Author: ERI

Pay-for-performance for executives is incentive compensation aligned to business objectives that are typically defined prior to the beginning of the performance period. Most pay-for-performance plans are short-term incentive plans that qualify for IRC Section 162(m) tax deduction. The award amounts are derived based on a formula and reported in the Non-equity Incentive Plan Compensation column of the Proxy’s Summary Compensation Table.

Curiously, Microsoft Corporation has a discretionary bonus plan yet sill garnered a high approval vote for their Say-On-Pay, despite shareholder activism related to pay for performance. Let’s review their discretionary plan by taking a closer look at Microsoft’s 2012 Incentive Plan. Unlike the typical attributes just described, Microsoft 2012 Incentive Plan awards are not determined based on a formula or measured against predefined targets; rather, they are based on the executive’s performance across financial, operational, and strategic factors. The qualitative and quantitative factors used to evaluate 2012 performance included the following:

• Compliance and integrity
• Contribution margin
• Corporate citizenship
• Customer acceptance
• Customer satisfaction
• Developer community satisfaction
• Efficiency and productivity
• Innovation
• Operational excellence
• Organizational culture and leadership
• Organizational diversity
• Product development and implementation
• Quality
• Revenue
• Sales and licensing volume
• Strategic planning

The Incentive Plan design includes 20% of the target award payable in cash and 80% payable in stock that vests in four equal installments. The Plan is funded as a percent of Microsoft’s fiscal year 2012 corporate operating income and is capped at 0.3%. The CEO target award is 0% to 200% of base salary, whereas the other Named Executive Officers have 0% to 150% of the incentive target award. Also, the specific business rationale disclosed in the Proxy that supports the discretionary pay-for-performance approach:

• incentivize efforts to create shareholder value that may not produce tangible results within a fixed or predictable time period, which is important given the long-term characteristics of Microsoft’s business

Based on this plan description, let’s take a look at Steven Sinofsky’s 2012 compensation and how this information was disclosed in the Proxy Summary Compensation Table.

Notice that there are three standard columns not included in the table: Option Awards, Non-Equity Incentive Plan, and Pension & Non-Qualified Deferred Compensation. The Bonus amount reported reflects the 20% cash portion of the Incentive Plan awards, and the Stock Award amount reflects the 80% stock portion of the award. Microsoft aligns pay with performance focusing on the long term by not including hard business targets, options awards that may tempt executives to focus on short-term performance of stock price, and tenure-based plans like Pensions. At the same time, they assess the executive performance with a comprehensive set of factors that measures performance holistically. Microsoft shareholders continue to support these executive pay programs, demonstrating that there is more than one way to align interests and maximizing IRC 162(m) deductibility isn’t a necessary requirement.

For more information, analytics. and tools related to executive compensation, visit www.erieri.com.

Research assistance provided by Ben Croudace, ERI Subscriber Services Associate

With the advent of Say-On-Pay and the prolonged sluggish economy, one might think that business executives are risk averse and look to retain stock price levels for shareholders as opposed to attempting to increase them. One reason for this type of business leadership approach could be attributed to shareholder activism that advocates for more focus on long-term results, curbing excessive risk taking and the resultant Stock Ownership Policies (SOPs).

SOPs have been around since the 1990s; however, they are more prevalent today. The key elements of a SOP are:

1. A defined level of ownership of all shares applicable that executives have to maintain during their tenure in the role.  This may be expressed as the following:
   • a multiple of the executive’s base salary (most commonly used)
   • maintain a percentage of all shares acquired
   • a fixed number of shares as the target threshold
   • a combination of definitions (e.g., base salary multiple and a specific number of shares)
2. Contain a provision which indicates the amount of time required to achieve the specific ownership level.
3. A defined retention or a holding period, in which an executive must hold the shares.

Executives look to equity compensation as a vehicle for wealth accumulation, and there are a number of programs or ways in which executives may achieve the requirements of SOPs. The types of equity that can be counted toward the ownership threshold include common stock (vested or unvested/restricted), stock options (vested, unvested, exercised, or unexercised), stock in deferred compensation accounts, stock in 401(k) plans, employee stock purchase plan (ESPP), stock in trusts, stock owned by immediate family members, and stock acquired through open market purchase.

The Microsoft Corporation recently disclosed an SOP in its proxy. The stated business objectives indicated that executives have a personal financial stake to promote a long-term management focus and to align with shareholder interests.   The board has discretion to waive compliance of this SOP if it creates severe hardship or prevents a covered officer from complying with a court order.  Those employees required to comply with this SOP are the executive officers and specific executives who participate in the Executive Incentive Plan.  The types of equity that count toward meeting the guideline are shares acquired in open market, vested stock awards, exercised stock options, stock from an employee stock purchase plan, shares held by the spouse or dependent children of the officer, shares held in trust, and shares held in a 401(k) plan.  The ownership guidelines were defined as a multiple of the executive’s base pay (as of the end of fiscal year) and the average daily closing share price of the 12 months ending on June 30.  Each officer is required to retain 50% of all net shares (post tax) vested on or after October 1, 2007, until minimum share ownership requirements are met.  If promoted to a position with higher requirements, the higher standard will apply.  The base salary multiple is progressive depending on the role of the executive as noted below:

• CEO and Executive Chairman – 10x base pay
• Division Presidents and COO – 5x base pay
• Other Covered Officers – 3x base pay

As a result, based on this SOP and the disclosure in the Beneficial Ownership table (as of 9/2/2011), we calculated some values to demonstrate how this policy could be evaluated. Below is a summary based on a stock price of $25.80 on September 2, 2011:

Last Name	# of Shares Owned	Base Salary	$ Value Shares Owned	Base Salary Multiple
Ballmer	333,252,990	$682,500	$8,597,927,142	12,597.70
Turner	163,044	$732,500	$4,206,535	5.74
Sinofsky	1,109,619	$649,167	$28,628,170	44.10
DelBene	120,895	$603,333	$3,119,091	5.17
Klein	83,503	$525,000	$2,154,377	4.10

We have examined some reasons why companies use SOP and have explained a best practice SOP and how it could be potentially evaluated.  As a parting thought, it is worth reviewing a few excerpts on the other side of this topic from business guru, Warren Buffet, who has been quoted as saying the following regarding SOPs:

… stock options as “a royalty on the passage of time.”   Source

…a manager can do nothing and stock prices will still rise.   Source

…stock options are more often wildly capricious in their distribution of rewards, inefficient as motivators and inordinately expensive for shareholders.    Source

Including equity in compensation programs requires evaluating their appropriate use as well as intended impact. The goal of achieving alignment of interests between business leaders and shareholders has come to the fore in the current regulatory and economic times.  SOPs can be part of a comprehensive solution that helps organizations achieve this alignment.  Boards and Compensation Committees should monitor and evaluate the effectiveness of such policies as part of their overall program, as well as “fine tune” them along the way.

For more information, analytics, and tools related to executive compensation, visit www.erieri.com.