Options - the universal incentive program

Management systems are designed to serve people. The question is do they serve people equally? One important element of a management system are incentive programs. Unfortunately most incentive programs are poorly structured. Mostly poorly approximate the contribution of recipients, few hold recipients accountable, and thus few serve people well, or rather, some serve some people at the expense of other people. Generally active interests are served at the expense of passive interests, bosses at the expense of subordinates.
So what would constitute an effective incentive program? Clearly one that rewards achievement and penalises failure. There are several matters that have to be considered:

1. Risk-reward balance

Does it serve the organization that authority figures have everything on the line? Clearly not when you consider that high risk can cause stress, and executives might be expected to make bad decisions if they have personal risk of loss clouding their judgement.

2. Sustainable rewards

The problem will option schemes is that they are date-stamped. The options are only an incentive in a rising market, and absolutely no incentive in a falling market. I dare say executives are inclined to adopt shares in-lieu of salary at these times. I remember executives telling me that they were not getting any salary back in the late 1990s - I don't doubt it, they were likely accumulating shares at low prices. The record lows in mineral exploration were a testimony to the way executives were 'mining the market'. It made more sense at that time to preserve cash by issuing shares to directors and doing minimal exploration. They were in effect acting as 'absent directors'. This was no doubt in the interests of directors, but it also was good for shareholders as well, as it makes sense to spend money when you are able to raise more at higher prices.

When options have the possibility of being worth something, I think we get a very different decision making path by directors. The long term best interests of a company come from investing in cheap emerging projects, but instead we see executives supporting acquisitions or mergers with similar sized companies despite them enjoying a similar market premium in the market. The company does not lose (in absolute terms) because the other company likely trades at a similar premium, it just carries an opportunity cost because it could have bought projects cheap and developed future revenue streams. Executives thinking first of their options however would just seek companies that they can merge with to increase fund manager interest in the short term. This occurs because CEOs want to lift the short term share price so they can cash out their options when the 'vendor' limits expiry, allowing them to freely sell their shares or options they have accumulated. It helps that these options have staggered expiries.
Another examples of this issue is a decision by an executive not to upgrade computer systems because the cost of the upgrade will impact on his short-run profits, and thus his options benefit. It seems sensible that options should be provided on the basis of profits after capital expenses, so that executives dont defer capital spending. If this was the case, its seems likely that executives would be more inclined to invest, but they might still only invest for as long as they can make returns over their period of responsibility.

3. Meaningful reward

Executives are given options that give them benefits that far exceed their contribution. The reason I say this is because serving executives have no role in initiating the stock market boom that has extended from 1986-2007, so why should they profit from it at shareholders expense. Why aren't their option payments tied to an index of similar-sized companies since ultimately that is the standard which determines their contribution - how well they perform ahead of other executives. Afterall the salary component reflects their remuneration for 'nominal levels of performance', so the option should be based on the extent to which they have differentiated themselves from other directors.

4. Contribution of benefits
The other problem with rewards is that they don't necessarily go to the right person. The CEO and the directors might be the public face of the business, but sadly it is often the subordinates that account for a great deal of the value-add. Its unfortunate that accounting has not developed in such a fashion that accounting systems are not low-maintenance. It seems probable that this will come with fully-electronic monetary solutions. This will allow essentially every person to be considered a cost-centre, whether they work as a captive, shared or public contractor does not matter.

A better reward program
I am suggesting a better reward program would make provisions for:
1. Benefits to be offered on the basis of performance relative to other directors or companies
2. Outsourcing business responsibilities so that we can see the real contributors to an organisation.
3. There needs to be a salary & incentive elements to a salary package
4. There needs to be greater accountability to determine the contributors to the organisation
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Andrew Sheldon www.sheldonthinks.com