Constructing the Pentagon of Incentives

If I told you that you should aspire to create the “pentagon” of incentives, you may think that I was confused about your industry. To you, the word pentagon might bring back terrible memories of geography, but to me, the “pentagon” is a graphical representation to illustrate a diverse and balanced set of incentive metrics which also happen to align with the stakeholders of a corporation.

Broadly speaking, there are five categories of employee incentives, ranging from the first dimension to the fourth dimension of operational metrics, and a final fifth category which is a strategic catch-all.

First Dimension

This dimension represents metrics that focus on top line revenue, sales, or market share.

Second Dimension

This dimension represents metrics that focus not only on top line, but also includes the consideration of bottom-line expenses. The most prevalent second dimension metrics are EBITDA, cashflow, net income, or operating margin.

Third Dimension

This dimension represents metrics that focus on top and bottom line, but also includes finance, investment, and capital funding metrics. The most prevalent third dimension metrics are earnings per share growth, return on invested capital, return on equity, and return on assets.

Fourth Dimension

This dimension represents the prior dimensions (top line, bottom line, and financing activity), but also includes future expectations. By future expectations, we mean that the metric measures future expected growth, and that the company maintains or grows investors’ multiples. Largely, the only measure that incorporates future expectations is the fair market value of the stock, and therefore total shareholder return is the most prevalent fourth dimension measure.

Strategic

As a final catch-all, there are other KPIs or strategic goals that don’t focus on the financials or stock prices. These important measures are sometimes seen with environmental, social, and governance (ESG) goals, discretion, and other specific business outcomes.

Balancing the Dimensions

When thinking about this dimensional framework for organizing and collating your incentives, both short-term and long-term, you can easily determine how much leverage (i.e., what percentage of your incentives) is focused on each of these five dimensions/categories. In the aggregate, I’ve seen that a balanced weight of approximately 20% of the total incentives in each dimension is optimal, as it doesn’t allow for any systemic perversity to focus only on a single operational dimension.

Further, the dimensional framework has a nice complimentary parallel with the stakeholders of a corporation (customers, suppliers, employees, shareholders, and the community), as defined by the Business Roundtable. The stakeholders loosely align with the dimensions of incentives. Graphically, I envision the stakeholders, the dimensions, and the optimal pentagon shape with about 20% weight of incentives supporting each dimension.

In 2020, I studied the weighting of incentives for the components for the BDO 600 (read more here), which yielded the following weights of each dimension for the CEO and the remaining named executive officers. Superimposing the results from the study into the graphic above captures a great narrative. In the aggregate, it is clear to see that the weighted incentives for both the CEO and the NEOs loosely resemble the pentagon.

There are a couple of areas where this framework guides me. First off, it immediately helps to identify if and when there may be overlap of incentive metrics. For example, let’s think about a company who uses both operating income (in the short-term plan) and EBITDA (in the long-term plan) within their incentive programs. Technically, these are different performance metrics. However, they each drive very similar behavior and fall within the same second dimension—measuring top and bottom line.

Secondly, one of the maxims I use in incentive design is that the weightings of the dimensions should increase as you get higher into the organization. For example, a CEO should probably have a greater weight on the third and fourth dimension than the remainder of the incentive eligible population. Note that in the data above, the CEO has 22% of incentives in the fourth Dimension (TSR), while the remainder of the NEOs only have 16%. This is a very intuitive result, since it puts more incentive compensation at risk for the CEO based upon stock price.

Thirdly, it provides a very clear roadmap on how much weight should be applied to strategic goals, and most importantly with environmental, social, and governance goals—which focus on the very important stakeholder of the broader community. You will find that it is virtually impossible to get to a 20% weight on strategic goals, without adding some component into the LTIP programs. Therefore, we can expect far more ESG goals incorporated into performance equity in the future (how to do this appropriately is worthy of many textbooks), and that the strategic dimension will increase over 14% for the CEO and continue to help shape the pentagon of incentives.

Much like the famous US building, a renowned symbol of strength and security, the pentagon of incentives can help to construct a strong and balanced rewards structure. What do you think?