Insights

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 (an illustration of which accompanies this article). 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.