The Tightrope of Incentive Plan Adjustments

You are sitting in the boardroom, and incentive payout decisions are on the agenda after an unpredictable year. What can be attributed to management decisions, and what was totally beyond anyone’s control? Did management strategically help the long-term health of the company, and knowingly sacrifice some short-term performance? Myriad circumstances require “further consideration,” all while keeping shareholders and “fairness” in mind.

One such example to consider: A company whose fiscal year ends on December 31 increases shares outstanding through an equity offering to the public in November. The funds raised will be accretive to earnings the following year when they can be deployed. The added share count dilutes what would have been target earnings per share performance (remember: more shares but not yet more earnings). How would you treat this? What’s fair? Does your company have a methodology or plan?

In today’s dynamic and often unpredictable business environment, companies sometimes face circumstances that force them to reconsider their existing incentive plans midstream.  Unpredictable conditions—global crises, economic downturns, unforeseen industry disruptions, or governmental policy changes—pose significant challenges to maintaining standard performance metrics and reward structures. Adjusting incentive plans under such circumstances requires a careful approach that safeguards the credibility of compensation plans, ensures transparency, and upholds governance standards.

The following are just three examples that highlight different circumstances leading to incentive plan adjustments sourced from public disclosures and lightly edited.

Scenario 1: Force Majeure

The threshold, target, and high goals for Adjusted EBITDA were established in February 2023 by a hotel chain’s Compensation Committee. The goals were based on the [hospitality] company’s 2023 business plan and budget, both of which were approved by the board. As in prior years, the company approved an operating budget through a rigorous hotel-by-hotel analysis and budget expectations that reflected industry consensus. The committee adjusted EBITDA goals by removing the operating results of a property in Naples, Fla. That hotel sustained damage from Hurricane Ian in September 2022, forcing the property’s closure. At the time goals were established in February 2023, there was significant uncertainty as to when the hotel would reopen. That made it impractical to establish 2023 targets, which would have included the hotel’s performance. The hotel remained closed until July 2023.

Scenario 2: Workforce Disruption

For purposes of calculating performance under the Annual Incentive Program for Executive Officers, an adjustment, as permitted by the program, was made to adjusted EBITDA, net sales, adjusted EBITDA margin, and operational cash flow for the fiscal year ended December 31, 2023. This adjustment offset the unfavorable impact of the UAW Work Stoppage that occurred in the last several months of 2023. The committee approved this adjustment because the impact of the work stoppage was outside management’s control, and there was no practical opportunity for the industry and the company to offset 2023 performance.

Scenario 3: Currency Fluctuation, War, Inflation, Supply Chain

The compensation committee evaluated the 2022 performance of the CEO and COO, considering their leadership amid sizable currency movements, pandemic-driven challenges in China, the Russian war in Ukraine, rising inflation, and supply chain disruptions.

Risks and Benefits

The primary rationale for modifying incentive plans is to align executive and leadership behavior with the evolving realities of the organization. When external or extraneous factors meaningfully impact company performance, traditional metrics may no longer accurately reflect effort and results. Without adjustments, stakeholders risk outcomes that are heavily influenced by external shocks rather than genuine operational excellence or strategic prowess. Moreover, failure to adapt can demotivate leadership, compromise morale, and damage trust in the company’s governance processes.

Incentive plan adjustments might include revisiting performance targets, payout formulas, or, in certain circumstances, introducing temporary measures to incentivize critical behaviors that support the company’s recovery and resilience. These modifications provide clear, thorough justifications grounded in external developments and internal strategic shifts. Such documentation facilitates oversight, accountability, and future review, reinforcing the integrity of the decision-making process.

Implementing these adjustments involves a well-structured process. It begins with an assessment of the external environment, internal performance data, and stakeholder expectations. Engaging relevant governance bodies—such as compensation committees or boards of directors—is crucial for approval and oversight. Clear communication channels are established to inform all parties involved about the rationale for changes, the scope of adjustments, and the expected outcomes. Detailed disclosures should be made at the appropriate time, typically aligned with the Compensation Discussion and Analysis (CD&A) disclosure in the proxy, to maintain transparency and stakeholder confidence.

Stakeholder engagement is a vital component of this process. Transparent communication through proxy disclosures, earnings calls, or investor discussions helps ensure clarity regarding the reasons for adjustments and how they align with overall corporate governance principles. Such openness not only reinforces trust but also enables stakeholders to understand the context and necessity of these measures in safeguarding the company’s long-term health.

Throughout this process, best practices should be adhered to. Developing specific policies in advance can streamline responses when extraneous conditions arise, reducing delays and promoting consistency. Regular reviews and updates of governance frameworks ensure that policies remain relevant and effective amid changing circumstances. When necessary, engaging external advisors—such as industry experts, legal counsel, or compensation specialists—can provide valuable insights and reinforce the credibility of the adjustments.

When Crisis Calls

When modifying incentive plans during times of crisis or unexpected challenges, the board must approach the changes with care, transparency, and adherence to sound governance principles. Adjustments should aim to support sustainable long-term performance rather than short-term gains, aligning incentives with the company’s current or evolving strategy. Maintaining high-quality documentation throughout the process helps justify decisions, facilitate oversight, and prepare the organization for subsequent reviews. Transparency is paramount.

Other considerations for best practices when adjusting performance plans include:

• Clear rationale and thorough documentation: Define the reason for the adjustment. Adjustments should be made only when external or extraordinary factors (e.g., economic shocks, regulatory changes, tariffs, pandemics) meaningfully impact company performance, and when traditional metrics no longer reflect true effort or results. Boards should document all modifications, providing clear justifications rooted in external developments and internal strategic shifts. This facilitates oversight, accountability, and future review.
• Transparent communication and stakeholder engagement: Communicate the rationale, scope, and expected outcomes of adjustments through proxy disclosures, earnings calls, and investor discussions. Transparency builds trust and helps stakeholders understand the necessity of changes. Adjustments should also be disclosed as soon as possible, with clear articulation of the governance procedures involved.
• Governance and oversight: Engage the relevant board committee, especially the compensation committee, which must approve and oversee adjustments to ensure alignment with governance standards and shareholder interests. Governance frameworks should also be reviewed and updated regularly to ensure policies remain relevant and effective amid changing circumstances.
• Alignment with strategy and performance: Adjustments should support sustainable long-term performance, not just short-term gains. Incentives must reflect the company’s current and evolving strategy. Consider both short-term and long-term objectives, ensuring executives are incentivized to deliver immediate results without compromising future viability.

Robust goalsetting and measurement are also essential. Best practices include:

• Use of GAAP and Non-GAAP adjustments: Companies use a mix of GAAP (Generally Accepted Accounting Principles) and non-GAAP measures for incentive compensation, with non-GAAP measures often adjusted to remove items outside management’s control, such as acquisition costs or foreign currency impacts. While this offers flexibility and can better reflect core operating performance, it may face scrutiny from shareholders if it appears to yield more favorable payouts than standard GAAP measures.
• Preemptive policy development: Having clear policies for adjustments streamlines responses when extraneous conditions arise, reducing delays and promoting consistency.
• Market and peer alignment: Compare incentive plan designs and adjustments with peers to ensure competitiveness and market relevance.
• Accountability: Adjustments should not insulate management from the consequences of their decisions; they should only exclude impacts that are truly outside their control.
• External expertise: When necessary, consult industry experts, legal counsel, or compensation specialists to reinforce the credibility of adjustments and ensure compliance with regulations.

Farient’s View

These steps help uphold trust and demonstrate the company’s commitment to integrity and responsible governance. When executed thoughtfully, such adjustments can effectively reinforce strategic priorities, motivate the workforce, and position the organization for sustained success.

Ultimately, adjusting incentive plans is a delicate task that requires a balanced approach that considers stakeholder interests, regulatory requirements, and long-term objectives. By following best practices—developing preemptive policies, maintaining thorough documentation, engaging external expertise, and communicating transparently—companies can navigate these complex scenarios effectively. These practices ensure that incentive adjustments serve to bolster the company’s resilience, protect shareholder value, and uphold the principles of good governance even amid crises.

 

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By Jarret Sues and Muskan Parnami

Jarret Sues is a partner and Muskan Parnami is a senior business analyst at Farient Advisors.