Is your business engineered to create wealth? Part 5: Incentives

Most CEOs would prefer to create more wealth for shareholders than less.

But most companies are not ‘engineered’ to create wealth – internal processes often act to hinder wealth creation, rather than encourage it.

In this article we look at the role of incentives in wealth creation and why incentive programs often do more harm to shareholders interests than good.

At-risk pay has grown to be a significant part of the way managers in Australian companies are remunerated. For many public companies, the use of share based incentives has brought a renewed focus on growing the value of the company for shareholders, but ironically, short term incentives remain anchored in measures and structures that often encourage managers to destroy, rather than create wealth.

Of course short term incentive plans differ from company to company, but let’s review some of the most damaging aspects of the more popular plans before outlining a different approach that is engineered for wealth creation.

Wealth destroying measures
As the amounts available under short term incentive plans (STIs) increase, Boards are demanding more objective and formulaic measures of performance.

Unfortunately, that too often means formulas based on EBITDA or EPS growth. As we’ve seen in parts one and two of this series, these measures and a host of similar ones encourage managers to invest large amounts of money at low rates of return, destroying wealth.

Any incentive plan that has EBITDA or EPS at its heart is actually paying managers to destroy shareholder wealth.

Many managers understand that investing funds at low rates of return will destroy wealth for shareholders, but find themselves in the invidious position of having to choose between what’s best for shareholders and what’s best for their families.

Having established an understanding of what creates wealth and put in place performance measures, investment appraisal and planning processes to match, it makes sense to cement the focus on wealth creation by structuring STI plans around Economic Profit. This has the
added benefit of increasing the value of share based rewards as well.

Incentive targets set from budget
One of the most significant barriers to wealth creation in typical incentive plans is the use of the budget as the incentive target. Any manager with a few years of experience understands that under this approach, there are two ways to increase their bonus: 1) increase performance and 2) reduce the budget.

Unfortunately reducing the budget does nothing to create wealth for shareholders and it needs to be engineered out of the incentive process.

I suggest that, rather than using the budget, the target for the incentive plan be based on shareholder expectations, as implied in the market value of the company.

As part one of this series demonstrates, when investors form the opinion that a business is capable of generating and sustaining high returns on the capital entrusted to it (ie Economic Profit), the price they are prepared to pay for the business rises well above the capital invested by shareholders and wealth is created.

Using this logic in reverse, Boards can take the market value of the firm as a starting point and derive the EP growth that is implied and use this as the target for incentive payments. Figure 1 illustrates this process.

Figure 1: Derive EP growth targets from the market value of the business

Derive growth targets from shareholder expectations

 

 

 

 

 

 

 

Crucially, setting targets based on shareholder expectations decouples the budgeting process from the incentive program. It removes the incentive to sandbag budgets and makes that process more productive and a better use of shareholder funds and management time. It puts managers back in alignment with shareholders and means managers no longer have to choose between what’s best for the company and what’s best for them and their families.

Finally, by deriving targets from shareholder expectations, high levels of rewards are only paid when those expectations are exceeded and lower rewards flow from falling short of shareholder expectations: greater alignment is achieved.

Short term focus
As we’ve seen from part one of this series, wealth is created by sustaining high returns on capital. Yet the vast majority of cash incentive plans in Australia pay for short term performance; usually just one year.

Most business people accept it takes two to three years to become confident that performance gains can be sustained and that, therefore, a reward is truly deserved.

So an incentive plan that is engineered to create wealth would pay for sustained gains in Economic Profit, not a single year spike in performance. To do so, the Board should set rolling three year targets and give managers the headroom and the accountability to improve performance within that time frame.

Don’t ratchet up targets just when the business is improving and don’t negotiate a lowering of targets when things turn sour. Instead invest the time up front to agree to a set of targets that everyone can stick to, come what may.

To further reinforce the importance of sustained gains in performance, use an incentive reserve that holds a meaningful percentage of each year’s rewards at risk and subject to loss if performance cannot be sustained.

Capped
If an incentive plan is capable of paying managers to destroy wealth, as any plan that rewards gains in EBITDA or EPS does, or it pays for short-term gains, without any reference to sustainability, then it makes sense to limit rewards with caps on payments.

But caps have unintended consequences. They send a signal to managers to take their foot off the pedal once the cap is reached and push good performance into next year (where they’ll get paid for it). Caps encourage managers to defer revenue and bring forward expenditure (because it has no impact on the current year’s rewards and may even increase next year’s) and few shareholders would ever want that.

And perhaps even more damaging than that, caps are an admission that the incentive plan does not pay for wealth creation. If it did, why would a Board ever put a cap on payments?

So it may be better to ask the Board, ‘Under what circumstances would you accept no caps on an incentive plan?’

Most directors (and institutional investors and governance advisors for that matter too, in my experience) are not fundamentally opposed to an uncapped incentive plan. But they rightly expect significant safeguards to be put in place if the plan is to be uncapped.

Safeguards like using a measure of performance that takes into account the key drivers of wealth creation, that is, the quality of the business and quantity of funds invested in it. Setting targets not from the budget, but by reference to shareholder expectations. Making some payments annually, but deferring full payment until gains have been sustained for three or more years. Calibrating the plan in such a way that outsized rewards are only available for truly outsized and sustained gains in wealth creation.

With safeguards like these in place, managers can be put on an incentive plan that truly is engineered to create wealth.

Figure 2: If the incentive plan pays for sustained wealth creation, why cap payments?

Incentive plan alternatives

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