New technologies have been disrupting business for decades, especially since the internet became widespread in the late 1990s. But a new wave of innovation, centered on artificial intelligence, big data analytics, and the internet of things, is now intensifying the pace and magnitude of disruption. AI-powered advances by themselves, according to a 2019 McKinsey study, could boost annual global GDP by $13 trillion, or an additional percentage point.
The coronavirus pandemic has now accelerated technological change and innovation across industries, especially in e-commerce and remote work. Adding to the turbulence, social forces and business dynamics have undercut shareholder primacy while strengthening other stakeholder interests. With business changing in fundamental ways, strategic stability has fallen from its pedestal in favor of strategic agility.
Executive compensation, however, has not changed accordingly. Even as industries are restructuring, most executives operate within standardized pay plan parameters that can hinder creativity. Metrics that promote innovation and transformation are still relatively weak. Many companies rely on three-year performance periods that are too long or too short to capture the strategies they are implementing — and may thereby be contributing to the steady decline in corporate investment over the past decade. Also, boards frown on using discretion and qualitative measures in pay packages, even as they want their companies to be more agile and adjust strategies frequently. A clash is inevitable.
Not every company, however, should overhaul its executive pay immediately. Boards need to calibrate compensation to the state of their business.
At one end of the spectrum are stable innovators: industries that have yet to face major technological disruption. In most consumer products, for example, changing customer preferences are leading to new products, categories and shifts in strategy, but not fundamental changes in business models.
In the middle are intermittent disruptors, who face discrete challenges. Carmakers, for example, are moving to electric vehicles now, and will eventually offer autonomous and connected vehicles. They’ll probably also become platforms for mobility services instead of sellers of individual cars. While electrification is a major change now, these other disruptions won’t fully occur for several years, and all of these changes are fairly knowable already. Car companies have a good sense of the future, even if the timing is uncertain.
At the far end of the spectrum are ongoing disruptors, who regularly face dynamic upheaval. Financial service companies are scrambling to address collapsing market boundaries, “fintech” rivals, and new blockchain products. Health care delivery is wrestling with not only a variety of technological advances, such as artificial intelligence, remote connected sensors, and advances in gene editing, but also with intense pressure on costs and potential government intervention, all exacerbated by the pandemic. Media companies are likewise dealing with the far-reaching rise of streaming and other digital distribution channels, as well as competition from deep-pocketed software giants. Here everything is uncertain: both the timing and the future state.
Designing Compensation to Support the Business Model
Intermittent and ongoing disrupters must continuously adapt and develop new business models, which generally involve wholesale changes in strategy, talent requirements, organizational structure, and other areas.
Compensation can be a highly valuable resource in responding to disruption and clarifying key priorities and areas of focus. As they guide companies through the straits of disruption, boards will be more effective if they adjust their incentives according to the pace and magnitude of likely changes.
In these industries, boards can continue to pay leaders within the traditional compensation parameters: a salary and annual bonus in cash, and long-term incentives through a mix of stock options, restricted stock awards, and performance-based equity grants. Boards can adjust these parameters to best support the strategy.
Some boards are innovating a great deal here. Most interesting are those adding non-financial goals to encourage operational and strategic improvements, or to promote the interests of stakeholders beyond investors. Some are also evaluating different measurement time frames.
For example, a major branded food company is fighting longstanding pressures to commoditize the business. Retailers’ private labels are gradually weakening the company’s mainstay brands. The solution is the same as always in this industry: Innovate ahead of the commoditizers. A big current food trend is toward healthier choices and more socially responsible practices. This company has determined to be all in on this trend with low-sugar, low-trans-fat, and low-salt recipes to address the obesity and hypertension crises. Sustainable sourcing, of both food and packaging, is another customer focus.
These goals are ambitious in advancing the customer value proposition, but they do not alter the fundamental business model. So the board can follow historical practice with executive compensation. It uses targeted metrics tied to the profitability of the healthier-product strategy and its effect on market share. For the annual bonus, 70% rewards sales growth and profit margins, while 30% follows non-financial targets such as net promotor score, productivity, and sustainable sourcing. Because changing a full product line to healthier choices is likely to be more difficult than the usual innovation, the board might want to create interim milestones for the long-term incentive (LTI) program, with measures such as market share and the proportion of revenue from new products.
These companies are in a transition period where the legacy business must generate the cash flow to finance innovation for the new offerings. Boards at these companies may opt for a hybrid compensation model, with an annual bonus that looks more traditional while the long-term incentives incorporate new elements to support the transition.
A major car company, for example, has focused its annual bonus on the cash flow and profitability (not growth) of the legacy internal-combustion business. A third of the bonus is tied to operational metrics such as efficiency to help fund investments in electrification and mobility.
Long-term incentives can then be focused on building the future business model, and denominated 100% in shares. Boards can award most of those shares according to performance, incorporating proof-point milestones at critical time periods (such as two and four years) and perhaps with relative shareholder return as a proxy for the new strategy gaining traction. The remaining awards would be restricted shares or stock options, gradually vesting over the period to deliver the benefits of the value created.
Industries in this group have the toughest compensation design challenge, as they face what is likely to be a continuing series of disruptions. The challenge is not just in the variety of disruptions, but also in the great uncertainty over timing and magnitude.
Companies facing ongoing disruption can work from some strengths, but they must revamp their business model regularly. As one of us argued recently, these companies should no longer center compensation on strategies that may be obsolete in a year or two. Instead they should work from their underlying mission, which is enduring. The mission offers consistent, yet flexible guidance for long-term transformation, agile course correction, and building the stakeholder-rich ecosystems the company needs for a highly uncertain environment.
Let’s take a conventional bank with the mission of “providing a full range of affordable and timely financial services solutions with full regulatory compliance and an acceptable level of risk.” From that mission, and adjusting to the current disruption, the bank’s leaders might derive a new customer value proposition emphasizing speed and lower transaction costs, out of which would come the profit formula and other elements of the business model. The board would then translate that model into a set of mission-focused compensation goals.
Indeed, because the board needs the executive leaders to stay agile, it might drop narrow financial goals from the annual bonus. The bonus should still have operational metrics, such as customer satisfaction and time and cost per transaction, that promote the mission without constricting the strategic possibilities. With financial goals removed as specific targets, the board might still set a financial floor to ensure responsible investment in strategic and operational measures.