Insights

In this series of articles, we’ll review some of the most common mistakes that privately held companies make in approaching the question of incentives, before looking at a sketch of what I have seen work well.

Mistake #6: The wrong measures

The wrong measures of performance are too often used to determine bonus payments. The most popular financial measures used in bonus plans are pre-tax, pre-financing ones like Earnings Before Interest and Tax (EBIT) or Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA). But these measures ignore a major component of doing business, the capital put up by investors.

Most businesses require capital – money from banks and owners – from day one and every day thereafter as they grow and prosper. But measures like EBIT and EBITDA completely ignore the use of capital and hence give managers no incentive to manage it more efficiently.

For example, for an EBIT of $2m, would you rather put up $10m in capital or $20m? A bonus scheme based on EBIT doesn’t differentiate between these two alternatives and so it’s not surprising that EBIT and EBITDA based schemes often go hand-in-hand with bloated working capital, gold-plated asset purchases, and a preparedness to pay suppliers early to keep them happy.

Under these schemes capital has no cost, so it’s not surprising that it’s used so wastefully.

But you can’t blame managers for responding to the rules of the game that are written for them. Owners and Boards need to think carefully about what they want from their managers and how they transcribe that into measures of performance and the design of a bonus plan.

Next we’ll look at how these common mistakes can be avoided and instead, an incentive plan put in place that pays managers like owners.