Economic Incentives when creating a company

One of the critical attributes of the value creating company is the degree of attention paid to providing appropriate near-term and long-term incentives to its managers and employees. There should be a true causeand- effect phenomenon surrounding incentives and results. If a company’s incentives are based on some of the common, broad accounting measures such as return on equity, or return on assets, or even earnings per share, there is a real risk that decisions, large and small, will suffer from the economic disconnect and time lag inherent to these measures.

While the complex subject of management incentives is not one of the areas we’ll cover, we believe the principles involved are the same basic economic choices that affect financial analysis and planning.

Therefore, both near-term and long-term incentive programs should reflect a careful set of measures designed to reinforce shareholder value creation. Since value creation depends on consistent cash flow generation in excess of the cost of capital, incentives chosen will tend to reward results from consistent cash-flowbased decision-making. Targets are set and measured with yardsticks as close as possible to cash. This approach is directly applicable in the operational area, where the cause-and-effect relationship between incentives and results can be found in fairly basic targets, such as volume goals in sales or production, carefully calibrated against quality standards and relative contribution from products and services, or cost effectiveness standards that encourage enhanced performance within required service and quality levels. We’re not talking merely about managing budgetary variances, but about setting specific sub-goals within a broader set of systematic expectations, accompanied by open communication about the fit of these sub-goals into the overall strategic context. The process in effect focuses on identifiable and measurable value drivers.

In the strategic area, long-term incentives should primarily be based on the cash flow expectations from specific plans, whether for a product or service sector in the business, or for the company as a whole. In essence, incentives are founded on the ability to bring about the cash flow streams committed to in strategic plans, and rewards fluctuate in response to such performance. The value creating company structures true incentives, that is, underperformance means a tangible penalty, while excellence is well rewarded. In addition, there is great emphasis on long-term performance to avoid the temptation to make decisions that enhance short-term results to the detriment of shareholder value creation.