Three Principles for Common-Sense Compensation
Getting management to share the pain.
Compensation is among the most critical issues for an organization to get right. It shapes incentives, behaviors, attitudes, performance and, in many cases, results.
All good compensation plans involve 3 basic principles:
1. a concise definition of what's being measured;
2. a clear formula for reward if certain measures aren't reached; and
3. a sharing of risk between management and shareholders.
Too much of compensation in today's world is, for management, "heads I win, tails you lose." When management has skin in the game -- and the game is defined according to maximize shareholder interests --you have a formula for success.
The most effective measure of compensation is economic profit. This measure calculates the after-tax returns achieved by management after an appropriate cost of capital has been deducted. The cost of capital is critical.
Consider a company that must use leverage to reinvest in its business. If management is motivated, say, to increase sales of EBITDA, this will create additional bonus money. After all, buying a new plant, opening a new store, or making an acquisition will certainly increase sales of EBITDA. But real value is only created if the after-tax return on the new investment is greater than the cost of capital utilized for the project.
So, if a retailer opens a new store for $10 million, and the $10 million was borrowed at 7%, value has only been created for the shareholders if the return on that money exceeds $700,000 per year, or 7%. It's not a difficult concept, but you would be amazed at how few companies actually compensate their people like this.
The logic of charging a cost of capital is difficult to refute. Why would you ever want to borrow money -- or spend excess shareholder capital -- at a rate in excess of that at which you can redeploy it? Would you knowingly borrow money at 7% to reinvest it at 5%? But that's effectively what most compensation plans encourage management teams to do. Increase sales, increase EBITDA, and get paid.
Any compensation plan that doesn't incorporate the idea that part of management's job is to redeploy your money at a rate of return in excess of the company's cost of capital is both deficient and counterproductive. As a shareholder, you want to see after-tax cash flow per share increase. Just because a company grows its sales doesn't mean it's growing its after-tax cash flow per share. As an investor, you have only yourself to blame if you remain a shareholder with one of these plans in effect.
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