It's not you, it's them that are wrong
Tell 'em to take out their tongues
And bring on the backlash!
Arctic Monkeys – Who The F***k Are The Arctic Monkeys
There was a piece in the New York Times recently (yes I do occasionally still read newspapers) that talked about the Obama administration's fear of a populist backlash against the bank bailouts. Their fear is correct and the backlash is upon us and it is real and it is ferocious.
The Gotham Gal penned her thoughts on the topic yesterday on her blog and suggested we all cancel our policies with AIG. I am with her on that one. We won't be AIG customers in short order. If you'd like to join us in our own populist revolt, please do.
There is no question that the word "bonus" will now be political poison. And that is unfortunate. Because I believe that bonuses, when properly constructed, can be an excellent way to compensate executives.
In the startup world, the primary way that founders and the management teams they hire are compensated is via equity. And that is the very best way to compensate people who run businesses. It aligns the interests of the shareholders and the managers.
But until we get some sort of liquid market for secondary shares, it is impossible to feed a family, send your kids to college, buy a home, and do all the things we all want to do for ourselves and our families with founder stock, options grants, and restricted stock.
So when our portfolio companies get to profitability and are growing and meeting all of their goals, but aren't yet ready or able to go public or exit, I am always in favor of a bonus plan for the management.
Let me start with what I am not in favor of:
1) guaranteed bonuses – This is, I believe, a big part of the AIG problem. Guaranteed bonuses are not in anyone's interest other than the person receiving them. I don't like them and will do my hardest to make sure they never are part of a compensation structure in any of our portfolio companies.
2) multi-million dollar bonuses – We want the majority (ideally the vast majority) of management's compensation to be in the form of equity so our interests are aligned. When management is generating millions (or tens of millions of dollars) of cash compensation via bonuses, the equity becomes immaterial to them and that is very dangerous. That is what went down on Wall Street as the Gotham Gal pointed out in her post.
3) contractual obligations – all bonuses should, at the end of the day, be subject to board and compensation committee approval (even if the goals that trigger the bonuses have been met). The board has a fiduciary responsibility to look after the stockholders first and foremost. If paying the bonuses (even if they have been earned) puts the company in trouble, then there needs to be a mechanism for the board to avoid paying them. Compensation committee and board approval does that.
4) Bonuses should not be paid in unprofitable companies. I have violated this in a few instances when we wanted to recruit a CEO who had a compensation need that we could not meet with base compensation. I feel that bonuses in unprofitable companies are really just a form of additional base compensation. But the nice thing about bonuses is you have the board approval "kill switch" and we have used that recently to deal with a need to reduce burn rates. Bottom line on this one, I am very uncomfortable with bonuses in unprofitable companies and getting more so.
Now that we've dealt with the "no nos", here is what I like to do with management bonuses.
I prefer bonuses that are based on ebitda. My thinking is that value creation in companies comes from earnings growth. The more ebitda you have, and the faster it is growing, the more value you are creating for stockholders. But I don't like the idea that management is incented to maximize ebitda in the short run to create bigger bonuses for themselves while starving the business of needed investment.
So I've become fond of an approach where the company pays management bonuses on "incremental year ove year ebitda." The way this works is you pick a base year and for the next year you pay management a bonus of x% of the incremental ebitda they generate. The best way to do this is a five year plan with a goal of obtaining a significant increase in ebitda so management has time to make the investments needed to get there.
Let's take a hypothetical example. Say a company has just had its first profitable year and made $1mm in ebtida. The plan is to get to $20mm of ebitda in five years. So the board approves a plan to pay out 10% of incremental year over year ebitda as management bonuses. Let's say that the next five years produce the following ebitda numbers:
Year 1 – $2.5mm
Year 2 – $5mm
Year 3 – $9mm
Year 4 – $14mm
Year 5 – $20mm
Then the management bonuses would be:
Year 1 – $150k
Year 2 – $250k
Year 3 – $400k
Year 4 – $500k
Year 5 – $600k
The management team could choose in any year to not grow ebitda at all (and not get any bonus) if they had an opportunity to make an investment in the business that would generate significant incremetal ebitda in the out years and they would get paid for doing that.
There are some issues with this approach. One is acquisitions which generally force a reformulation of the numbers in the plan. Another is that this plan does not allow for incentives for "qualitative goals" like building a high quality management team, creating a long term strategic plan, etc. You can pair those qualitative goals with a quantitative plan but it dilutes the laser like focus on long term ebitda growth and that is not always good.
There are plenty of other approaches I've seen over the years for management bonuses and as long as they meet the four rules that I laid out, I am generally in favor of most anything that helps management get some incremental cash compensation for generating shareholder value before they can get liquidity on their investment of time and energy in building the company.
In summary, the word bonus is going to be a loaded term going forward and it is going to be harder for boards of all kinds to put in place bonus plans for management. In many ways that is a good thing and hopefully we'll see less of the bad bonus activity that I laid out in my four "no nos." But a well structured modest bonus plan for management can be a very good thing for shareholders and I believe we should not walk away from the concept entirely.