What a Stakeholder Approach Means for Executive Compensation
What does it mean for boards and compensation committees that 181 CEOs from the Business Roundtable amended a long-standing statement of corporate purpose last month? The CEOs declared that the purpose of companies is to serve their five key stakeholders—shareholders, customers, employees, suppliers, and the community, not shareholders alone.
In putting their signatures to that idea, these CEOs challenged the notion of shareholder primacy, a principle of business for the last fifty years. Not surprisingly, the Business Roundtable’s statement sparked a host of editorials in the business press, some arguing that the group had made a grievous error. Many writers seemed to suggest the choice is binary: You’re either with shareholders, or you’re not. The Business Roundtable, in contrast, implies the choice isn’t either/or. It’s both.
Rightly or wrongly, the question will now come up in many boardrooms and on many investor calls: What is being done to address the needs of all stakeholder groups? Some commentators may even point to academic research that shows a positive correlation between companies that promote the interests of stakeholders and better financial performance.
The challenge for management and boards, of course, is to take the Roundtable’s broad principles statement and translate it into action. For companies that have not already traveled far along this path, we suggest three steps:
- Identify key stakeholders and their interests: What do stakeholders need and expect so they give the company, in return, what it needs to create long-term value? What value proposition should be created for each?
- Resolve tradeoffs: What are the company’s highest priorities, and which stakeholders can support them? What will the company do, and what won’t it do?
- Create accountability for achieving priorities: How do you focus and align the efforts of executives through goal setting and pay?
Both executives and boards will be forced to respond to the stakeholder issues, and directors on the compensation committee in particular will have to adjust their thinking to establish accountability to stakeholders in executive compensation. What new kinds of information will the board and the compensation committee need? Which measures of performance should they ask management to see? How should they set goals tied to pay? How can the company respond to stakeholders and unleash value creating strategies?
Establishing Agreement on Stakeholder Needs to Address
As a first step, boards and management teams may want to back up and be more explicit about the company’s mission and vision — explicit enough so the mission indicates how the company can and should create value for key stakeholders. CEOs and boards may even have to spend time refining key strategic priorities and initiatives to assure that stakeholders, as a group, eagerly provide the outside capital, employee talent, customer enthusiasm, and public support needed for company success.
The approach will require querying stakeholders and soliciting feedback on how to win their support. This feedback then serves as the basis for executives and the board to make tradeoff decisions. Which stakeholders’ needs represent the greatest opportunities if their needs are met? Which represent the greatest risks if their needs are not met? Should the company focus on just needs and risks or simply doing no harm? Not all stakeholders’ interests will get equal weight during this process, but each should get equal consideration.
Not surprisingly, this exercise does not relieve boards and management teams of the age-old task of weighing benefits against costs. Nor does it eliminate the need for executives and the board to solicit feedback and get buy-in from major investors on its choices. Does the strategy for involving stakeholders in maximizing corporate value make sense to shareholders? In yearly conversations with investors, does the head of the compensation committee explain the stakeholder rationale and let investors voice their opinions? How does everyone feel about the tradeoffs, especially those that, in the near term, depress shareholder value in the interest of boosting it three to five or more years hence?
Linking Stakeholder Needs to Executive Compensation
Once management and the board agree on the stakeholder value propositions (and the associated payoff for the company in return), the compensation committee can begin to consider how (if at all) it should establish accountability in the company’s executive compensation programs. It will have to take into account three factors in the process: the status of the company’s
- economic or industry-level constraints,
- and acceptable standards of performance established through benchmarking.
Two questions stand out at this point: What is the company able to do? And what does good performance look like competitively on a long-term, sustainable basis?
This conversation about stakeholder expectations — and their linkage to executive compensation — must be reconciled against performance levels that are both reasonable and achievable within the given timeframe. Only then can the committee tie the goals to executives’ annual and long-term incentive pay in a manner that appropriately supports stakeholder priorities and is driven by a rationale that will be compelling to institutional investors.
A Retail Case Study
As an illustration of how the stakeholder approach works, and how the directors of the compensation committee might go about setting goals, consider a company like Trader Joe’s.
The food retailer has used the stakeholder approach for years, and it ranks as a top retail success story. Any visitor to a Trader Joe’s store can see that the company relies on meeting the needs of both employees and customers as a means to deliver premium value to investors. In fact, Trader Joe’s tops Forbes’ list of best places to work and ranks second highest of all companies in customer satisfaction. By spending money on employees—through wages, training, and career opportunities—the company cultivates a high-quality, engaged workforce. The workforce, in turn, assures that the company creates an engaged, loyal base of customers—customers who enjoy the fruits of the employees’ efforts.
Because it is private, we don’t know what Trader Joe’s board has approved as goals in its executive pay plans, but we can assume that making good on the value proposition promised to employee and customer stakeholders is top of mind for top executives. Providing that value allows Trader Joe’s to differentiate itself with premium store-branded products, helpful, informed store employees who can tell customers about those products, and low prices without sales promotions in a store environment that, by constantly evolving based on employee input, invokes customer surprise and delight.
In this model, shareholders, customers, and employees win together—and we can guess that suppliers and communities do as well.
With Trader Joe’s as a model of creating value through—rather than at the cost of—fulfilling the needs of stakeholders, let’s illustrate how a compensation committee at a hypothetical retailer would take on the job of goal-setting to comply with the stakeholder approach. We don’t need to assume the retailer follows Trader Joe’s business model, only that the model chosen depends on stakeholders winning together. The goals in a pay plan then follow the model naturally.
To start, management at the retailer would ask shareholders, “What are your needs and expectations?” The board could then build goals from the answers. The likely result would be some conventional targets, for example, overall sales growth exceeding peers, profitability, return on investment above the company’s cost of capital, and total shareholder return that outpaces peers.
Management would also ask the same question of customers: What are their expectations? The board might then choose targets related to the following: satisfying customer experience in terms of interacting, buying, and resolving customer-service issues; providing an appealing product selection in line with brand strategy; timely and convenient delivery and return options; and competitive pricing.
For the employee stakeholder, the board could affirm incentive goals such as adequate wages and benefits to meet personal and family obligations; adequate work hours and predictable or family-friendly work schedules; long-term career potential; and a satisfying or engaging work environment.
Executives could then get on with the job of making tradeoffs and accommodating realities. A variety of questions might come up at this point: Do the goals take into account the state of company systems to train and cultivate knowledgeable and engaged employees? Do they take into account the status of systems to curate the product line and manage inventories? What is the state of the fulfillment system?
After making adjustments for such factors, the compensation committee could set annual bonus-plan goals to support near- and intermediate-term strategies. It would link pay, for example, to management hitting significant, game-changing strategic milestones, often related to meeting stakeholder expectations that serve company interests. See the box for one possible formulation of goals for annual bonus plans for a retailer. Of course, the board would need narrow down the list of goals to a precious few, although using different goals at different levels does provide more flexibility.
The long-term incentive plan might then include both a conventional financial goal and some nonfinancial goals related to stakeholder outcomes, assuring that the company isn’t leaving behind a constituency fundamental to long-term value creation. Because the long-term plan again has limited room for measures—two to three at most—directors might consider goals for key stakeholder outcomes such as total shareholder return exceeding peers, customer retention levels continuously improving, growth in average customer spending, and average employee tenure versus best-in-class for the industry.
Goals based on stakeholder expectations, as with any corporate goals, will remain in flux. They vary with the strategy and how the stakeholders’ needs evolve over time. This doesn’t suggest that a company accountable to many stakeholders is accountable to none. When executives choose to focus on stakeholders goals—and the compensation committee sets performance levels and links those goals to pay—the risk isn’t that management will choose pet projects at the expense of shareholders, but that management and the board haven’t aligned their views on strategic priorities (and the right goals) to win for shareholders through stakeholder interdependence.
Compensation committees sit at the nexus of solving an equation far more complex than in earlier decades. More variables go into how to motivate and reward executives for running a company to successfully compete for talent, customers, suppliers, and public support.
Committees have the responsibility to choose the right incentives to encourage value-creating decisions and behaviors. When they get it right, executives will do the bidding of shareholders— increase profits and returns—but also increase the wealth and satisfaction of the stakeholders that those profits depend on.
To view this article by Mark Emanuel and Seymour Burchman as it was originally featured, visit Directors & Boards.