Boards today spend a lot of time and energy on establishing appropriate compensation arrangements for the CEO—including base salary levels, incentive plan design, and performance measures and targets. Often though, not enough time is spent on provisions triggered on various exit scenarios. While some companies choose to rely upon applicable common law at the time of the exit, many others choose instead to agree upon and document specific exit provisions upfront. In these scenarios, the board and CEO have an opportunity to negotiate before conflicts arise, providing greater certainty for both parties. Particularly in the current climate, where executive mobility is high and the spotlight on compensation decisions bright, it pays to ensure that compensation outcomes on various exit scenarios are reasonable, and well understood before a departure is in sight.
Executive compensation arrangements can be complex, but when establishing a CEO’s exit provisions the focus is typically on three broad areas: i) cash compensation made up of fixed base salary and short-term cash incentive; ii) long-term incentive program, typically tied to the company’s equity, and iii) retirement arrangements where applicable. While other programs come into play—including continuation of benefits and post-departure shareholding requirements—the salary and short-term incentive programs typically receive the most attention, with the treatment of long-term incentives often overlooked. When considering the provisions for exit scenarios, it is important that boards consider these compensation components both separately and as a whole, to understand trade-offs, reduce excessive awards and avoid competing provisions.
The exit scenarios in a CEO employment agreement typically cover the following scenarios—resignation, death or disability, retirement, termination by the company with and without cause, and resignation/ termination following change of control.
When negotiating a CEO’s exit provisions, it is important to recognize the significant role that existing contractual arrangements can play. An external hire leaving a generous employment agreement behind will typically negotiate hard to retain all of the favourable provisions of his or her existing contract. Similarly, an internally promoted executive will often go to great lengths to understand the nature of the outgoing CEO’s agreement, and then lobby to have its more favourable provisions matched. This highlights the importance of establishing exit provisions that the board can live with for the current, and possibly future, leaders of the company.
The vast majority of companies encourage retention by ensuring that compensation is left behind in the event of a resignation. This typically means foregoing any bonus for the year of departure. Typically resignation also triggers forfeiture of unvested long-term incentive instruments—those awards that were granted in previous years and are in the process of vesting over time.
Requiring complete forfeiture of all unvested long-term incentives has the power to affect executive behavior before and after a resigna- tion. Before, the forfeiture provides a clear incentive to stay with a company; but after, this strategy grants the CEO a clean break—there are no more monetary rewards on the table following departure, and therefore “nothing to lose.” For this reason, some boards rethink the forfeiture requirement after receiving notice of a resignation. Depending on the CEO and the nature of the departure, boards may choose to allow some portion of long-term incentive awards to continue to vest and pay some or all over time, according to the schedule set out upon grant.
By continuing to vest and pay out unvested long-term incentives over time, the company is providing an incentive for the executive to behave as a “good leaver”—for example, by complying fully with non-compete, non-solicit, non-disclosure and non-disparagement provisions. This approach also arguably reinforces the long view for executives, by keeping them exposed to company performance after their departure. While this tactic is mostly seen in financial services today, the principles behind it can be applied more widely, and for this reason it is likely to gain some traction outside of the financial world as well.
There is wide variety in how companies deal with compensation elements on death, disability and retirement, but typically these types of exits allow for compensation to be paid that may have otherwise been held back in a resignation scenario. Depending on the nature of the retirement, and how a particular board views it, the annual bonus will typically be pro-rated for the amount of the year worked. Provided that the agreed retirement age has been reached, unvested long-term incentive instruments may be either pro-rated for the portion of the incentive term that the CEO worked, or allowed to vest fully and pay out as originally intended.
Terminating a CEO without cause typically provides for severance, or salary continuation (or lump sum equivalent) of up to two years (the “notice period”) for a long-serving CEO of a large company. Most programs will also pay a portion of the incentive the CEO would have been eligible for during the severance period. Similar to the resignation scenario above, the starting point for treatment of unvested long-term incentives is forfeiture, but often negotiation at the time of the departure results in allowing some portion of long-term incentives to vest during the notice period. By contrast, terminating a CEO with cause results in immediate complete forfeiture of short- and long-term incentives.
Change of control agreements are severance provisions designed to protect executives in the event of termination following a change of control. There are two basic types of change of control triggers, single trigger and double trigger. Single trigger agreements provide for payout upon any type of exit following a change of control, including resignation. Double trigger agreements result in payout upon termination by the company, or resignation for “good reason” (e.g. when an executive’s role is significantly reduced or otherwise altered), but not upon resignation more generally.
From a shareholders’ perspective, single trigger provisions have an inherent flaw in that they empower the executive to trigger his own payout, by resigning following a change of control. They are generally considered to be unacceptable by large shareholders and proxy advisory firms, leading to a possible vote against the re-election of those directors thought to be approving such provisions. With boards focusing more on understanding the risks associated with compensation design, and working hard to avoid unintended windfalls, there has been a pronounced move from single to double triggers in recent years.
In terms of the amount paid following a change of control, historically it was not uncommon to see a payout of three times a CEO’s combined annual base salary and annual target bonus. In recent years there has been a general containment in these amounts. Today, two times is the more common multiple for newly negotiated agreements at large issuers, and some boards are moving to apply the multiple to base salary only. As with single triggers, directors agreeing to more than two times may find shareholders voting against their election to the board.
It is clear that exit provisions are not an issue to be glossed over, and spending sufficient time upfront can reduce challenges in the future. Established thoughtfully, compensation provisions upon departure can contribute to driving desired behaviour both before and after an executive’s tenure, all while protecting the board and shareholders from unexpected outcomes when an executive inevitably departs.
Ken Hugessen is founder and president of Hugessen Consulting Inc. E-mail: email@example.com. This column is co-written by Allison Lockett, an associate at Hugessen.