Bonus Backlash Is Upon Us, But a Well Structured Plan Benefits Shareholders

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-over-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 EBITDA. 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.

Comments

[Lord Byron]

I feel the AIG bonuses are way out of line, and the recent $165,000.000.00 is just another example of the greed involved at the executive level of the company. They deserve NO bonuses for 2008 and their full attention should be on getting AIG back in good financial shape not their own personal gain. I hope President Obama is successful in having all these bonuses reversed.

2009 Mar 19 08:53 AM

[kilroydq]

Your point #4 makes sense for smaller companies, but perhaps not for large companies. While we could question the wisdom of paying ANY bonuses to ANYONE at AIG, they did have divisions that were profitable. If someone did a stellar job at those divisions and loses their bonus because some PUTZ at another division screws up royally, then there is REAL risk of losing that 1st person to another company and they might be losing real talent.

Paying bonuses to the people who nearly destroyed your company is reckless and shows gross incompetence on the part of upper management.

2009 Mar 19 09:20 AM

[overopinionated youngster]

Anyone smart working at AIG right now is doing so for the money. If you take that away, you lose the incentive for the best people to stay there, and you are left with a 200B$ investment in a company of people working there simply because they have no other place to go.

I would not find that to be a wise investment.

2009 Mar 19 09:22 AM

[I weep for this country.]

Why would you protest the Insurance division of the company if you are made at the FP division in England? That is like protesting UCONN basketball games because the Governor is an idiot?

2009 Mar 19 10:58 AM

[I weep for this country.]

The real genius here is the architect of this outrage residing in the current adminstration. They were able to turn the country's attention to these bonuses (which they knew about for months and endorsed since AIG's Board is unable to take any action without running it by the Fed) and away from the billions that went to the counterparties, i.e., Goldmen, etc... They were the ones bailed out, not AIG. They were the ones who created the mortages not AIG. The day the identity of the counterparties were released the outrage from Washington was created.
It is obvious, but still the sheep all waive their pick signs and our upset that these folks got bonuses because they are trying to unwind accounts that could cost the taxpayers way more than they have paid so far!
_
The greatest trick the Devil ever pulled was getting the world to believe he didn't exist!

2009 Mar 19 11:10 AM

[Chris B]

Think multi-million dollar bonuses encourage good performance? Compare the performance of Warren Buffet's companies with the following:

Bear Stearns
Lehman
AIG
Citi
GE
BAC
Fannie Mae
Freddie Mac
Goldman Sachs
Home Depot

I think you'll conclude that overcompensation in the form of massive bonuses and stock options is a good predictor of failure, rather than success. Among short-timer corporate leaders, who are only likely to be in place for 1-3 years, it creates a "take the money and run" mentality that leads to imprudent risk taking, overleverage, and financial statement manipulation.

Experience shows that companies rarely get better leadership because they paid more for it. That's a cultural myth. Companies don't "compete" on how high their executive compensation is, they compete on products & services, sales & marketing. These hotshot CEO's who claim they're worth $50,000 per day should be laughed out the door, just as I would be if I told my boss I was worth $1,000 / day and threatened to leave.

Compensation should be rewarding and it should be in the form of cash. Options, if any, should be dated so that they can only be executed 10 years down the road, not the following quarter. Until then, shareholders will be taken advantage of.

2009 Mar 19 12:15 PM

[dw57]

not sure that equities as part of executive compensation has really done what every one thinks it does. it really has not aligned management with the shareholders. all it does at best is make decision making be based on a time line of one month to a max of 6 which isn't always best in the end. and then of course we can point to the facts that shareholders are not as rule not allowed to do much of any thing at all. but that is in part because almost none keep the stock for long any way. so what we have with equities or bonuses is the worst of both worlds. and executive salaries are out of control as it is and usually have no basis in how well the company does.

2009 Mar 19 03:17 PM

[A. Corinne]

All the talented people, especially in finance, will end up at privately held boutiques. You would have to be insane to continue working 80 hours a week for a firm that isn't able to pay you any of the profits you generate for the firm. The WSJ has just posted the following...

The House voted 328-93 to approve a bill imposing 90% taxes on employee bonuses from firms bailed out by taxpayers.

The bill would tax bonuses paid by firms that received more than $5 billion from the TARP. The Senate is working on its own plan to try to recoup bonuses.

The House bill is a response to the furor over millions in retention bonuses paid by AIG.

2009 Mar 19 05:12 PM

[dcb]

Lewis' subcommittee looked at the top 23 TARP recipients and found that more than half owe unpaid federal income taxes.

THIS IS FROM REUTERS. WHAT A CONGRESSMAN FOUND. 50% of 23 looked at. The whole thing is a scam and the faster people start to see that the better off we all are. Stop the bailouts to the connected banks and their lobby money

2009 Mar 19 08:04 PM

[dcb]

Robinni figured out that the US banks are insolvent and thinks we should nationalize them as do many others. They aren't going to be able to get enough government money as a gift to them through tarp and talf, so bernake has come up with creative ways to make up for the missing money. That's what is going on. But it has to sodl sold to the public in a manner that will make it appear acceptable. So, it's to help the economy, or restore credit. It really just another form of the same thing. It's a bailout. and that's what the new T-bill purchase program is. This is what you get for giving lots of lobby money. If the can't give directly, or through Talf, they will alter the yield curve to do the same thing and it doesn't matter to them if they sink the dollar or cause inflation. It matters that Lewis, Blankfein, Dimon, etc get what they want, (which means money in their pockets). AIG is a backdoor way of getting oney to the same people. No haircut on the CDS which hasn't defaulted and still has cash flow? WAKE UP PEOPLE, WE ARE BEING TAKEN FOR A RIDE

2009 Mar 19 09:26 PM

[dcb]

you mean like all the folks who have to work 80 hours a week holding down two jobs just to put meals on the table or pay their rent. I can't imagine anyone working over 40 hours a week for anything less than a million myself.


On Mar 19 05:12 PM A. Corinne wrote:

> All the talented people, especially in finance, will end up at privately
> held boutiques. You would have to be insane to continue working
> 80 hours a week for a firm that isn't able to pay you any of the
> profits you generate for the firm. The WSJ has just posted the following...
>
>
> The House voted 328-93 to approve a bill imposing 90% taxes on employee
> bonuses from firms bailed out by taxpayers.
>
> The bill would tax bonuses paid by firms that received more than
> $5 billion from the TARP. The Senate is working on its own plan to
> try to recoup bonuses.
>
> The House bill is a response to the furor over millions in retention
> bonuses paid by AIG.

2009 Mar 19 09:29 PM

[dcb]

I urge you to e-mail your congressman, the white house or the senate. Let your voice be heard. you can see they are starting to feel some pressure to behave.

2009 Mar 19 09:32 PM

[mkreisel]

Most of our current financial industry is nothing but an OPM ponzi scheme, and it has sucked away too many of our bright young people because of the outrageous short term profits.

This entire business model must be dismantled.

If we succeed in doing that, talents will finally be coming back to engineering, science, and other more productive professions.

2009 Mar 20 12:04 AM

[rcprofit]

Tax the Bonuses..... Yeah!!!

Finally a good idea…… Way to take back some control of the waste-less spending of the hard earned money we the TAX payers are paying for, by severely taxes the Bonuses of our failed Corporate American Corporations!

2009 Mar 20 08:23 AM

[prairiedog555]

The problem is in the boardroom. No man is worth hundreds of millions of dollars in compensation. I have little confidence in how US companies protect and treat shareholders.

2009 Mar 20 09:33 AM

[frosty]

Definitely the word 'performance' needs to be juxtaposed once again with 'bonus'. Companies losing money are not performing so no bonuses. Divisions that don't perform - no bonuses. Bonuses should not be contractual and should ALWAYS be at the discretion of the board of directors even if performance targets are met - they have a fiduciary responsibility to shareholders. Bonuses that are an exponential function of rank should be eliminate (arithmetic is better) and made less rich for higher levels and more rich for lower levels. Cash bonuses, if any, should be a small % while stock,etc. a large % with a multiyear vesting period. Rich executive bonus plans such as we have seen on Wall Street and beyond are little more than theft from stockholders and consumers. We all pay for these outrageous plans which is not that different from taxpayers paying for them.

2009 Mar 20 09:40 AM

[frosty]

Not ALL the talented people. Only those who think they're valuable will move on. So what! There are plenty of other talented people vying for the vacated jobs. Besides, it won't be long before these private boutiques learn that they can hire new employees at a much lower rate. It's also offensive that you seem to value financial people who work 80 hours a week for megabuck more than commoners who work 80 hours a week to keep up with their rent and feed their families. This strikes me as class arrogance.


On Mar 19 05:12 PM A. Corinne wrote:

> All the talented people, especially in finance, will end up at privately
> held boutiques. You would have to be insane to continue working 80
> hours a week for a firm that isn't able to pay you any of the profits
> you generate for the firm. The WSJ has just posted the following...
>
>
> The House voted 328-93 to approve a bill imposing 90% taxes on employee
> bonuses from firms bailed out by taxpayers.
>
> The bill would tax bonuses paid by firms that received more than
> $5 billion from the TARP. The Senate is working on its own plan to
> try to recoup bonuses.
>
> The House bill is a response to the furor over millions in retention
> bonuses paid by AIG.

2009 Mar 20 09:50 AM

[rcprofit]

Next year they'll just add the bonuses into their salaries. That's what the smart companies do.

2009 Mar 20 03:04 PM