Scrap management by objectives. Managers should be rewarded same way shareholders are: increasing capital value.
Judging by the mail and phone calls, my last column struck a deep chord. I wrote that managing capital and aligning managers' interests with stockholders' should be high on the agenda of any board of directors. Many readers asked for amplification. Here goes: Think of the board of a company as a licensing authority. Managers apply for capital to build or run a business for the coming year. The licensing authority's job is to get the capital into the hands of the managers who will do the best job improving its value. This means trying to identify the managers, businesses or projects with the highest returns, i.e., the ones that produce the highest sustainable cash flow per dollar of capital invested. This is easier said than done. The problem is that as an owner or director, you don't really know very much about how capital is used to run the business. Most of the decisions that affect the use of capital happen in the branches, warehouses and factories, not in the boardroom. You have to depend on other people to do the right things. Your job is picking the people to trust and setting up the system that makes it all work. First, I will say something obvious. Select your managers on character, not simply competence. Some managers have an innate respect for capital and its owners, some have none at all. I know of no strategy, tactic or compensation program that will protect you from the damage done by entrusting your capital to the wrong people. Once you pick the right people, scrap the MBO (management by objectives) program. It doesn't get to the heart of capital management. Shareholders get paid when managers create equity value, not when managers check off items on to-do lists. To align manager interests with owner interests, pay managers the same way shareholders are paid. The best way to do this, by far, is by encouraging managers to buy shares in the company. Next best is to sell, not give, the managers options to buy shares at a later date. Never give stock away. Period. By requiring the option-holders to pay, you are reminding them that capital is a scarce resource, not to be used lightly. Make the option's exercise price rise over time to reflect the cost of equity capital. (For more on this idea you can read Bennett Stewart's fine book, Quest for Value.) To the extent that you want to use a bonus program to reward performance, base it strictly on creating equity value. In this method I prefer creating a pool at the end of each year in which managers share, based on a fixed, known percentage of the increase in equity value they created during the year in their branch, division or, for senior executives, the whole company. What if you don't have a public stock? For most companies, simple rules of thumb for value, such as "six times operating profit minus debt," are close enough, as long as everyone knows the rules to be used. Or you can pay bonuses based on the increase in economic profit (operating profit less a charge for the capital used to run the business) over the previous year. Above all, don't set caps on the maximum bonus payable if managers knock the lights out. If they make the company rich, let them get rich, too. The hard moment for directors, of course, is when they know the managers are doing the right things, but are not adding to value. The temptation is great to pay bonuses anyway. Don't do it. Uncoupling rewards from economic performance defeats the whole purpose. Of course, you should make sure that. base pay is high enough to support the manager and his family, but bonuses are for creating value, not rewards for hard work. Adopting these disciplines sounds easier than it is. It is quite common for directors to go through an exhaustive process before approving or disapproving a new investment but then failing to follow through to see if the investment authorized really earned what it was projected to earn. That's why we find companies with a 20% hurdle rate for approving capital spending and a 2% return on capital. In companies where I sit on the board, we back-audit annually the returns on new capital items purchased. We also periodically break the company down into the smallest units for which capital and cash flow can be measured, and conduct a formal value audit of the resulting pieces.
This process results in a financial CAT scan of the company along product lines, locations, warehouses or divisions. It identifies specific winners and specific losers. Above all, it gives us a road map for redeploying scarce capital.
|
