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THE DEEP DIVE

Lessons Learned From a Failed Incentive Structure

This is Week 5 of 6 in a series on FP&A.

Let me share a compensation horror story.

One time, we brought in a new President (we’ll call him ‘Kevin’) to improve a meandering business unit.

At face value, it worked. EBIT more than doubled in three years.

But in the same period, the equity value in his business fell by an estimated $250m.

How can both be true?

Whilst profits were high and growing, this had come at great cost. The future profit prospects were destroyed.

Aggressive price increases had burned customer relationships. Quality was slashed out of the product to save cost. R&D expenditure went to zero. No clear strategy. All the best employees left, tired and burned out.

These things juiced in year profit, but destroyed shareholder value at the same time.

What drove this behavior?

Let’s look at the incentive.

Kevin came in with total annual comp potential of just under $2.0m. The comp committee on the CEO’s recommendation agreed the following structure:

• 25% in salary

• 50% in annual bonus

• 25% rolled up into an Long Term Incentive Plan (LTIP) payment paid after 3 years.

The bonus was linked to each year’s performance. Levered 100% on EBIT. The LTIP was a fixed sum payable after 3 years (3 x 25% of salary).

And what happened?

Kevin maxed out his annual bonus in each of the three years with a maniacal focus on in year EBIT.

He performed what the incentive asked of him.

He grabbed the guaranteed LTIP payment on the third anniversary. Then disappeared straight afterwards into a different business. Presumably onto the next destroy and exit job on the strength of his stories of doubling profits in three years.

But the business was a mess. A husk.

EBIT crashed by more than 50% in the following year, and was on a dangerous downward spiral.

Kevin’s reign had cost about $250m of equity value by my calculation.

The CEO and I fell out over it. I could see what was happening early on, but he couldn’t see past the impressive short term EBIT performance.

I still wish I’d done more to stop it.

Don’t misunderstand me. There is nothing wrong with running a business for cash, if its right. But that was not needed here. Nor was it intended.

Long term equity value was the goal.

Through a poor incentive structure we had created a management : shareholder agency issue.

With disastrous consequences.

I learned a lot from that mistake, and realized the importance of precision and detail in designing financial incentives.

Today I’ll share what I learned, so you need never make the same mistake.

How to build an comp structure that incentivizes the behavior your want.

But first a disclaimer. This is not ‘HR Secrets’. It’s not designed to be a comprehensive guide to reward or how to keep people happy. Not to say it isn’t important. It is. But not the focus of my newsletter or this post.

We’ll focus solely on how to build the structure of an incentive to drive business performance. The CFO lens on reward.

Likewise, I won’t talk about individual incentive instruments; stock options, RSUs, ESOS, etc. They are specific to local tax and company law considerations.

My subscribers read from all over the world, with no single country representing more than 30% of the total. I’ll assume you will work out which instruments work best in your geography and situation.

But we are going to talk about the principles behind getting the comp structure right.

Let’s start with a recap of where we are in the FP&A cycle:

• Started with a high level multi-year cashflow in the Long Term Plan.

• Used Year 1 to set the guardrails for a detailed next 12 months Budget.

• Found an appropriate way to keep that live with in-year Forecasts.

• Last week we engaged the whole business into a full set of KPIs with measurable targets.

• This week we connect individual financial reward to that KPIs performance.

This flow is important. Unbroken links in a chain. From high level strategy all the way down to KPI linked bonuses by individual.

I have obsessed with the idea of incentives ever since I read Freakonomics, back in 2005. The idea that incentives were everywhere. Even unintended incentives. And incentives are what drives behavior.

Being intentional about incentives is what matters.

In business the purest form of incentive is the employee compensation structure.

Typical management compensation structure has up to 3 components:

1. Base compensation (e.g. salary and benefits)

2. Annual Incentive (e.g. bonus)

3. Long Term / Multi Year Incentive (e.g. share based compensation, or LTIP)

Everyone in the business gets 1. Management get 1 and 2. Then the most senior get 1, 2, & 3. Exactly who depends on the situation, the business, and the sector.

And typically, each of those three components can have one or both of a fixed, and variable component:

To put it crudely:

• Fixed Compensation - Employee is paid for their time

• Variable Compensation - Employee is paid for their performance

Things went wrong with Kevin, through the structure of his LTIP.

With that payment linked to time, rather than shareholder value.

His comp incentivized him to milk profit at all costs for 3 years, and then disappear, collecting his LTIP on the way out.

Had that LTIP linked to a longer period, or better, been paid in equity. It could have had a very different result.

So what does a good compensation structure look like?

Here are 9 principles:

1. Base compensation is fixed. But annual incentive and long term incentive are linked to performance

2. The annual incentive is linked to a combination of business and personal performance (mix depends on seniority of individual)

3. The long term incentive is solely linked to business performance (specifically shareholder value)

4. People should feel they have control over their bonus outcome through their performance.

5. At more junior levels bonuses weight to individual contributions and KPI delivery

6. At more senior levels bonuses weight toward outcome measures (specifically financial outcomes)

7. There is a financial bias. But the bonus scheme should also cover non-financial KPIs

8. Performance against the bonus measures is transparent. People know at all times what their expected outcome is, and what they can do to change it.

9. The shape is designed to make sure the ‘marginal incentive’ is attractive at all times.

Annual Incentive Structures

Great entrepreneurs have a wide locus of control. They believe they can bend the universe around their will. As such they are comfortable with the purest incentive possible; equity.

No profit, no pasta.

But the best executive teams behave like owners too.

How do you make them behave like owners?

Incentivize them like owners.

So if the business has a bad EBIT year due to external factors. And the senior exec blow out their bonus despite everyone doing their best? For the senior exec, that should be tough shit. The reverse is also true, after all.

But at more junior management levels, they don’t control the big outcome measures. For these levels, give them a healthy exposure to the outputs but lever their variable comp on inputs. The things they can control.

Here is an example structure (all numbers illustrative)

Notes:

• EBIT = Profit Attainment vs Target

• MFCF = Cashflow Attainment vs Target

• KPIs targets are set specific to the individual, based on their direct locus of control, as follows:

  a) The KPI measures defined through the process described last week. At an appropriate point on the People - Profit Chain.

  b) Employees should have a mix of KPIs and be exposed to KPIs outside of their function. I.e. everyone should have exposure to Employee Engagement. Not just HR.

  c) The job spec for each individual should define which KPIs are important. This should map directly

• The bonus becomes more weighted to KPIs at more junior levels. Where contribution is more isolated to individual functions or areas.

• At more senior levels bonuses are more weighted to financial outcomes. As we said last week sustainable profits come from in the People - Profit chain. And the LTIP can be used to keep a keen eye on long term value and avoid the ‘Kevin mistake.’

The above sets out an example based as delivering ‘on target’ for bonuses.

But earlier we also said the marginal incentive was important.

Last thing you want is someone delivering the target inside 10 months and taking their foot off the gas because they’ve bagged their bonus.

Or worse giving up altogether half way through the year because the target is out of site.

There should be a gradient, below target and above target.

It might look like this:

• ‘Lower Bound’ Performance (in this example 80% of KPI target)

  • Below which payment is zero

  • Above which payment kicks in at 50% of On Target Bonus Level

• Straight Line up to Target Performance so if a target is hit it pays out of 100% of entitlement

• ‘Upper Bound’ performance, a maximum of 200% of bonus entitlement can be achieved up to an ‘outperformance target’. In this example at 110% of target.

I like to ensure the gradient is steeper above target than below. Make sure the next ‘step’ is always worth striving for. Using the ‘marginal incentive’.

Behavior happens at the margins, not in total or on the average.

Always keep the carrot in view.

This should all be calculated by individual bonus component meaning that the financial measures and each KPI will each need 3 targets (Target, Lower Bound and Upper Bound)

For example, a Director of Operations might have 20% of their total bonus linked to a KPI for Units Produced Per Labor Hour. Producing an outcome range for that one KPI like this:

Creating a gradient between different performance thresholds is vital. Remember people are incentivized by the marginal $.

So ensuring there is always a valuable $ to chase (within guardrails) is important to optimize performance.

Long Term Incentive Plans

We left the discussion behind on Long Term Incentives earlier on. So let’s pick it up again now.

From my experience the best LTIPs align executive interests directly with shareholder interests. The best way to do this is to make make them shareholders. Private Equity, and VCs understand this.

And in many countries there are tax advantages for this also.

But if share ownership plans don’t work for your business, you can create a multi-year bonus structure. And here is the cool bit, you can link it directly to the targets in the 3,4 or 5 year targets you set in the Long Term Plan.

Isn’t it beautiful how it all comes full circle …

The way LTIPs intersect with the annual bonuses are crucial. This is where it went so wrong with Kevin. LTIPs and equity awards apply to the most influential people in the business, and are typically big $.

The design of them will directly influence your long term outcomes in a material way. So spend time designing them very deliberately. The detail matters.

Imagine if we had have got Kevin (or preferably not Kevin) on a variable LTIP.

Linked to Long Term value creation targets, with a rolling 3 year vesting schedule. Kevin would always have had a future LTIP payment in site linked to long term health of the business.

He would have run the business differently, or maybe wouldn’t have joined altogether. Either is fine.

Even if we tripled the size of the LTIP opportunity, it might have cost us $5m.

But we could have saved $250m of equity value.

A lesson learned.

Next week we will finish this series on FP&A through how we monitor performance against the plans we have set.

BOOK CLUB

There aren’t many newsletters I read every week, but Mostly Metrics by CJ Gustafson is one.

CJ is a tech CFO, and a great thinker on all things business models and metrics.

With real battle scars from the trenches leading venture backed finance teams, CJ is a voice to trust in tech.

His recent interview with VC and memelord Turner Novak was a must read.

Join 26,000 other start up operators and VCs for this free newsletter

THIS WEEK ON TWITTER

Had a good idea this week to stop lazy idiots spending money on consultants

And on a separate point, we should all take a moment to recognize those that have walked before us. Especially this guy…

I’ll be knocking the door of the Chair of the Board on Monday.

FEEDBACK CORNER

A review of last week’s edition:

I’ve had a lot of requests for a book. At some point I will write one, but I’m not ready yet. Watch this space, there is an awful lot more to come …

POACHED GREG

Back to a simpler time, when we first met our boy. Looks how far he’s come since these days.

Anyway …

That’s all for this week. As always you can find me here on CFO Secrets, Twitter, & LinkedIn.

With your teams all fired up to make bank with their bonuses, next week we move onto monitoring progress against the plans you’ve set.

Until next time…

Stay Crispy,

The Secret CFO

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director or friend. Well, maybe I’m your friend. But I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need to make the right decisions.