M&A and Incentive Plans: Three Scenarios for Planning

One of the trickier aspects of measuring performance for an incentive plan, according to a recent Pay Governance piece, is figuring out how to take into account the impact of M&A on the company's financial success during the performance period. Although M&A activity has a huge impact on financial results, it’s also hard to plan for in advance.

Here are three of the most common scenarios along with some key considerations for you and the Compensation Committee when planning M&A activity.

1. Scenario 1: Fully Adjust Targets. Under this scenario, the company will adjust performance targets for the estimated impact of the M&A, while keeping the same level of stretch. This makes sense when:
   
   
   1. The acquired company has been fully integrated into financials and tracking performance separately is unfeasible.
      
      
   2. The board wants to ensure that management is driving the success of the acquired company. 
       
2. Scenario 2: Fully Exclude Targets. Under this scenario, the company will, for the purposes of incentive plan calculations, act as though the transaction did not occur. This may be true for the annual plan and for the 3-year long-term plan ending in the year of the transaction. This makes sense when:
   
   
   1. The acquisition is a standalone business with easily identifiable results that are simple to exclude.
      
      
   2. The acquisition is in such poor financial shape that it requires significant operational changes before being included in overall incentive plan calculations.
      
      
   3. The acquisition will cause a short-term drop in stock price, and including its revenue in overall numbers would cause a misalignment of pay and shareholder value.
       
3. Scenario 3: Partially Adjust Targets. Under this scenario, the company will exclude financial results for a portion of the acquired company’s performance and allow the rest to flow through (which will generally be a positive impact on incentives for the year).

Food for Thought: Pay Governance lists several key considerations for the board’s decision:

1. Impact on Metrics. The committee likely wants to avoid significant windfalls or penalties that are due solely to the M&A activity, and this can differ based on incentive plan metric. Companies with revenue and profitability measures in the plan might experience a windfall if the financial results of an acquisition are included, while those using return metrics might be penalized by the same acquisition.
   
   
2. Acquisitive Strategy. If the company anticipates M&A activity annually, it makes more sense to plan for this ahead of time by establishing a materiality threshold for M&A – anything below the threshold passes through, anything above the threshold is adjusted for.
   
   
3. Shareholder Scrutiny. M&A adjustments will certainly be analyzed by investors and proxy advisory firms, so consider additional CD&A disclosure.