When Owners Design Management Incentives

Following my Q3-2020 report a partner inquired on management incentives. He indicated some internal debates in his own business. I shared some rules of thumbs I’ve picked up over the last few years. I wanted to try and bulletpoint my thinking such that it helps my future self, and possibly other business owners. Here are my current beliefs when it comes to owners designing management incentives:

  1. Most employees trade time and talents for a fixed wage. They view incentives as “extra.” This differs greatly from entrepreneurs or investors. Employees by and large like a 5-10% bonus opportunity of their base, and this is for going way above and beyond what an owner would do for the same incentive. This mindset includes many managers and sales people. I know people say the best way to demotivate someone is to cap their earnings, but they often cap it themselves because they want what is reasonably achievable. It’s a problem many owners struggle with. Its common practice versus common sense. Owners don’t need to cap earnings. But they also shouldn’t put insane expectations on people that don’t want it. It crushes them. Be nice.
  2. If you find someone willing to defer >40% of their present earnings for a future benefit of >41% in the future, discounted back to the present, they will make themselves an equity partner with or without you. This category of people won’t always need others to lay out a plan. If you are the majority owner then you need to listen closely to this group and evaluate if you ought to partner or not. This is where the commission-only salesmen and long term partner-managers live. Both types will bet on themselves and don’t require the owner to guarantee a base. The commission-only type are sellswords and should be considered independent contractors. The investor-type will want lots of equity. As the majority owner you can work with both but be more careful of the sellsword. They’ll cut you and take “their” customers. The investor-type could be a healthy, life-changing partnership for both parties. Just be sure your goals and character match up well.
  3. If a partner does not have control they will desire liquidity. Without ability to sell or redeem their interests they will require a faith in management that is far greater than themselves on the particular business at hand in order to stay. If this breaks down problems can occur on both sides. It’s best to define ways out ahead of time and then work with people to help them accomplish what they seek. This is how and why marketable securities exist. Great businesses with excellent leadership deserve to be public. They can exist privately, but cutting the pie and allowing partners to self select is good leadership. If a controlling shareholder can filter out “bad” actors that’s even better. A buy-sell agreement or some regular liquidity offers help create a relief valve.
  4. If a partner has >6x their base wage in ownership they demonstrate loyalty and longevity. This rule of thumb separates the sellswords from the active partners. It also filters the traders from the owners. Some gamblers could meet this condition if it were not for the liquidity test. A lower liquidity will chase away the gambler. It doesn’t have to be a zero liquidity. A three year delay will be sufficient. (this can exist in marketable securities, which is helpful way to evaluate management as an investor.)
  5. The ideal management incentive plan ought to influence every decision. It must be simple enough to live at the root directory of their minds. The designer must make a judgement call on where and how this is created. I personally like management to earn a share of return on invested capital. However, this model often requires a business large enough to justify its execution. The execution can occur at really small scales if both parties “get it.” But, this plan is rarely simple enough for most management incentive plans. If the manager is an employee you both can generate lots of value by establishing the key goal and a simple small, medium and large bonus wrapped to the key metric of the business at a 5,10, or 15% bonus on base. It doesn’t have to be terribly complex and might even be totally subjective if you work closely on a regular basis.

Again, I wrote this for my future self and other owners that struggle thinking through this sort of challenge. The reason owners struggle is we often see more levers available to pull, and we like the availability of levers. It overwhelms most non-owners. And an employee telling you, the owner, that it overwhelms them is too great a risk because it’s an easy step for you to assume they are incompetent. In most cases they’re not incompetent of managing, they’re incompetent in capital allocation. They need you, the owner, to help them on the undefined exceptions. Do your job.

–and get help installing a simple plan.

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