In this series of articles, we’ve looked at some of the most common mistakes that privately held companies make in approaching the question of incentives, and we’ve sketched out the common themes that owners tend to look for in an incentive plan.
Let’s now move to see how those themes can be realised in practice, by including five key elements in the incentive plan design that will make managers think and act like owners.
#3: Ensure the budget plays no part in determining rewards
As we’ve seen, using the budget as the benchmark to determine incentive rewards unintentionally encourages managers to low-ball their budget. The answer is to decouple incentive targets from budget altogether and set incentive targets that reflect reasonable three to five year expectations for the business.
Setting ‘reasonable’ three to five year targets could be just as prone to gaming as the annual budget if not done carefully. The key is to have an independent third party involved such as a trusted accountant or experienced advisor. They should conduct and present to the owners and managers a recommended growth target based on analysis including a detailed review of the historical performance of the business and that of a group of peer companies, examination of forward projections for the business and of the valuation of the business. Comprehensive scenario testing can then be conducted with the owners and managers to build confidence in the appropriateness of the target.
Just as important is the sensitivity of the plan. At what level of performance would no bonus be paid? At what level of performance would a double bonus be paid? These questions are best addressed again with the help of an independent third party who, through detailed analysis and collaboration with the owners and managers, can recommend the sensitivity of the plan.
In the next article we’ll discuss how to ensure only sustainable gains in performance are rewarded.