Management Incentivization the Right Way
Posted by Dr. Earl R. Smith II in Advisory, tags: adviser, advisor, advisory board, board of directors, CEO, chairman, coaching, consulting, director, Executive Coaching, Governance, Leadership, leadership assessment, leadership coaching, leadership development, leadership styles, Life Coaching, management assessment, non-profit, nonprofit, Personal Growth, spirituality, turnaround, Turnaround ManagementDr. Earl R. Smith II
DrSmith@Dr-Smith.com
www.Dr-Smith.com
One of the major sins committed by Boards of Directors comes in the structuring of the compensation scheme for senior management – particularly the scheme for the CEO. Historically, most members of a senior team have received a multiple of their base salary in the form of options. In the past, boards have linked the rising value of the shares of a company to the incentivization of management – in other words, give them options that are only valuable if the share price increases. The weakness in this scheme is the increasingly difficult challenge of creating a public market for shares – as through an IPO. Now that companies are ’staying private’ longer – or, sometimes, not going public at all – the options become valuable only if another private investor comes along with an interest in purchasing them.
But there are downsides to this practice – well, several downsides but I want to focus on just two. The first becomes clear when a company approaches the second opportunity for a ‘liquidity event’ – merger or acquisition. Most acquirers have little interest in continuing, without substantial modifications, the option program of the company they are targeting. In face, the elimination of existing options is a way to further dilute the shares of the target company. In a battle of interests between the investors and the management option-holders, the investors almost always win – if for no other reason than their interests lie more closely with the acquirer than the option holders – they do not want to be diluted either.
Conversion of options in anticipation of an acquisition will seldom work. Most often, a sophisticated acquirer will lock in the capital structure early on in the negotiations. The acquirer will dictate the capital table of the combined companies and they will have little interest in diluting their position.
The second downside of the traditional strategy of incentivizing management with options that only become valuable is the price of shares increases is that the awards are not connected to metrics for individual performance. Each member of the senior team ought to have performance metrics – performance targets – that define company expectations. The good metrics are very granular – they define expectations in easily measurable terms. The very good metrics focus on long-term performance and penalize pursuit of short-term gain in lieu of long-term advances. Good compensation schemes reward performance that is in the interest of the shareholders. The rewards for such performance should be immediately valuable – not subject to the performance of the rest of the team.
Boards – or the compensation committee of a board, if such exists – better represents the interests of the shareholders if they insist on a compensation scheme which:
- does not excessively dilute existing shareholders
- ties awards to performance that advances the interests of shareholders – remember the primary duty of a board is to protect and extend shareholder value
- emphasizes the long-term interest of the shareholders over the shorter-term interests of management – shareholders are in it for the long pull while management will almost always act to maximize current period benefits
In this new, post Sarbanes Oxley world, there is mounting pressure on boards – including boards of privately held companies – to structure more effective and focused compensation schemes. Tying compensation to performance – particularly to long-term performance – whole structuring incentivized compensation that will survive a liquidity event is one of the major challenges that a board faces.
© Dr. Earl R. Smith II
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Related Articles:
- Management Incentivization the Right Way
- Components of Good Governance – Three Committees
- Good Governance – The Compensation Committee
- Good Governance – The Chairman’s Role
- Executive Committee Operations
- Board of Directors Responsibilities – Compensation Committee
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Dr. Smith is a proven senior executive, successful entrepreneur, published author and public speaker. He serves on boards of directors and advisory boards or as a strategic adviser to CEOs. Dr. Smith specializes in turnaround management, strategic planning, leadership development and executive coaching. He also works as an executive and/or life coach in the areas of personal growth and spirituality. He is the author of Amazing Pace: Turbo-charged Business Development – a book that shows how Advisory Boards can dramatically increase revenue. Dr. Smith is also the author of Dream Walk: Parables for the Living – a book of Raven Tales and exploration.
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