Mind the Gap: GAAP vs Non-GAAP Metrics for Incentive Plans

Our popular “Meet the Speaker” series, featuring interviews with speakers at the 25th Annual NASPP Conference, is a great way to get to know our many distinguished speakers and find out a little more about their sessions in advance of the Conference.

For today’s “Meet the Speaker” interview, we feature an interview with Takis Makridis of Equity Methods, who will lead the session “Mind the Gap: GAAP vs Non-GAAP Metrics for Incentive Plans.”  Here is what Takis had to say:

NASPP: Why are non-GAAP metrics a hot topic?

Takis: Almost all companies use non-GAAP metrics in their long-term incentive (LTI) programs. Line of sight between efforts and results has never been more important, driving executive compensation leaders to look for metrics that aren’t influenced by factors well outside an executive’s control.

GAAP metrics, although consistent and comparable across companies, can be sensitive to unpredictable factors that are not critical to the incentive goals and strategy of the company. Should interest rate spikes really cause an executive to earn (or not earn) their awards? Accounting standard changes can also trigger large payout windfalls or misses. The same with M&A activity.

But there’s a big problem. While using non-GAAP metrics makes good sense at conceptual level, the broader use of non-GAAP metrics in financial accounting is under major fire. In the spring of 2016, the SEC issued interpretive guidance, essentially blasting companies for how they use non-GAAP measures in financial reporting. This doesn’t affect how companies structure their incentive awards, but it does cover performance discussions in the proxy. Add to that the problem of proxy advisors only using GAAP metrics in their analytics and compensation committees being extra concerned with staying within the goal posts of reasonability, and we have a hot topic!

NASPP: What is a common mistake companies make with non-GAAP metrics and how can they avoid this?

Takis: The biggest mistake I see is that many companies don’t carefully vet upfront how they’ll handle a broad variety of situations that can raise question marks in their metric of choice.

Here’s the thing: suppose you’re using a non-GAAP metric like EBITDA—it’s not enough to simply state that and assume you’re in the clear. It might be straightforward to find earnings and then back out interest, taxes, depreciation, and amortization, but numerous other considerations need to be thought through. Two big ones that can wreak havoc are accounting standard changes and corporate actions.

Most companies will be adopting the new revenue recognition and lease accounting standards. They’re setting metrics before the standards go into effect, but paying out after. How will results three years in the future be adjusted for the effect of the accounting standard changes? Or, what if a business unit is sold next year that generates $400 million in pre-tax earnings? Will you adjust your target down by that amount? These are examples of the level of nuance that needs to be thought through upfront.

The solution? Socialize with your key stakeholders (the compensation committee, general counsel, executive compensation, and finance) how you will treat future events that can insert ambiguity into your payout determination and certification.

I’m especially excited to hear my co-panelist, Dave Thomas of Wilson Sonsini, share some war stories during our session—he’s the master of bringing plain-English clarity to dense legalese. One specific best practice we’ll discuss is building and socializing a checklist that explains how, at a principle level, each future event will be handled so that the compensation committee is not backed into a corner to choose a treatment that’s favorable simply to avoid conflict.

NASPP: What is the silver lining to non-GAAP metrics?

Takis: When all is said and done, if non-GAAP metrics are used in a company’s LTI plan, having a clear framework for how it will perform adjustments to GAAP results will eliminate unnecessary surprises and friction with participants. But getting there takes a lot of work, and I think there’s an extra silver lining to all that work…

When you take the time to sort through how different business events will be handled in your LTI payout, this vetting drives mindshare. It drives mindshare with key executives who may be part of the planning process, and also with your compensation committee. How often do we hear that committees don’t really understand how the LTI award works or how participants view their awards as lottery tickets? I’ve seen a vetting process around non-GAAP adjustments drive engagement from both committee members and executive stakeholders, resulting in greater line of sight with what the award is really intending to incent.

NASPP: What is your favorite memory from a past NASPP Conference?

Takis: It was probably almost fifteen years ago, and I was running late to make it to the opening day reception. It might have been in San Francisco, but I remember it was raining and I was stressed that everything was taking a little longer than planned. I eventually arrived and within five minutes ran into a client, who embraced me with a big “thank you” for some work we had recently finished up.

That was a pivotal moment in my career. At that moment, it hit me that as technical as our field gets, we are all in the business of solving problems for other people. I think that’s true regardless of whether we’re in consulting, law, or work at an issuer—what we do matters, and it matters to other people.

I’m stoked for this year’s NASPP. So much has changed in the technical topics of what we all do, but we’re still a collection of people trying to make a difference—and I’m really excited that this hasn’t changed and that we can celebrate this together in DC.

Don’t miss Takis’s session, “Mind the Gap: GAAP vs Non-GAAP Metrics for Incentive Plans,” at the NASPP Conference!

About the NASPP Conference

The 25th Annual NASPP Conference will be held from October 17-20 in Washington DC. This year’s program features close to 100 sessions on today’s most timely topics in stock and executive compensation; check out the full agenda and register today!