Crunching down on contracts

Like many in the electronics industry who have served as CEO of multiple companies, Rajeev Madhavan runs hot and cold on the subject of employment contracts. During one of his CEO posts a couple of years back, Madhavan neglected to put a contract in place, only to be burned, he says, when the relationship soured and he was forced out. Fresh off that bad experience, Madhavan pushed for a contract at his next CEO venture-running EDA software vendor Magma Design Automation. Madhavan says the contract was a safety net in the event of a repeat performance. Yet, when his contract was up for renewal four years later, Madhavan reversed his stance and took the contract off the table.

Magma Design Automation CEO Rajeev Madhavan has had both good and bad experiences with contracts. He's currently satisfied to work without one.


Why would Madhavan do an about-face on something so critical to protecting his future? It boils down to having what he believes is an open and solid relationship with Magma's board and the acknowledgement that in today's world, any monetary focus should be on company performance, not on the particulars of a CEO's package. "I'm not against contracts, but I don't have one at this juncture," says Madhavan. "My compensation has never changed, with or without a contract. It's the same compensation structure as other employees'-using well-defined metrics to tie compensation to the performance of the company."

Many in the electronics space are equally lukewarm on the matter of CEO employment contracts and as passionate as Madhavan about tying CEO compensation to company performance. Although surveys say that a majority of electronics firms still extend contracts to CEOs, there is a transition on the horizon that represents a sea change in both how contracts are handled and whether they'll be used at all. The trail of well-publicized corporate accounting scandals and excessive CEO severance deals has soured many on employment contracts, which traditionally have been more about guaranteeing a specific pay package for the CEO regardless of the company's financial standing. Regulations such as the Sarbanes-Oxley Act, enacted in 2002, have also had a hand in changing the nature of employment contracts. Sarbanes-Oxley, which enacted new standards of corporate governance and financial reporting procedures, has prompted company boards to exert more control over CEO compensation and put limits on anything-whether part of a contract or not-that might foster excessive payouts that will then become part of the public record.

As a result of all this, any CEO contracts put in play today are decidedly different from their predecessors. Unlike employment contracts serving up a bounty of bonuses, stock options and lavish perks to the incoming CEO, most current contracts have tightened up on the guarantees and extracurricular options. Gone are the disproportionate awarding of stock options, severance deals with no strings attached and use of the corporate jet for personal outings. In their place are carefully spelled-out agreements, created with direct involvement from the board of directors, that outline broad compensation structures that tie any CEO financial gain to the overall performance of the company.





"You can expect to see far fewer guaranteed perks - things that used to be emblems of power, such as country club memberships and company airplanes."
—Jack Marsteller, Towers Perrin


Compensation experts say the pendulum has swung away from favoring the wants and needs of the individual, where it's been for some time, back to considering the overall requirements of all parties involved--the executive; the business; and most important, its shareholders. "There's a swing back to having protections for the organization as well as for individuals," explains Paul Hodgson, senior research associate with The Corporate Library, an independent research firm focused on corporate governance. Still, Hodgson suggests, many companies are getting rid of employment contracts altogether, feeling external pressure from the financial community and shareholders, who, despite adjustments, still equate contracts with excessive CEO pay.

What's in, what's out
The change isn't happening quickly. Many companies still have put or are putting modified versions of CEO employment contracts into place. Pearl Meyer & Partners, an executive compensation firm, ran a quick sampling of companies under electronics in the SIC code to gauge the prevalence of CEO employment contracts. Seventy-five percent of smaller ($100 million to $300 million) public companies in this sector have CEO contracts, whereas nearly all of the larger companies have such agreements. However, smaller companies are far less likely than their larger counterparts to have formal CEO contracts, notes Matthew Stinner, managing director of the firm, if they are still run by their entrepreneurial founders.

Although contracts differ in their particulars, they cover several standard items. The typical CEO employment contract stipulates a base salary and benefits and outlines the terms of short- and long-term incentives--again most often linked in some manner to the company's performance. There is usually a basic job description in the contract, including an outline of core responsibilities and reporting structure. Other common elements include the term of the agreement (today, typically three years or less), provisions for contract renewal, and restrictive clauses. The latter include clauses that restrict solicitation of company employees if the CEO is moving on to a different company (nonsolicitation), nondisclosure clauses, and noncompete clauses that prevent the CEO from taking a role at a competing company for a specified time period.

What prospective CEOs seek with such a contract is some period of protection, especially if they're coming on board at a company that's in a precarious or turnaround situation. Board members, on the other hand, are motivated in their use of contracts to ensure that the incoming CEO is locked in and discouraged from moving on without leaving something on the table. "Contracts tend to be more prevalent in more-mature companies or when you're bringing in a CEO from outside of your industry," explains Jack Marsteller, principal at Towers Perrin, a global human resource consulting firm. "CEOs coming in emphasize the risk associated with the role. They want to have some sort of protection if something happens on their watch and the board wants them gone."

Many of those protections are being scaled back considerably in this new age of corporate governance and fiscal responsibility. Severance packages-long referred to as golden parachutes-have been among the hardest-hit. Although the severance clause remains a key element of a CEO employment contract, the details and structure of what most packages cover have evolved. For one thing, experts anticipate that the deals will be far less generous-a direct result of the fallout of huge severance payouts to such high-profile executives as Disney's Michael Ovitz and, more recently, to Hewlett-Packard's Carly Fiorina, who reportedly stands to collect more than $21 million after being ousted by the board in February.

Specifically, recent changes to an IRS regulation known as Section 280G have had a huge impact on how severance is handled. Whereas at one time it was common for outgoing CEOs to be paid three times their average salary, or more, changes to the IRS regulation are designed to discourage such excessive golden parachutes. They essentially eliminate a 20 percent excise tax burden (which historically has been covered by the company as a nondeductible corporate expense) if the payout is capped at 2.99 times the executive's average compensation. As a result, companies are now writing CEO contracts that keep severance payouts under that cap, as much to avoid the escalating costs as to steer clear of any ensuing bad publicity.



"I'm not against contracts, but I don't have one at this juncture."
—Rajeev Madhavan, CEO, Magma Design Automation

In addition to the monetary aspect of the severance clause, there have been modifications to the change and control provisions, which essentially outline what happens to CEOs in terms of their duties and compensation if companies are bought, sold or merged. In the past, severance payouts were made according to what's called a "single trigger," meaning one impact on a CEO could invoke a severance deal. Consider this example: Company A gets acquired, and the CEO becomes division president yet still retains the same autonomy and responsibilities. Under the old rules, that alone could have theoretically invoked a severance clause. That's not likely today. Most current contracts call for a "double trigger" for severance, meaning that a couple of factors need to change to bring about a payout-for instance, having an ownership change and a CEO's duties being diminished, or being merged and the work location's being moved more than 50 miles. "The reflection over the last few years is to make sure CEOs can't cash out if nothing has changed for them," explains Dan Moynihan, principal of Compensation Resources, a compensation consulting firm.

Perks are another area in which we've seen dramatic changes. Contracts inked five to 10 years ago commonly had provisions that granted CEOs everything from exclusive country club memberships to unrestricted use of company-owned apartments, to being set up in a postretirement office with regular access to a support staff. Now prospective CEOs can expect few or none of those extras to be outlined in any formal employment contract. "Although high tech was never as rich in perks as more-mature industries, you can expect to see far fewer guaranteed perks-things that used to be emblems of power, such as country club memberships and company airplanes," Marsteller says. "If a board is starting over with a new CEO these days, it generally wants to start with a limited list of those kind of perks, if any at all."

Performance-bound
Perhaps the biggest change in CEO contracts is tying top-executive compensation to a set of criteria that reflects company performance (see the sidebar, "Measuring Up," below). For many companies, a common gauge has been stock price, but that metric crashed and burned for many high-tech companies, along with their stock price, during the downturn of the early 2000s. Today, a variety of metrics is employed to gauge CEO performance. Although stock price is still a valid indicator for some, there are other preferred metrics-everything from earnings growth to cash flow from operations. CEO employment contracts generally stipulate that overall-performance evaluation be predicated on performance metrics, but the details of any such arrangement are typically not written into the agreement. "Pay-for-performance metrics are getting awfully specific for an employment contract," says Don Delves, president of The Delves Group, a compensation consulting firm. Companies want to have a lot of flexibility to change, and contracts tend to be rigid. Delves suggests moving such metrics into annual agreements such as bonus plans.




Determining exactly what those metrics are is now a role that demands active board involvement. Many boards are hiring their own compensation specialists to advise them in this area, instead of rubber-stamping plans presented by management. Board members are also taking greater pains to do scenario planning, ensuring that they have a clear understanding of the complete payout package under all possible circumstances. Although boards used to be involved in impending deals, they often didn't take the steps to run the numbers reflecting various scenarios. Greater board involvement, experts say, should help prevent any big surprises. "The boards are more involved in the actual negotiation and understanding what's in the contract," notes Pearl Meyer's Stinner. "Previously, there was less emphasis on understanding each element and making sure you could quantify all the various possible scenarios. There was less scenario planning than what's being done now."

"CEOs who put too much emphasis on their own protection are sending a message of weakness or skittishness."
—Peter Levin, CEO, Dafca

Active board involvement and using metrics as a gauge for compensation are trends that show no sign of abating. Prospective CEOs, therefore, had better get used to it, and even embrace it, experts say. Peter Levin, CEO of EDA software startup Dafca certainly feels that way. Levin championed his own CEO employment contract at Dafca, not to guarantee any perks or big payouts, he says, but to put a mechanism in place that could promote transparency to the board. "CEOs who put too much emphasis on their own protection are sending a message of weakness or skittishness," says Levin. "At this point, the contract is about an overall package the board can use as an instrument panel or dashboard."

Still, Levin doesn't rule out pushing for some extras once Dafca moves out of startup phase. Given the amount of time he spends on a plane, Levin says, business-class travel, a perk he enjoyed as a CEO at other companies, ranks high on his list. Says Levin, "It may not be part of my contract, but I will push for it at some point."

If Dafca meets its milestones, Levin is certainly entitled to a little comfort and a whole lot more. That's the lesson for today's CEOs: Expect such remuneration after you succeed—not before.

How are new contract restrictions going to affect companies' ability to hire and retain CEOs? Send your thoughts to www.feedback@eb-mag.com.

Beth Stackpole is a freelance writer who covers business and technology trends.

Measuring up For years, there's been chatter about tying CEO compensation to company performance. Today, the talk is not about whether or not to do so; it's about how to do it and what kind of metrics best reflect performance. Stock price, which in the boom years of technology, was often the sole measuring stick on which to base CEO bonus structure, is not necessarily the preferred, or only, metric employed today in the new climate of corporate fiscal responsibility. Technology companies are now instead emphasizing such metrics as revenue growth, earnings growth, return on assets, return on capital, margins, and EBITDA (earnings before interest, taxes, depreciation and amortization). The goal: to have CEO pay structure reflect both the short- and long-term performance of the company and to focus on metrics within the direct control of the CEO, as opposed to relying on stock price, which is influenced by factors outside the executive's control. "Companies are now looking for the fundamental components of the business that add up to the stock price, which are more realistic and of more interest to shareholders," says Don Delves, president of the Delves Group, a compensation consulting firm. Although various metrics are in use, most companies generally combine two or more to gauge CEO performance. Whatever measures a board uses can also signal the company's key priorities. Another common approach is to evaluate a CEO's performance relative to that of a peer group. A board of directors of a chip manufacturer, for example, might consider the stock performance or revenue growth of its key competitors to evaluate how to compensate its own CEO. "For years companies were insisting they had to pay CEOs above the median," Delves explains. "But with the competitive market out there, boards are now saying, `If we're going to pay at that level, the company had better be performing at that level relative to its peer group.'" To some, the shift away from stock price to other measures is an attempt to strike a balance. "Companies are striving for transparency of performance and balance in terms of what they pay for," says Will Ferguson, principal at Mercer Human Resource Consulting. "The shift is putting the focus on more-productive things-the kinds of things that link clearly back to strategy and to the day-to-day things that create a successful company."-B.S.