidelines and associated preferences for executive compensation programs. They often focus on general principles for executive compensation (e.g., transparent disclosure of performance criteria and objectives, managing share dilution, majority of long-term incentives tied to performance criteria, etc.). Some smaller institutions delegate their voting decisions to shareholder advisory firms (e.g., Institutional Shareholder Services, or ISS, and Glass, Lewis & Co., or Glass Lewis) who have their own principles related to executive compensation. A third constituency is activist investors who tend to take a much more intrusive and customized approach to executive compensation. They can be extremely critical of existing executive compensation practices for management teams that they view as underperforming. However, we sometimes see these activists advocate for very aggressive pay packages for the “right” management team, as long as they are supported by stock price performance goals.

In recent years, the compensation committee’s purview has been expanding. We have seen committees changing their name from the compensation committee to the human resources committee or the human capital committee to reflect the new scope of responsibilities. Increasingly, we find compensation committees dedicating a significant portion of their time to leadership development and succession planning. For many of our clients, the compensation committee is also where the company reviews it efforts related to employee diversity and pay equity. These are highly charged political topics in the current environment and the compensation committee is frequently on the spot for advising management in how to address these topics.

With this as background, one may ask “Why would I want to serve on the compensation committee of a public company?” It is our view that compensation does matter, and service on the committee allows a member to make a meaningful contribution to the company. Additionally, new compensation committee members can provide a fresh perspective on existing practices. Certainly, the focus of shareholder advisory groups and even plaintiffs’ attorneys is often on all that can go wrong with executive compensation. We believe that when compensation programs are designed correctly, they provide the company with a valuable management tool that can help attract and retain top talent, drive long-term performance, and effectively align the interests of management and shareholders. While compensation committee members do not need to be experts in executive compensation, they do need to apply their understanding of the company’s business model and its strategic objectives to ensure that the compensation designs they approve serve to advance the company’s mission.

Compensation committees help ensure that the board of directors carries out its fiduciary duty to shareholders to use their resources in an efficient manner. The goal of the compensation committee is not to minimize the cost of compensation to the company. Instead, the committee must ensure that it uses compensation wisely. If it does, it will successfully attract the right kind of executives and keep them focused on the activities that will improve the performance of the company and ultimately lead to greater shareholder value. As mentioned above, many compensation committees are now also responsible for leadership development and succession planning. A well-designed compensation program can aid in leadership development by supporting the attraction and retention of critical talent and by maintaining the flexibility required to differentiate pay for employees with high, long-term value to the organization.

The committee must be vigilant to ensure that the company’s executive compensation program will not expose the company to multiple risks. When executive compensation programs go wrong, they can be a source of embarrassment for management and board members. Compensation scandals can turn into a distraction that diverts the attention of management and the board away from running the business and towards addressing external criticism directed at the company by shareholder advisory groups, the press, and potentially attorneys.

We wrote this book to provide compensation committee members with information that we believe will help to make you more effective in your role and make your job a little easier. We try to avoid going too deep into the technical weeds of executive compensation (e.g., tax rules such as IRC sections 409A, 162(m), 83b election, etc.). Instead, our focus is on the mindsets, activities, and processes that lead to the creation of successful compensation committees. The first section of this book focuses on compensation committee processes and requirements. The second section provides an overview of the material that may come before the committee over the course of a year and identifies key questions that committee members should have in mind when reviewing each topic. This section is intended to serve as reference material, and we do not recommend trying to wade through it in one sitting.

In this edition, we have added new sections to address special situations in compensation. Section 3 covers executive compensation issues that arise in multiple private company contexts (e.g., family-owned, venture-backed, private equity portfolio, etc.). In Section 4, we cover executive compensation issues in corporate transactions. Here, we discuss executive compensation issues specific to the initial public offering (IPO) and in the years immediately following IPO, including an overview of emerging growth company compensation disclosure requirements. In addition, we address some specific events that may impact public companies, including mergers and acquisitions and spin-offs, or sales of a business.

We have also updated data from the previous version, often with reference to the “CAP 120,” our review of a 120-company subset of the Fortune 500 representing a cross-section of nine industry groups. The industry groups include the following: automotive, consumer goods, financial services, health care, insurance, manufacturing, pharmaceutical, retail, and technology.

Our thoughts are informed by interviews with compensation committee members that have particularly impressed us over the years, as well as our experiences observing compensation committees in action as consultants.

We asked these committee members to share the benefits of their experience with us by answering the following questions:

What has worked well for you in your committee service?
What do you view as the best practice for setting up the annual calendar, prepping for a meeting, running the meeting, etc.?
How should a committee structure its relationship with management?
How does the committee deal with differing points of view within the group?
How does the committee evaluate its own performance?
What were the most challenging aspects of committee service?
How did the committee interact with shareholders?

We would like to thank Ed Campbell, Tony Coelho, Lewis Campbell, Peter Haje, Gary Heminger, Charles Hinkaty, Jill Kanin-Lovers, Lee Higdon, and Lois Juliber for sharing their perspectives with us on what makes compensation committees most effective. We would also like to thank all the compensation committee members we have learned from over our careers, as well as our past and present colleagues. For specific help in putting together these materials, we would like to thank Shaun Bisman, Michael Bonner, Hanna Borsack, and Grace Tan for research assistance and assistance in drafting the book, along with other Compensation Advisory Partner (CAP) staff members who contributed to the development of our 120-company research. In particular, the chapter on mergers and acquisitions is based on research by Margaret Engel, and the chapter on spin-offs builds on research by Melissa Burek and Eric Hosken.