On Management Incentive Structures.
I had an interesting session with my business partner the other day, and we were discussing, at a high level, how variable remuneration for the management team (who are partners in the business) at Mäd could look like.
We did an interesting exercise where we tracked the journey of the cash that comes into the business, and how this comes from the customers and the various spending priorities before we can pay bonuses, issue dividends to shareholders, and also liabilities like tax.
As I have previously written before, I am a big fan of cash accounting where possible, because I think it can eliminate a lot of the bullshit games that management and finance team play with accounting records, massaging financial statements to make showcase better business performance than what is indeed the case.
With cash, there are no versions of the truth; there is only cash in and cash out.
And so, let’s take a look at this journey, starting with a hypothetical $100 payment from a customer.
- A customer pays Mäd $100.
- Mäd uses $35 to cover the costs of the team members or consultants that are working on the project. $65 are remaining.
- A further $30 goes towards operational costs such as office, equipment, insurance, and various other day-to-day running costs. $35 remains.
- Of these $35, we take $15 to cover for unforeseen eventualities. Most businesses don’t do this in their planning which is a shame because it can lead to problems down the road. Unforeseen eventualities are unforeseen, so, by definition, you cannot put them into any business plan! But you can build a buffer.
- Ok, so $20 remains, and this is our profit before tax.
- Let’s call the corporate tax rate on profits 25%, so that takes off another $5, and we are left with $15
- So, $15 is our NET profit for the year.
Now, this is where it gets interesting. How should this profit be divided up?
There are three main interests that both compete and are aligned, but perhaps on different timeframes.
- Shareholders (looking for the largest dividends)
- Management (looking for the largest bonuses)
- The business (looking for the largest reinvestment for growth).
In reality, the long-term interests are all fully aligned, that’s the beauty of capitalism. But, in the short term, there is obviously a tendency to take cash off the table, as this is the ultimate fungible token — you can spend it on anything!
This is where I think a lot of businesses go wrong. They focus on the short-term gains for shareholders and management, rather than reinvesting for long-term growth. This means that the business can stagnate or even decline as less money is available to invest in new products, marketing, or team members.
My first-ever business partner taught me that a good incentive structure should automatically create the behaviour that you want. As a shareholder, my ideal behaviour from a management team is to grow the long-term value of the business, year on year, while not requiring significant outside injections of capital — so the business should be able to fund itself at all times.
And the best incentive structure to achieve this is to provide a mixture of long-term shareholding for the management team in the form of shares that vest over multiple years, with a combination of cash bonuses that trigger based on growing the company’s profit year-on-year.
This last point is important, as just keeping profits stable or growing them at the rate of inflation is a sign that people are just checking in and that nothing innovative is happening. There needs to be a real incentive to drive growth; this is where a correctly structured bonus system can come into play.
To be able to grow profit year on year consistently takes a different mindset, which is precisely the mindset of a high-performing management team.
The formula for this is:
([current year’s profit]-[previous year’s profit])*[Management team profit share]
So then, there are several more things to consider, what should the % of profit share be, and how to distribute the profit share between multiple team members in a management team.
The first point will vary from company to company, while for the second point there are a few clear ways to do it:
- Equal share between all management team members.
- A weighted distribution based on seniority, and amount of time in the organization.
- Perhaps, in some organizations, it can also be linked to clear individual results. But, this may lead to competition between team members in a management team, which is hardly conducive to leading a high-performance organization.
That’s it — some initial thoughts.