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.
#4: Only pay out if performance is sustained
The value of any company reflects what buyers (and sellers) believe it can earn well into the future. The future being uncertain, buyers usually put great store in the sustained, historic earnings of a business.
Any incentive plan that aims to pay managers like owners, therefore, needs to recognise the importance of sustained gains in performance. One way to do this would be to measure performance over five years, for example and only make incentive payments at the end of that period.
But managers asked to wait five years for an incentive payment would rightly demand a higher level of payment, to justify the risk that they might leave during that time without any payment and to cover the time value of money.
A more practical alternative is to assess performance on an annual basis, calculate a reward and then place that reward into a reserve, paying out just a portion in the current year. The balance would be paid out over time if the performance can be sustained. A simple illustration of an incentive reserve or ‘bonus bank’ scheme is included below.
In this illustration, the profit growth of the business in year 1 is good and a $100,000 incentive is declared for the manager. This amount is put into his incentive reserve and 50% of the balance is paid out, or $50,000. The balance is carried forward as the opening balance of his reserve for the purposes of calculating the following year’s payment.
In the second year, profit growth is very strong and a $200,000 incentive is declared. The manager now has $250,000 available, of which 50% is paid out and 50% carried forward.
In year three, all of the profit gains of the prior year are lost and the incentive declared is negative $200,000. This is offset against the $125,000 carried forward leaving a negative balance of $75,000. This amount must be earned out through improved performance before any payment is made in following years.
Coming off a low base, year four sees a big leap in performance and a $300,000 incentive declared, which brings the incentive reserve balance back into positive territory allowing a payment to be made.
There are many different types of incentive reserve structures – some pay out faster, some slower – but all allow annual payments to be made that reflect multi-year performance.
While the deferral of incentive payments is increasingly common, many companies fail to hold deferred payments at risk, that is, subject to loss if performance is not sustained. This is a crucial component if managers’ and shareholders’ interests are to be aligned.
In addition to providing Boards and owners with the comfort that incentive payments reflect sustained gains in performance, the incentive reserve also acts to smooth payments through the economic cycle and can act as ‘golden handcuffs’ – a mechanism to retain key staff, as the balance of the reserve is forfeited on the termination of the executive’s employment.
In the next article we look at the final element to make managers think and act like owners: the size of the rewards on offer.