Three Things to Know About Incentivizing CEOs

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When boards are hiring a new chief executive, they have tough choices to make as they negotiate terms of employment with their top pick. CEO contracts are complex documents that typically include incentives tying compensation to performance on a range of metrics. But how should a CEO’s contract be structured to produce the best results for company performance? Here are three findings from recent academic research that boards can consider during the process:

1. Encourage innovation through cash-flow metrics. CEOs whose compensation is tied to internal cash flow metrics tend to avoid the problems of both overinvestment and underinvestment. Their focus on boosting free cash flow makes these leaders more prudent about picking projects with a good rate of return; those projects then have better odds of success because more resources are available to them. This improved resource allocation fosters a conducive environment for innovation.

2. Align CEO contract duration with company goals. Shorter-term contracts may push CEOs toward making quicker, less risky acquisitions, which could limit a company’s strategic growth options. Boards should consider establishing a time span in the contract that aligns with the time horizon for the company’s long-term strategic goals. This balance can help mitigate the risk of suboptimal decision-making driven by the pressures of short contract timelines.

3. Simplify executive compensation. Overly complex compensation packages can negatively impact performance. This complexity can lead to cognitive overload and fairness concerns among executives, which may detract from their performance and motivation. For boards, the takeaway is clear: Simplify compensation structures to enhance clarity and effectiveness, ensuring that executives are motivated in ways that are easily understandable and perceived as fair.

These insights underscore the importance of thoughtful contract design in motivating CEO behaviors that align with company objectives and enhance overall performance.