What the remuneration report can tell a canny investor

While some investors may see the fuss about remuneration as ‘full of sound and fury and signifying nothing’, others understand that, like most things in the world of company valuation, the more you look the more you see.

And in a time when corporate communication is carefully guarded and controlled, for those who know where to look, the remuneration report is an open back-door into many aspects of how the company and its directors really think.

So let’s look at five fundamental questions that the remuneration report can answer, if you know what you’re looking for.

#1 To what extent has management ‘captured’ the Board?

The absolute amounts on offer to the CEO and the executive team should be of interest to any investor, but not because of the simple politics of envy.  Rather, the amounts on offer tell a great deal about the power that the executive has over the Board and ultimately how effective the Board will be in overseeing the actions of management.

If the Board is convinced that they have to pay the CEO far more than what is offered elsewhere, it says the Board places inordinate importance on keeping this CEO.

Any Board that is that enraptured with its CEO is unlikely to effectively oversee his performance or provide the vital check to the power invested in that role.

This can be a particularly dangerous situation for investors when the company is considering questions of capital allocation.

#2 What’s more important to this Board: substance or form?

Long term incentive plans (LTIPs) are a ubiquitous feature of remuneration reports.  Since the advent of the ‘two strikes’ policy, the form of LTIPs has narrowed to those most likely to be approved by the governance advisory industry.  Typically this means using relative TSR, cliff vesting (ie nothing for performance below the 50th percentile of the peer group), and a testing period of three or more years.

But, as many directors will quietly admit, they are also a colossal waste of money.  This is because the vast majority of executives who participate in this type of LTIP see any rewards that it offers as so beyond their control that the LTIP is really little more than a lottery.

In fact a 2013 study by PwC and London School of Economics professor Alexander Pepper showed that only 38% of Australian executives rated their firm’s LTIP as an effective incentive.

The capriciousness of the typical LTIP and its consequential ineffectiveness as an incentive is not new.  So, a Board that chooses not to employ the typical LTIP may well care more about effectively applying shareholders’ money than following the listed company herd.  A focus on substance over form augurs well for the treatment of shareholder funds in other matters.

#3 What does the Board think really drives the value of the company?

It is fair to assume that most public company directors are genuine in their desire to see the value of the company grow over time.  But what do they think really drives the value of the company?  Is it earnings growth?  Asset growth? Free cash flow? A higher return on equity?

This is important, because ultimately the Board is responsible for the big capital allocation decisions that can make such a difference to shareholder returns.  On what basis do they judge those opportunities?

Few companies set out what they think drives the value of the company (unfortunately), but the remuneration report can provide useful insight into this question because in structuring a reward program, the Board must answer a basic question, ‘What are we prepared to pay for more of?’

Assuming the Board will reward more of what they think drives the value of the company, the metrics used in the company’s reward programs are telling.

For example, Boards that reward EPS or EBITDA growth trumpet to the world that they recognise the importance of profit growth.  But they also make it clear that they don’t value what rate of return the business generates on investors’ capital.  After all, money invested at as little as 2 or 3% will grow EPS and EBITDA, even as it destroys the wealth of investors.

What does this mean when the company is faced with a major capital allocation question?  Any Board that is prepared to reward managers for EBITDA or EPS growth is likely to view favourably investment proposals that grow EBITDA or EPS, even if that means a return on investment as low as 1%.

A Board that pays for EPS growth or EBITDA growth either doesn’t understand the importance of generating a return above the cost of capital, or doesn’t care.

Return based measures, such as Return on Capital Employed (ROCE) and Economic Profit signal instead that the Board is awake to the importance of getting a decent return on investors’ money and of encouraging managers to recognise this as well.

What’s more, a remuneration report that includes transparent return measures signals the company’s confidence that it will be able to invest funds at attractive rates of return.  EBITDA and EPS based reward structures are silent on this point.

#4 How aspirational are management?

Most investors accept that the growth prospects of a firm are vital in assessing its value.  But the actual growth achieved by a firm is dependent on the aspirations of management and in particular the targets that they set for themselves.

How can an investor get a sense of how aspirational a business is likely to be in its target setting?  For any business priced for strong growth, investors need to watch for two flags, found in the remuneration report that may threaten how aspirational the business is in its target setting and hence how fast it grows.

First, where financial metrics are used, watch for Short Term Incentive plan targets set off budget.  In this situation, managers can improve their rewards by either improving performance or lowering the budget.  The latter is most likely easier than the former, especially given management are closer to the business than the Board and so better able to negotiate a target to their advantage.

For investors, tying incentive targets to budget can be very damaging.  Not only does it waste resources by dragging out the budget setting process, but budgets that have been ‘sandbagged’ lead to missed sales and profits due to under-resourcing.  Worst of all, it creates of culture mediocrity, where setting aspirational targets is actually in direct conflict with the interests of managers.  And it has a corrosive effect on the organisation as managers down the line see that it pays to lie to their superiors.

These problems are also found where rewards are made at the discretion of the Board.  Here what is likely to matter most to the executive is managing perceptions; perceptions of how well management has performed in the circumstances.

It pays then for the CEO to bring down Board expectations by putting up plans that are as conservative as he can get away with.  Again this is the opposite of what is needed in most companies but especially in one priced for growth.

#5 Are management being paid to grow the value of the company?

From an investor’s perspective the ultimate question on remuneration must be, ‘Are management being paid to grow the value of the company?’

Most investors would look to equity based remuneration to address this question.  But as we have seen, most managers ignore the typical equity reward program, treating them as little more than lottery tickets.

As the PwC/LSE study found, managers actually put far greater emphasis on salary and short term incentive payments.

Salaries are largely a function of size – the bigger the business that I run, the bigger the salary I take home.  But revenue levels, assets or headcount – all the size measures used to determine salaries – are poorly correlated with growing shareholder wealth.

That leaves the humble Short Term Incentive Program (STIP) to do all the heavy lifting with respect to directing management attention toward growing the value of investors’ capital.

Unfortunately, most STIPs are designed to create management wealth, rather than shareholder wealth.  They function more as deferred compensation than truly ‘at-risk’ compensation.

Here again, there are clues to how well the STIP will align management’s interests with those of shareholders.

Firstly, how many measures are used?  The more measures are used, the greater the ‘portfolio effect’ that will apply, allowing managers to get some reward even in a very poor year.

Second, are incentive targets set off budget, allowing managers to increase their rewards by ‘sandbagging’ their plans?

Finally and most telling: is the STIP capped?  If the STIP encourages managers to sustainably grow the value of the firm, why would the Board ever cap it?  Why would they ever say to managers, ‘This much shareholder wealth is enough: we won’t reward any more’?

No, a cap on an STIP is a vote of no-confidence in it, by the designers of it.  It says loud and clear, ‘This incentive plan does not pay managers to grow the value of the business.’

In summary

The purpose of equities research is to glean an informational advantage over other investors.  If you know where to look and what questions to ask, the remuneration report can provide fascinating and often overlooked insights into the way decisions are made, capital is allocated and wealth is created (or destroyed) within a listed company.

Sharing success: How does a high-growth, privately held company compete with industry giants to attract and retain the best people?

How does a high growth challenger business attract and retain good quality people?  Can the way you pay your people be used to differentiate your business in the market for talent?

In this case study we look at how West Australian based Perth Energy is using entrepreneurial rewards to take on the giant of its industry and how that has led the company to think more broadly about how it measures success, thinks about investment opportunities and sets strategy.

Download the full case study here: Perth Energy case study

Sharing success

In the late 1990s Ky Cao was working for the West Australian government owned power monopoly Western Power, when reform of the industry presented a once in a generation opportunity.

Cao saw the future would be an openly contested electricity market with privately-owned retailers and generators competing for customers, improving service and delivering value.

He left the safety of his job at Western Power to found Perth Energy, relishing the chance to be at the forefront of change in his industry. He raised seed funding from a group of Perth investors and by 2006, the business had revenue of over $8m.

By 2010 Perth Energy had established itself as a leader amongst a small group of commercial providers that competed with the government owned retailer, now renamed Synergy. Cao had also won the support of one of the region’s leading infrastructure investment houses, New Zealand listed firm Infratil, which took a majority stake in the company to help fund the purchase and installation of a $130m, 120 megawatt power station at Kwinana, south of Perth.

As a mark of his achievement, in 2011 Cao was presented with the prestigious Ernst & Young Entrepreneur of the Year award for the Western Region.

Attracting and retaining key people

But as new participants followed Perth Energy’s lead into the industry and the West Australian mining boom continued unabated, the competition for staff presented Cao and the Perth Energy Board with a new problem: how to attract and retain quality people?

“Electricity and gas supply is a relatively complex industry,” Cao explains. “It requires technical and commercial brainpower and experience. To attract and retain good staff and align their interests with those of the company, we needed an incentive scheme that fairly, transparently and efficiently linked company performance to staff bonuses. And it needed to cover short term and long term aspects.”

Rod Jones, a director of Perth Energy and founder of the ASX listed global education business Navitas Limited, suggested Cao contact Juno Partners Managing Director, Justin Bown.

“Justin had helped Navitas put in place a profit sharing program that offered a meaningful reward for staff, but only if gains were sustained over three or more years”, says Cao. “It had also allowed greater variability in employment costs: up when the business could afford it, but well down and acting as a cushion to profits when the business had an inevitable down year.”

Juno Partners was engaged to develop and implement a profit sharing scheme with similar qualities for Perth Energy late in 2010.

“We spent about three months working through all the design considerations with Juno Partners. We discussed a range of options that would allow for rewards to be uncapped, but in a way that ensured only sustained gains were rewarded,” says Cao.

Measuring success

An important part of making the program shareholder-aligned was the choice of metric to measure performance. Juno’s Justin Bown explains, “Most people come to work each day wanting to do a good job, but every employee needs their manager to clearly define what ‘good’ looks like.”

“Justin asked us to think carefully about how we defined good performance”, continues Cao. “Given the capital investment program that lay ahead of us, we chose Economic Value Added (EVA) as the financial metric at the heart of our reward program.”

EVA was developed and popularised by US consulting firm Stern Stewart & Co. in the early 1990s. “It’s profit as it would be measured by an owner,” says Cao, “that is after including a charge for the shareholder’s money tied up in the business. Traditional accounting profit charges for the use of the bank’s money [interest], but not for the use of shareholder’s money. By charging for all the capital tied up in the business, EVA gets staff to think about revenue and expenses but also asset utilisation and working capital management. Other measures like EBITDA don’t do that.”

Cao had come across EVA earlier in his career and the logic of it appealed immediately. “It clearly shows the value a company creates for its shareholders. Our goal was to share the success we had with our staff in a way that aligned their interests with those of shareholders, so sharing sustained growth in EVA made really good sense.”

Owner-like rewards

The ‘ValueShare’ plan was approved by the Board in February 2011. In addition to the use of EVA, it includes other aspects designed to differentiate Perth Energy in the market for talent and align the interests of employees with those of shareholders.

The plan offers uncapped potential – both on the upside and the downside – but with the safeguard that rewards declared in any one year above a pre-set threshold are deferred and settled over time, provided the employee sticks around and gains are sustained.

The sharing formula is set for three years in advance, providing certainty to the Board and accountability to managers. “I’d seen the crippling impact that tying bonuses to budget could have on the planning process,” says Cao. “You’re basically paying people to lower their forecasts and game the system. We’ve got away from all that, again making the culture more entrepreneurial than our competitors.”

While the majority of rewards are based on the financial performance of the Group, Cao also wanted to recognise the contribution made by individuals. He retained a small pool to reward outstanding achievement by individuals, allocated annually by him as Managing Director.

“The EVA reward is the bigger number, it rightly focuses attention on how we perform as a team,” says Cao, “but the individual reward balances that and allows me to recognise those who have put in a particularly good effort during the year.”

To make the most of the change he had led, Cao recognised the importance of education. “Having designed and gained approval for the new program, we wanted staff to embrace it and understand what they needed to do to grow EVA.” Juno Partners led education sessions that were reinforced by changes to monthly reporting. Cao continues, “I was pleased to see how quickly people picked up on the principles and the way conversations began to give more emphasis to efficient capital management.”

Changes to capex and planning

Changes were also made to the capital expenditure and planning processes. “We began by including EVA in capex proposals and the annual and long term plans we presented to the Board.” Cao says. “And that gave great focus to balancing profit and capital growth. But after a few years we became more focused on the conditions that were necessary for EVA growth.”

“Only about 50% of Australian businesses are profitable from an EVA perspective,” Bown adds. “To grow EVA you have to be investing funds at attractive rates of return, which in turn creates wealth for owners. But because high returns are the path to creating wealth, any business that enjoys high returns usually finds they are quickly surrounded by competitors looking to mimic their offering, but at a lower cost, or with more features.”

“To grow EVA sustainably therefore, you have to think about how to create value for your customers, but you also have to think about how you’re going to defeat the ravages of competition and keep a worthwhile slice of that value for yourself.”

Cao comments, “We started out looking for a way to share our success with our people and we’ve achieved that, but that journey also brought other benefits. It forced us to define clearly what we expect of our people and the company and think through what it is that really drives value for shareholders. It’s been a very useful process.”

A key role in doubling revenue

Cao sums up, “Perth Energy has always been a forward-looking company, not least because we were instrumental to the opening up of the electricity market in WA in the 2000s. This reputation helped us attract high quality staff to the company, which at the time was still a small business.”

“Our retail business grew ten-fold in the five years to 2010 and at the same time our generation arm was in the midst of delivering on time and on budget the Kwinana Swift power station project and soon after a second, $90m, 82 megawatt power station in Merredin, east of Perth.”

“So we had to implement innovative management tools to glide the company’s operation into medium sized enterprise mode. The ValueShare scheme was an important part of that.”

“The results from the first 3-year cycle, which paid out in FY12, 13 and 14, show the scheme working well. We are now into the 2nd 3-year cycle and staff have become very familiar with and supportive of the rationale, intent and transparency of the scheme.”

“The introduction of the ValueShare scheme has played a key role in Perth Energy doubling in size to nearly $300m in turnover, without a hiccup on the HR side.”

Incentive plans for privately held businesses: A case study

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 and the five key elements that can be used in incentive plan design that will make managers think and act like owners.

Let’s wrap up this series by looking at a case study where many of these issues arose and were addressed.

Case study

The Bicycle Warehouse (the name of the business has been changed to protect its privacy) is privately owned sporting goods retailer with operations throughout regional New South Wales, the ACT and Victoria.

Recently, the owner-managers of The Bicycle Warehouse were looking for a way to attract and retain store managers in an employment market where the Group competed against highly paid public servants and mining businesses.

One plank of their strategy was to put in place a carefully designed incentive plan for store managers and head office staff.

A Working Group was formed with the owner-managers and an advisor from Juno Partners to develop a plan that would pay store managers for sustained increases in performance.

Over three months, the Working Group developed and implemented the new plan, starting with how to measure performance. After some deliberation, Economic Profit (EP) was chosen, with the aim of getting managers to think about profits and capital invested. But the Working Group recognised that EP would be a new measure to their store managers, one that would require some time for their managers to get used to.

To help speed that understanding and show managers the link between the Key Performance Indicators they were used to, like conversion rates and items per basket, and the new measure of performance, Economic Profit, a detailed EP driver tree was developed. Built in a spreadsheet, it allowed managers to simulate the impact on EP of changes in different KPIs, building understanding and confidence in the new measure.

Next, the Working Group developed an incentive plan design with the aim of rewarding sustained gains in EP.  To that end, the plan included:

  • store level, three year targets for growing EP;
  • a simple incentive formula that shared a constant amount of the sustained gains in EP with each store manager; and
  • an incentive reserve that allowed payments to be made annually, but also kept some in reserve in case gains turned out not to be sustainable.

Then the Working Group moved on to look at how much could be offered to managers under the plan.  With a number of safeguards in place that ensured only exceptional, sustained gains in performance would lead to large payments, the Working Group decided to set target variable pay, the amount declared for hitting targets, at 25% of base pay.  To pay for this increase in remuneration, the Working Group decided to offer the plan to all managers in exchange for a three year freeze on fixed pay rises.  This freeze would represent real skin in the game for managers used to 5% pay rises annually.

Finally, education material was put together ahead of a launch day, that involved all store managers coming together to go through the workings of the new incentive plan.

The plan was received well by managers, as shown by their willingness to accept the fixed pay freeze over three years, used to fund the introduction of the plan.  Key to that acceptance was the transparency and objectivity of the plan.

In the period following the implementation of the new plan, the Group has successfully attracted new talent, while minimizing unplanned departures.  Managers report being more interested and more involved in the financial performance of their store and the business and the owners have reported that managers are taking a more thoughtful approach to managing their stores, including expansion opportunities.  In short, The Bicycle Warehouse has developed more of an ownership mindset amongst their managers, without the complexity of issuing shares.

Summary

Many privately held businesses struggle to compete with the rewards on offer at larger, publicly held companies. But the truth is, while public company rewards can be generous, they are often poorly designed and undervalued by employees. This presents an opportunity to shrewd owners to design and put in place well designed incentive arrangements that attract and retain managers prepared to back their abilities and that only reward sustained gains in the value of the business.

Five elements to make managers think and act like owners #5: Make the rewards on offer meaningful

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.

#5: Make the rewards on offer meaningful

While good managers, like good owners, are motivated by more than just money, the rewards on offer to employees need to be competitive to attract, motivate and retain key staff.

A well designed incentive scheme allows owners to safely offer meaningful sums to managers, amounts that can have a significant impact on the wealth of the manager over three to five years, but that represent a fraction of the increase in the owners’ wealth.

Indeed, managers are more likely to look for greater amounts of their remuneration tied to performance if 1) they are prepared to back their abilities and 2) the plan is well designed and they are confident, therefore, that the owners will stick to it.

Finally, managers tend to value the sums on offer under well-designed plans more highly than those offered under poorly designed plans. This allows privately held businesses to compete with publicly held companies: even though they may be putting less money on the table, their offer can be competitive with the more lucrative, but poorly designed plans on offer in most public companies.

In the final article in this series, we’ll look at a case study of a company looking to attract and retain key staff through the use of an incentive program for store managers.

Five elements to make managers think and act like owners #4: Only pay out if performance is sustained

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.

Bonus bank incentive reserve

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.

Five elements to make managers think and act like owners #3: Ensure the budget plays no part in determining rewards

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.

Five elements to make managers think and act like owners #2: Make every dollar of profit worth the same to managers

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.

#2: Make every dollar of profit worth the same to managers

For an owner, an extra dollar of profit is worth just that, one dollar. But many incentive plans reward managers in a dramatically different way. They require a certain level of profitability (such as meeting budget) before they pay the first dollar in incentives. Then, at the point of reaching the budget, one extra dollar of profit can be worth thousands to the manager, even if it’s worth just one dollar to the owner.

Many incentive plans also have caps, so that an extra dollar of profit to the owner is worth nothing to the manager.

Typical incentive plan structure

An incentive plan that paid managers like owners would have at its core a formula with a constant sharing percentage, just like if the manager had a 10% ownership stake in the business.

In the next article we’ll discuss how to decouple the budget from the incentive plan.

Five elements to make managers think and act like owners #1: Reward sustained improvements in profitability

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.

#1  Reward sustained, multi-year improvements in profitability
Ultimately an ‘ownership-like’ incentive plan must have financials at its heart, as it is sustained gains in financial performance that power the value of a business. Single period spikes in performance are unlikely to grow the value of the business a great deal however – buyers look for high levels of ‘repeatable earnings’. The more reliable the profit flow, the higher the premium buyers are likely to pay for a business.

I’ll discuss how to reward sustained gains in element #4, but it is worth focusing on how ‘profit’ is defined first, because, as we have seen, the most common profit measures, such as EBIT and EBITDA (or Net Profit, Earnings Per Share, Return on Equity and so forth) can actually encourage decisions that reduce, rather than grow, the value of the business.

One measure of profit that can be relied on to drive decisions that will grow the value of the business is ‘Economic Profit’. Economic Profit is the only metric that can be measured as easily as EBIT or Net Profit and yet ties reliably to wealth creation for owners. It’s measured like this:

Economic Profit calculation

Most owners know that ‘Profit’ is what is left over from sales revenue once all the costs of running the business have been taken out.  But accounting profit forgets one very important cost – the cost of using shareholder funds.  And by failing to put a price on the equity used to fund the business, accounting profit effectively says it’s free.

Pay managers to grow accounting profit and they will be encouraged to use as much of the shareholders’ money as they can put their hands on, after all its free and if they invest it at just 1%, accounting profits – and their bonuses – will grow.

But by charging for the owner’s capital used in the business at a rate that reflects what could be earned elsewhere at similar risk, managers are encouraged to treat capital like the scarce and valuable thing every business owner knows that it is.

Economic Profit puts into practice what anybody starting a new business has to think about from day one: if I put my savings into this business, will it generate more profit than I could have got elsewhere at similar risk?

For managers on an incentive plan linked to Economic Profit it forces them to think the same way: not just will this decision be profitable, but will it make enough profit to justify the owner’s investment?

In the next article we’ll discuss how to align the payoff profile of managers to that of owners.

An incentive plan that pays for sustained gains in the value of the company

Having outlined some of the most common incentive plan mistakes that privately-held companies make, let’s look at what works well.

Different owners have different objectives for their business and for the incentive plans that they offer to their managers. But in my 18 years advising in this area, some common themes have arisen:

  • Owners want an incentive plan that will encourage managers to do the things that grow the long term value of the business. This means sometimes making decisions that will lower near term financial performance for the sake of the business’ long term value. It also means putting safety and regulatory compliance above short term financial factors.
  • They want to share a fair portion of the success of the business with managers but they also want managers to have some real ‘skin in the game’ on the downside.
  • They want to encourage a collaborative culture, as much between owners and managers as within the ranks of management.
  • They want to encourage managers to reach for the stars and share the owner’s ambitions for the business.

In short they want an incentive plan to make their managers think and act like good owners without the complexity of actually selling them a piece of the business.

An incentive plan to achieve that aim might look like this.

  1. Just like an owner, the majority of the financial rewards would come from building the business – achieving sustained, multi-year improvements in profitability.
  2. Just like an owner, every dollar of profit would be worth the same to managers, as if they owned a flat 10% of the business.
  3. Just like an owner, actual results would be paramount, with the budget playing no part in determining the size of rewards.
  4. Just like an owner, some portion of rewards would be enjoyed annually but the majority would be deferred and subject to loss if performance was not sustained.
  5. Just like an owner, rewards on offer would be meaningful.

In the next five articles we’ll explore how each of these aspects can be built into a powerful and effective incentive plan for a privately held business, before looking at a case study of its application.

The most common incentive plan mistakes made by privately held companies #6: The wrong measures

In this series of articles, we’ll review some of the most common mistakes that privately held companies make in approaching the question of incentives, before looking at a sketch of what I have seen work well.

Mistake #6: The wrong measures

Finally, the wrong measures of performance are too often used to determine bonus payments. The most popular financial measures used in bonus plans are pre-tax, pre-financing ones like Earnings Before Interest and Tax (EBIT) or Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA). But these measures ignore a major component of doing business, the capital put up by investors.

Most businesses require capital – money from banks and owners – from day one and every day thereafter as they grow and prosper. But measures like EBIT and EBITDA completely ignore the use of capital and hence give managers no incentive to manage it more efficiently.

For example, for an EBIT of $2m, would you rather put up $10m in capital or $20m? A bonus scheme based on EBIT doesn’t differentiate between these two alternatives and so it’s not surprising that EBIT and EBITDA based schemes often go hand-in-hand with bloated working capital, gold-plated asset purchases, and a preparedness to pay suppliers early to keep them happy.

Under these schemes capital has no cost, so it’s not surprising that it’s used so wastefully.

But you can’t blame managers for responding to the rules of the game that are written for them. The blame sits squarely with the owners and Boards that write the rules of the bonus game without careful thought or research.

Next we’ll look at how these common mistakes can be avoided and instead, an incentive plan put in place that pays managers like owners.