Better Behaviors · Incentive Design
Pay for Performance
Make what’s good for investors and the company good for employees and their families.
Owners outperform
Companies that incentivize economic profit (EP) beat their peers and the market
Annualized TSR, since the date of EP adoption
15.8%
EP companies
Peer companies
S&P 500
S&P 500 measured by the SPDR S&P 500 ETF Trust (SPY). Greene, Milano, Curatolo & Chew, “Driving Outperformance,” Journal of Applied Corporate Finance (2022).
The Problem
Most incentive plans reward mediocre performance, invite sandbagging and gaming, and pay out with little connection to the value shareholders actually receive.
Scorecards
Too many measures
Scorecards of incomplete metrics send conflicting signals. One company we met had identified more than 400 KPIs.
Negotiated targets
Planning for mediocrity
Targets anchored to management’s own plans reward easy budgets and “hockey-stick” forecasts instead of striving for greatness.
Weak link to value
Pay misses performance
Transocean delivered 480% TSR from 2002 to 2007, yet its executives received no annual incentive in three of those five years.
Relative TSR
A lottery, not a link
Vesting can swing from 0% to 200% depending only on when the measurement period ends. Nvidia’s 1,712% TSR over 12 years would have vested just 79% on average under a standard test.
“We had a short-term incentive program that had six different metrics in it… Numerous times, the guys would make the right decision and see their bonuses suffer, and vice versa.”
Vulcan replaced the six-metric plan with a single economic profit measure and a moving-average target, which, Sansone says, “took all the argument and negotiation and budget bias completely out of the target setting.”
Our Approach
We design incentives around Residual Cash Earnings (RCE) that reward managers for thinking and investing like long-term owners, so the only way to earn more is to create more value for shareholders. The result is plans that actually pay for performance.
One measure, set once, paid for value
A value-based plan replaces scorecards and negotiated budgets with a single, complete, cash-based measure, with targets that improve automatically year after year.
- One complete measure. RCE captures growth, margins and capital in a single number that tracks shareholder returns.
- Paid for improvement. Because RCE is a complete measure of value creation, targets can be set from last year’s results. No budget negotiation, so there is nothing to gain from sandbagging.
- Built for ownership. Managers are rewarded for thinking and investing like long-term owners.
Reward all the value people create
| Are you rewarded for… | Traditional incentives | Owner-like incentives |
|---|---|---|
| Increasing overall company revenue or volume? | ✓ | ✓ |
| Improving overall company margins or EBITDA? | ✓ | ✓ |
| Achieving improved payment terms? | ✕ | ✓ |
| Being mindful of inventory levels? | ✕ | ✓ |
| Making smart investments to generate future value? | ✕ | ✓ |
| Ending projects that are not generating value? | ✕ | ✓ |
| Investing in safety measures to reduce risk? | ✕ | ✓ |
What this looks like in practice
- Payment terms. A customer asks for 90-day terms instead of 30. How much would the price need to rise to leave RCE unchanged?
- Smart investments. What volume and price would justify adding a second production line?
- Working capital. One company sized a new collections hire by how much it would need to cut receivables to cover the cost.
From Greg Milano and Marwaan Karame on Create More Value, episode 41
“We’re going to lose over half our bonus in the first year if we do this. But if we’re right, we’re going to get three, four, five times that back. Do we believe our forecast enough to put our money where our mouth is?”
In an illustrative simulation, a manager who gives up $75K of bonus in year one earns back $175K over the next four, a 55% annualized return on the bonus forgone.
Watch · Episode 45Make what’s good for shareholders also good for employeesThe Evidence
Our research on hundreds of companies shows how far traditional pay drifts from shareholder value, and how much closer a value-based design gets.
Value-based bonuses track TSR; traditional bonuses don’t
“From the shop floor to the top floor, everybody at Kimball can tell you the value of economic profit… It drives a philosophy that keeps everybody on the same page.”
Kimball’s profit-sharing bonus is calculated and paid out formulaically on economic profit.
Watch · Episode 37Jana Croom on driving real value creation with economic profitVarian Medical Systems
Varian launched “Varian Value Added,” an incentive program built on Fortuna’s RCE, linking management pay to value creation across strategic planning, operating decisions and capital allocation. Capital shifted from buybacks to R&D and acquisitions.
Ownership in action: when a rival bid 20% more for Sirtex Medical, Varian’s RCE analysis showed that topping it would destroy value, and management walked away within a day.
No requests for relief: when COVID hit, Varian’s CFO was asked whether management would seek relief from the compensation committee. His answer: “Why would we even consider that?” With objective targets, the team focused on finishing the year strong.
“Our team is now living and breathing this as part of our business management system.”Gary E. Bischoping, Jr., former CFO, Varian Medical Systems
2.5%→10.9%
compounded revenue growth, before vs. after adoption
2×
share price, doubled within about three years of adoption
59%→22%
share of capital going to buybacks, as Varian shifted to R&D and acquisitions
Where Varian’s capital went
How We Help
We work with boards, compensation committees and management to design, test and roll out incentives that drive better decisions.
Diagnose
Test how well your current payouts have tracked TSR against your peers, and where the plan invites gaming or short-termism.
Design
Build a value-based plan around RCE, with target-setting from prior-year results and a payout curve that rewards real improvement.
Simulate and forecast
Back-test pro-forma payouts against your history and peers, and forecast what managers would earn if they hit plan or their stretch goals.
Roll out
Win the support of the board and investors, then extend the plan to business-unit leaders and employees, so everyone shares in the value they create.
Further Reading
- Better Incentives Drive Better Decisions and Behaviors →
- Executive Compensation: Value-Based Incentives Drive Better Decisions and Behavior →
- Common Obstacles to Effective Incentive Comp →
- The Relative TSR Conundrum →
- Improving Managerial Behavior: A Better Plan for Success →
- Economic Profit Empowers CFOs to Drive Long-Term Value: Study →
Ready to
Pay for Performance?
Tell us how you pay your leaders today. We’ll show you how well it tracks the value you create.