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.

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.