The Advisors' Blog

Last week, Liz shared Part 1 of a two-part report from Pay Governance regarding non-GAAP adjustments to payout calculations. Part 2 is now available, covering the myriad of issues and considerations associated with M&A-related comp adjustments and the most common methods of addressing M&A impact on plan payouts.

One of the more complex issues when measuring performance for incentive plan purposes is how to consider the effect of mergers, acquisitions, dispositions, and the related transaction costs (M&A activity) on financial performance during the performance period. This is due in large part to the difficulty in anticipating/budgeting M&A activity when setting incentive plan targets at the beginning of the performance period and the outsized effect such activity can have on financial results (both positive and negative), depending on the measures being used and the effect the transaction may have on shareholder value. Based on our experience, approaches to adjusting for M&A activity are highly situational, and it is difficult to quantify what constitutes “typical” market practice.

Below is a summary of the key considerations, with each described in greater detail in the memo:

– Whether executives/employees will receive a windfall or be penalized without adjustments
– Whether inorganic growth was considered in setting targets (particularly for smaller acquisitions)
– Whether the company is able to track standalone performance of a newly acquired entity
– Whether adjustments will help incentivize management appropriately
– Aligning the treatment of management with the impact of the acquisition on shareholders
– When the transaction occurred in the performance period

The memo then describes common adjustment scenarios (see the memo for examples) and warns that companies need to check their plan documents and consider the accounting and disclosure impact of any adjustments that are considered award modifications.

Fully Adjust Financial Targets for M&A Activity: Some companies adjust performance targets for the estimated impact of M&A activity to try to maintain the same degree of difficulty as the original performance targets. These companies will often rely on the business plan/financial forecast submitted to the board as part of the acquisition approval process to increase both the annual and long-term incentive plan targets. However, small, or late year acquisitions may not require adjustments due to immateriality on incentive plan results.

Exclude M&A Activity from Financial Results in Year of Acquisition: Some companies exclude the impact of acquisitions from the financial performance of the company used to calculate incentive plan results in the year of acquisition. Thus, the annual incentive plan and the 3-year performance share plan cycle ending in the year of acquisition are calculated as though the acquisition did not occur. As noted under transaction timing above, it may be necessary to modify the incentive plan targets for the other open 3-year performance cycles.

Partial Adjustment for M&A Activity: Some companies may adjust their financial results for only a portion of the acquired company’s financial performance (e.g., 50%-80%) and allow the remaining portion to flow through the incentive plan calculations in order to recognize management’s success in completing the acquisition. While the effect of the acquisition may have a positive impact on the in-flight incentive programs, the targets for future performance cycles will reflect 100% of the expected performance of the acquired company.

– Meredith Ervine