Effective Financial Incentives for Key Managers
Financial incentives can play a critical role in attracting and retaining capable managers. There are two principal kinds: equity and cash. Because equity (stock ownership) in a private¬ly held company is a less effective manage¬ment incentive today than it was some years ago, we'll focus on how to get the most out of two common forms of cash incentives: stock ap¬preciation rights and bonuses.
Stock appreciation rights convey no equity ownership. Instead, if the compa¬ny is successful, the employee will re¬ceive what amounts to cumulative de¬ferred income. The basic mechanics are quite straightforward.
First, there is the SAR grant — the formal setting aside of SAR shares for an award to an employee, including the chronological schedule of awards. The size and timing of each award is up to management. Since SAR shares are awarded, rather than purchased by the employee, no cash changes hands.
The base share value — the value at the time of the award — is also up to the company. It is common to peg SAR value to pretax earnings divided by the total number of shares in the SAR pool. With this structure, if earnings in¬crease over time, the value of the SAR shares will increase proportionately.
There is usually a vest¬ing schedule, such as 25 percent per year for four years. When the employee leaves the company, the company purchases his or her vested SAR shares. The purchase price equals the current value of the vested SAR shares minus the base value. Non-vested shares have no value and are can¬celled. Should the company go public or be sold, all SAR shares typically be-come fully vested immediately.
An SAR program provides at least five specific benefits:
1. It directly links the bonus to the suc¬cess of the company.
2. It avoids issues surrounding employee ownership of equity.
3. Because everyone benefits if the com¬pany does well, it encourages coopera¬tion among departments.
4. The vesting schedule provides an in¬centive for longevity.
5. Payments for vested shares are fully deductible.
The principal disadvantage is that there is no immediate reward for ex¬traordinary performance. A periodic cash bonus fills this gap.
In the design of an effective bonus system, there is one immutable princi¬ple: Reward employees for success in ar¬eas they control. There is nothing more frustrating for a manager than to have a bonus docked for something that was out of his or her control. And it is point¬less and wasteful to pay a manager for success to which that manager con¬tributed little or nothing.
For a bonus system to work, financial accountability must be clear. You need profit centers, such as a manufacturing plant, a wholesale warehouse or a sales ¬and marketing operation. The critical element is managerial control.
If a manager or vice president has no control over general and administrative expenses, there is no point in tying his or her bonus to bottom-line profitability. (That type of incentive is better suited to an SAR program.) Gross margin of¬ten makes a far more effective bench¬mark. For example, when gross margin increases as a percentage of net sales, the executive could earn a higher per¬centage of a larger dollar amount. In this type of system, the bonus would in¬crease exponentially with the increase in gross margin percentage (a bigger slice of a bigger pie) creating a powerful incentive to concentrate on profit, rather than just sales volume.
These two incentive systems are not mutually exclusive. In fact, each can help make the other more effective. As long as the manager is rewarded fairly for success in areas over which s/he has significant control, both the manager and the company can profit handsomely, short-term and long-term.
Note: This article is adapted from one entitled "Stock options aren't the only way to reward" by Steven Popell and Tim Bailey, published in January 2003 in the Silicon Valley - San Jose Business Journal.
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