Effects of staff incentives on corporate value

by Les Nemethy   CEO of Euro-Phoenix

Les Nemethy from Euro-Phoenix writes in his blog for BBN that great care must be taken when designing a bonus system, so as to avoid the seemingly perverse effects that may actually destroy company value. 

On a trip to the US several years ago, the aircraft I was on pulled away from the gate on time. However, within a minute, the engines suddenly powered down.  We waited almost three hours on the tarmac, in the sweltering heat, without air conditioning, until the flight finally took off. The gentleman seated next to me explained what had just occurred: the airline staff’s bonus was based on the aircraft pulling away from the gate on time. They were not going to forego their bonus just because there was no available slot for taking off on the runway. With the best of intentions, the airline had actually created an incentive system which made passengers suffer. 

My point is that great care must be taken when designing a bonus system, so as to avoid the seemingly perverse effects that may actually destroy company value.  A well designed bonus system, one that creates genuine motivation for staff, is therefore a necessity for creating corporate value.

In different organizations, it is different combinations of the board, CEO, and senior officers who create the incentive system for all staff of the company.  Creating the right incentive system is one of the most important functions each group fulfils.  The following three considerations must be taken into account when designing any incentive system:

1. It must be motivating. 

There is no use in trying to motivate staff with equity if staff members have a short-term perspective, or are at a phase in life where they need cash to start a family or buy a first home.  As the saying goes, “happiness is getting what you want, and wanting what you get”.  It is therefore crucial for anyone designing a bonus plan to know the people involved quite well, to know what will really motivate them.  Very often it can be non-monetary factors such as recognition or a title.  In such cases, throwing money at trying to motivate people can actually be a complete waste.  Very often, there is a conflict between designing a system that is tailored to everyone’s individual needs, versus a “one size fits all” type of bonus system that has the advantage of being consistent, but may not take into account the preferences of a few individuals who are outliers.

2. Create the appropriate alignment of interests, particularly between senior management and shareholders. 

Generally speaking, equity, an option to obtain equity, or profit share may create the right kind of alignment.  However, it is extremely important to factor in the appropriate level of risk that may be taken by management—witness the undue risks taken by bank certain bank CEOs leading up to the financial crisis.  Another example: if you reward someone with a percentage of revenues, don’t be surprised if there is suddenly pressure on margins.  Are there checks and balances in the system?  Is the CEO allowed to make unfettered decisions about risk?  Is the person on a revenue-share bonus allowed to make decisions about margins?  If not, there is less of a problem.

3. Reward the types of behaviours you wish to encourage. 

 Is it top-line growth you wish to encourage?  Or is it frugality in terms of expenditure?  Is it the taking or avoidance of risks that you wish to encourage?  Is it team work or individual performance?  Make sure that your bonus scheme truly does create the desired behaviours, and that you are not creating undesired side effects (like cut-throat competition amongst your own staff) or inadvertently neglecting to encourage other behaviours that are equally important for the success of your firm (e.g. rewarding sales alone is unlikely to achieve the desired effects of quality, customer satisfaction, etc.)

A bonus system makes a statement about the values of a firm.  If you try to sell your firm or raise capital for your firm, investors will inevitably ask about what kind of incentive systems your firm has in place, and how well they are working.  Ultimately, you need a motivated team to build corporate value.  But there is no magic bullet, no ideal bonus system that works for all organizations.  The devil is, as so often, in the details.

Les Nemethy is CEO of Euro-Phoenix Financial Advisors Ltd. (), a Central European corporate finance company focused on Mergers & Acquisitions.  He is the author of “Unlocking your Company’s Value”

The importance of corporate strategy

by Les Nemethy			CEO of Euro-Phoenix

Companies are typically valued based on projected future cash flow or various multiples (e.g. of revenues, cash flow, etc.).  However, at some point in virtually every transaction, an investor will inevitably ask the seller for a written copy of the company’s strategy.  It is surprising how often the answer is that no such strategy document exists.  Does this matter?  I would argue most emphatically that, in most cases, the answer is “yes”. 

This article deals with three issues: (a) why is a written strategy important?  (b) what kind of issues should a strategy document address?  and (c) who should prepare the strategy document?

(a) Why is a written strategy important?

If you are thinking of carrying out an equity transaction, most investors will ask for a written strategy for the simple reason that a written strategy is an indication that there is not just an implicit framework in the owner or CEO’s head, but a coherent strategy that represents a consensus within the management team that has been communicated broadly.  Even worse, the lack of a written strategy may indicate that the firm has no strategy, or that it is “half-baked”.  If the company does not have a good strategy, there is a high probability that cash flows cannot be sustained or grown, and possibly also that the company is a “one man show” (for more on this, please refer to my earlier article on the “One Man Show” which can be found at www.europhoenix.com/node/480).  Putting a strategy in writing, and debating the subject among the management team, tends to sharpen minds.  A written strategy should be an evolving document, evolving as management thinking advances on the subject.

(b) What kind of issues should a strategy document address? 

Strategic thinking has evolved considerably over the years and, for an excellent book on the subject, I recommend The Lords of Strategy by Walter Kiechel.  There is not simply one monolithic method of formulating and carrying out a strategy.  However, in my opinion, investors will typically look for a strategy document that addresses the following issues:
· What is the vision and mission of the company?
· How does the company define its service/product/value proposition?
· How does the company define its market(s)?  (Geographically, in terms of customers, etc.)
· What makes the company unique?  Why would clients buy from the company  as opposed to a competitor?
· What are the barriers to entry for competitors?
· What are the strategic goals for the company (e.g. what position is it aiming to reach within its core market(s))?  Where would the company like to be in three to five years time?

Of course, once a company gives a strategy document to a potential investor, the investor will look for a business plan that is consistent with the strategy, and a management team that has the competencies and capabilities to implement the strategy.

(c) Who should prepare the strategy document?

From an investor’s perspective, it is best if management itself prepares the strategy document rather than farming it out to an advisory firm.  Or if outside advisors are used, managers should not be “hands off”, but use outside advisors as complementary to their own involvement.  Most investors find it important that management be capable of strategic thinking. 

In short, when preparing a company for a transaction, the objective is to show value in the company beyond its tangible assets.  The lack of a (good) written strategy will potentially increase the level of risk for an investor (increasing the discount rate in a Discounted Cash Flow valuation) and decrease the applicable multiples in a comparables valuation.  A written strategy, and then a credible plan for the execution of that strategy, form the cornerstone of a company’s value beyond the bricks and mortar.

Les Nemethy is CEO of Euro-Phoenix Financial Advisors Ltd. (), a Central European corporate finance company focused on Mergers & Acquisitions.  He is the author of “Unlocking your Company’s Value”, available at