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| | | 03/30/09 - Denver, CO | The headline in the Wall Street Journal March 13 was historic. Above a story about how New York State Attorney General Andrew Cuomo and Rep. Barney Frank had decided to regulate executive compensation, the headline declared:
Cuomo, Frank Seek to Link Executive Pay, Performance
It was so shocking partly because it was so long in coming. While many of us in the business trenches have been linking executive pay to specific performance for decades, and have had systems and processes in place to quantify performance and compensation, it was immediately alarming that Congress has only now decided this is smart policy.
It was equally alarming – if not downright frightening – that members of this tax and spend body with no P&L responsibility have decided they will be the ones to write the rules for pay for performance in public companies. Astonishing. They are so irresponsible the irony of this is inescapable. (We warned three years ago that we must keep Barney Frank out of the boardroom).
Why is Congress getting involved in executive pay? Because so many boards of directors of Fortune 100 companies have been criminally asleep on their watch. Their job is to protect the shareholders' investment, but they have ignored that to take on a new responsibility – maximize executive pay regardless of performance. These are the people who should be on trial for they abdicated their responsibilities as stewards of their investors' capital. Congress must stay out of business management just as the church must stay out of the state. What these derelict boards have done is let the fox into the henhouse, and this is a very deadly fox.
So now, we welcome you to a strange new world in which Congress becomes America's corporate paymaster. Alas, corporate America brought it upon itself, and has proven it genuinely deserves a heaping helping of oversight – as distasteful as that is to us all.
MY ADVICE TO THE ESTEEMED ELECTED OFFICIALSIf they are going to get it right, then members of Congress need some tutoring in how precisely to structure executive compensation packages so they reward quantifiable performance and penalize failure. I hope they won't think it presumptuous of me to suggest the following system, which has only worked for about the past 40 years for the honest, wise and ethical business people with whom we've been associated– and there are many.
By calculating residual income (RI) at all levels, performance can be measured accurately and rewarded appropriately. RI, which has been trusted by business for decades, is merely net income after taxes minus the various components of the cost of capital. And, over time, residual income is the best predictor of company value and stock price. Simple and logical, residual income should be the primary tool used to hold executives accountable.
All compensation strategy should be based on these principles:- The leader's job is to grow the value of the enterprise in both the short and long run.
- The leader and his team must be rewarded for incremental growth in value, as measured by residual income. Other measures such as EBITDA, external stock price, and other return ratios lack the rigor required to measure performance in a quantitative fashion that reflects reality.
- The compensation system for the entire organization must be based on incremental growth in corporate value and the rewards directly attached to the incremental growth. These apply to annual bonuses, whether for top executives or profit-sharing for all employees; they also apply to stock option plans, which really are better served when they are phantom stock based on incremental RI values.
- The compensation package will be based on achievement of specified RI targets for the each year contemplated in the Strategic Plan. A compensation plan should:
- Reward management and staff for achieving the goals set by firm ownership, measured quantitatively
- Reward the CEO and other relevant top management for growing the value of the enterprise as measured rigorously by RI
- Attract and retain quality people
- Clarify and quantify performance expectations
- Set quantitative standards of performance
- Formalize the approach to the performance review and reward
- Provide a means for measuring value growth of the enterprise"
AND, CONSEQUENCES FOR FAILUREIf Congress needs another model demonstrating how to compensate appropriately, its members need only to follow the sports pages more closely. In corporate sports, it's all black and white: Excel and you will be rewarded beyond your dreams. Fail and you're out. There is no in between. And, what's even more important is that the reward system is driven by clearly quantifiable numbers: hits, runs, outs, touchdowns, baskets, goals, hours, minutes, seconds, seats, gate revenues, tickets, fans, sponsors and other solid criteria. In that corporate culture, if you don't make your numbers, you go. Make your numbers, you stay and are entitled to millions. How simple, how refreshing. |
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