The Best Incentive Plan for Managers

What is the best incentive compensation plan for managers? Managers of acquired companies? or general managers?

Incentives are just rewards associated with specific goals or actions.

Goals should be (1) tailored to the economics of the specific operating business; (2) simple in character so that the degree to which the are being realized can be easily measured; and (3) directly related to the daily activities of plan participants. As a corollary, we shun “lottery ticket” arrangements, such as options on Berkshire shares, whose ultimate value… which could change from zero to huge – is totally out of the control of the person whose behavior we would like to affect. In our view, a system that produces quixotic payoffs will not only be wasteful for owners but may actually discourage the focused behavior we value in managers.
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‍Warren Buffett, Seeking Wisdom from Darwin to Munger

For the purposes of this discussion, incentive compensation and the general compensation structures for managers are one and the same. This discussion focuses on how incentives should be structured rather than specific total compensation. Compensation plans for management should generally include some form of incentive structure.

Proper incentives are critical for the success of a functioning of a business. Getting incentives right is not easy and each company will be different. Berkshire Hathaway, one of the world’s largest conglomerates, has faced this challenge in spades. The nature of the firm is one disaggregated parent company owning many component companies. Owning many companies requires incentive structures that are manageable and necessarily effective.

A one size fits all approach will not work. Instead we must rely build the best philosophical framework for incentivizing general management or employees on behalf of company owners.

Critical Components of Management Incentive Plans

Let’s unpack the above quote framework into its component parts:

How To Tailor Incentives To A Specific Type Of Business

It is important to understand that business in different industries are going to have fundamentally different underlying economic characteristics.

Consider two small businesses that produce the same amount of earnings. For simplicity, let’s say it’s a few million dollars a year in after tax earnings for their respective owners on an annual basis. One business is a service business assembling office furniture, the other is a company that drills oil wells and produces hydrocarbons.

The objectives of both firms from the standpoint of shareholders is the same. Maximize profits for shareholders and increase value per share.

But, the furniture assembly business is obviously not going to be as capital intensive as the energy business. How should the management of these two businesses be compensated and incentivized?

The answer is simple.

When a business requires no capital, we reward the manager on earnings. If it does [require capital], then we add a charge for the cost of capital. We don't have one compensation system.
We've never had problems with compensation. If capital is an important part of business, we include a charge for it. If not, if we don't.
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The main reason we get good results from our managers is that they like batting .400. Yes they like the pay, but it's incidental. It has to be fair, but that is not a complicated procedure. It's tailored to things under their control.
Some of our businesses are easy, so they much achieve high performance before [the CEO's] bonus kicks in. In tough businesses, lower performance requires as much hard work, so the hurdle is lower.

‍Warren Buffett – Annual meeting 2003

Each and every business should have incentives in place based on the return on capital employed with costs for new capital invested.

A business may not require additional capital to perform growth or continued operations, but a portion of its earnings must be spent annually towards. Businesses requiring no additional capital are very rare. Companies that require lots of capital, such as energy companies, often employ debt capital adding to the costs to their capital.

When you think about it, most existing businesses have some form of active capital base that exists within the business. Money that has already been put to work. This takes the form of people, marketing spend, equipment etc.

The furniture assembly business doesn’t require a great deal of additional investment in equipment to grow. But what it does require is spend on marketing and sales to find new clients as well a proportional increase in staff to assemble ever more furniture. Management’s currently employed capital is largely tied in its employees. Active operational spend on marketing and sales as well as a few tools and an office are the money already put to work.

While the company will earn a profit, a small portion will need to be spent next year to pay salaries to keep up with inflationary costs, marketing expenses and equipment.

For a business like this it would be reasonable to have incentives tied to a combination of the following:

• Growth of owner earnings in line with annual GDP and above inflation
• Increasing net margins by a nominal percentage without harming long term competitiveness of the firm and keeping Opex spend within a tolerable range
• The overall profitability of the firm relative to its history and a heuristic judgement as to its capacity for earning. (Tied to specific measures of ROIIC)
• Increasing the durable competitive advantage of the business in favor of a business model which resembles an economic franchise.

The energy company will probably need to spend more money drilling expensive new wells to maintain its current production volumes and revenue tied to those volumes. When compared to what the furniture company will need to spend to pick up more assembly jobs, the energy company will be forced to spend a far greater share of its after tax profit on capital projects (drilling wells).

The energy business management team should be incentivized to produce more hydrocarbons at a lower cost of production. Getting oil out of the ground more cost effectively is going be a material benefit to the company in the long term. In contrast to the furniture assembly business, the company will have to put a large percentage of its profits towards drilling new wells.

If management can reduce cost and maintain the relative yield of each well they drill; future profits will be in perpetuity all else being equal. Obviously, if prices for the commodity make it uneconomic to drill new wells then management should be rewarded for preserving capital. General incentives should look like the following:

• Reducing the cost of drilling a productive well (this is a specific measure of ROIIC)
• Safety of the employees and contractors undertaking operations
• A comfortable hurdle rate on the capital employed in a severe commodity glut.

Note that the management should not received outsized bonuses for favorable commodity price swings. In any business, the pendulum of profitability too easily swing other way due to no fault of a manager. Misplaced incentives take capital out of a business without appropriately tying effect to effort.

How To Make Incentives Realizable And Easily Measurable

Incentives need to be realistic. Most companies that create annual forecasts fail to achieve those forecasts. Even fewer companies perform retrospectives to analyze why they failed. It is human nature to want to know the future and human nature to avoid evaluating failure.

Owners and managers need to create incentives that fall within realistic ranges for the business. These measures should be based on the historical performance of the firm and couched against external measures. A few macro examples could include:

• Historical revenue growth rate for a small business is 7% over the last 5 years as reported by the Small Business Administration. The company still qualifies as a small business and experienced revenue growth rates of between 9-12%. An appropriate partial incentive could be for the company to incentivize management between a 7-12% topline growth rate. Rewards would occur on a sliding scale with profitability.
  
• Over time, most businesses will only grow at the same rate as the economy. This is GDP. As businesses grow their rate of growth typically slows. An appropriate floor for earnings growth would be the rate of GDP against a measure for market share.

Macroeconomic examples are important but should be limited. The bulk of incentives for a management team should focus on specific metrics tied to their business.

What is not tracked is not measured. Predictability in a business is a necessary pre-requisite for creating any incentive program. It is impossible to create effective incentives if owners have no historical or forecasted data to compare against.

The test for creating an incentive program with results that are measurable is simple. An incentive should tie directly to the financial reports of the company and be immediately understandable by any outside party or investor.

If the incentive requires running a formula or calculation more than simple division, addition or subtraction it is too complex to be effective. The more complex or hard to verify the metrics is, the more likely it can be gamed by management.

How To Create Incentives Directly Related To A Person’s Activities And Avoid Creating Unrealistic Incentives For Managers

Owners should avoid setting unrealistic goals for management. Objectives need to be within the capacity of the individuals hired as well as the capacity of the company to realize them.

Aspirational goals for the company should not be incentives for management. Unrealistic incentives can result in behavior that is too risky. Failure and extreme difficulty in meeting goals will dissuade and kill motivation.

Owners should also specifically avoid creating incentives around parts of the role that management enjoys to avoid turning a passion into just a ‘job’. Outside of this condition, incentives should be:

• Tied as directly as possible to explicit activities.
• Pair reward with effort and effect not just an effect where there is no direct input (example: options contracts).
• Long term oriented and not overly focused on the short term.
• Not too large as to induce undue risk.

Let’s explore some examples of incentive structure compensation plans using each of these components.

Example one – client delivery manager for a services company:

• Good – Incentive on client upsells he generates and the project management staff under him.
• Good – Incentive commission on all project estimates that convert to sales.
• Good – Incentive for every active client under his team’s management.
• Bad – Incentive based on the overall revenue of the company even though he has no direct management of the sales and market team.  

Incentives should be a combination of reward for desired efforts and the effect of those efforts. In this first example, the manager is properly rewarded for the efforts and effects under his direct control. The bad incentive is one that rewards effect with no direct effort.

Example two – General manager of a venture backed software as service business:

• Good – Increased annual pay for deploying the venture capital at a market rate of return producing higher sustained monthly recurring revenue and earnings.
• Good – Incentive on incremental increases in market share.
• Bad – stock options that mature based solely on time with the firm.
• Bad – Incentive for 10xing revenue.
• Bad – Incentive for keeping the stock price at specified price level for a defined period.

While the employee is incentivized to stay with the firm there is no applied effort for the timed reward. The large revenue goal, while within the ultimate control of the manager may not be achievable within a reasonable timeframe to be of any material consideration for the manager. The incentive to raise the stock price may be at the cost to shareholders. Because it is time based, share repurchases and special dividends may ultimately destroy value. The capital could have otherwise been put to good use within the company but the incentive for management changed the managers opportunity cost.

In both of the above examples, the number of incentives is likely too many. Fewer, simple incentives are almost always better.

The Ideal Management Incentive Plan

You should charge some cost of capital. Measure the key metrics, set a hurdle and only pay for adding value [above this hurdle], even if the returns appear low [but would have been a lot lower without the value the manager added]. If you had a group of network television stations, you would have 35% pretax margins if a chimp ran it, so you’d only pay for excess above this. It would be silly to have 10% or 15% hurdle, but a bad manager will try to get this.
In the end, if you have a great manager, you want to pay them very well.

‍Warren Buffett

While not exhaustive, the prior examples illustrate how the previously defined framework for thinking about incentive plans can easily go awry.

Some businesses will have inherent characteristics that are within managements control and some will not.

Commodity priced businesses are a perfect example. They are not bad businesses per say. But the nature of commodities with volatile pricing, such as oil and gas, will produce price swings that could disproportionately reward management for something out of their control. Only capabilities within direct control and related to the underlying business should be incentivized.

Second, measuring of return on capital is the a principal financial metric that should support incentive compensation for hurdle rates. This measure must be clearly tied to the company’s financial statements and be easily calculated. And, it must not be too short term focused. Ideally it is long term focused and bounded with realistic ranges based on historical data and conservative estimates of future performance.

Third, incentives must be multifaced and consider all negative effects that could occur as a result of their implementation. For example, rewarding just profits, would likely result in management cutting marketing and shrinking the business slightly to produce a higher personal return at the cost of future growth or market share.

These multifaceted criteria include but are not limited to:

• Rewarding individual performance and not effort or length of time in an organization.
• Rewarding people after and not before performance.
• Rewards being inherent in doing the job well. I.E. rewards not solely related to money – effective managers don’t necessarily want to be rewarded for what they like doing so as not to turn what they love into work. Many managers value autonomy and the self-persuasion of doing a valuable thing rather than being told to do it.
• Encourage the behavior desired and avoids perverse incentives. The system must make it hard for people to get away with undesirable behavior by making it costly to them.
• Requires that decision makers are directly responsible for their actions.

The best incentive plans account for the nature of the underlying business and the pay the manager for widening the differentiation between competitors. Incentives are after all, small behavior driven rewards for achieving goals that benefit managers and owners. The goals of owners and managers should be perfectly aligned.

When it comes to incentive plans. No single formula will work. And they should not be overthought or complex.

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