Bob MacDonald on Business

Sage Advice for Superior Business Management

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ESOP – The Fable and the Fraud

June 29th, 2014 · Business Management, Effective Leadership, Employee compensation

ESOP is a fanciful fairytale of sharing spun amidst the props of smoke and mirrors.

I have always been a believer in the motivational power of parallel interests that are created when employees share an ownership interest in the company they work for. It puts everyone on the same page and allows those who create value to share in the reward of success. And I know it really works.

After all, I helped create a very successful company – LifeUSA – that was founded on the premise that success is more likely to be achieved using a business model of direct employee ownership. But at the same time, I have also harbored the opinion that the employee stock ownership plan known as ESOP is not the best way to achieve that objective; it may, in fact, do more harm than good. The truth is that in many cases ESOP is an acronym for Employees See Only Promises.

My concerns about ESOPs emanate from the fact that they are a very complicated way to create parallel interests: they promise employee ESOPownership but fail to include rights of ownership. Plus, there is the potential for conflict of interest, which run counter to true parallel interests.

What ESOPs do is create a synthetic form of “group ownership” for employees as opposed to true, individual ownership that is enjoyed by company founders and management. Sure, using  ESOP “ownership” as a way to motivate employees  is better than no plan at all. But these plans are often more effective at demonstrating management’s desire to have their cake and eat it too, since they engender a feeling of false promises among the rank and file.

A Growing Concern

As ESOPs have grown to include almost 12,000 companies, the federal government has become concerned with the potential for abuse – if not fraud – that can occur in the structure and management of these plans. The Wall Street Journal recently reported that the federal government is currently the plaintiff in 15 lawsuits related to ESOPs. Virtually all of this litigation revolves around the potential abuse in the valuation of company shares (often sold by company founders or senior management) purchased by the ESOP “for the benefit of employees.” The Journal reported that since 2010 the Labor Department has recovered over $240 million from companies that had abused ESOP plans, all of which involved stock valuation.

The Nuts and Bolts of ESOPs

Technically, ESOPs are defined-contribution pension plans, regulated under the 1974 Employment Retirement Security Act (ERISA). As a qualified retirement plan, ESOPs offer favorable tax benefits for the company and employees. For example, contributions made by the company into the ESOP to purchase shares of the company are deductible and these contributions are not taxable income to the employee until they actually receive the benefits, usually at retirement.

Even though ESOPs are considered a retirement plan for the benefit of employees, the assets of these plans can be – and often are – used to enrich the management of the company, create liquidity for existing shareholders and serve as a lucrative “exit strategy” for company founders. This can result in a significant potential conflict of interest between existing shareholders and the employees who are “buying” the shares via an ESOP.

The vast majority of companies that have adopted ESOP plans are private; meaning there is no existing “market” for its stock. The result? Not only is there is no sure-fire way to determine the value of the stock, existing shareholders have little or no liquidity, that is, a ready-made market to sell shares. An ESOP remedies these problems for existing shareholders by creating a “captive” market for their shares and the liquidity they desire.

But, you ask, if there is no real “market” for shares, how can fair value for shares be determined? Simple. Outside consultants are be brought in (paid for by the company) to place a valuation on the stock, the price at which the employees (the ESOP trust) will purchase the stock from selling shareholders.

Now comes the tug-of-war. Existing shareholders seek the highest value possible, while employees seek share price as low as possible. This creates the potential for conflict of interest that ultimately has triggered the government lawsuits over valuation. And it raises an even more important question: If the stated idea of the ESOP is to motivate the employees with a feeling of ownership, just how much motivation and incentive will be engendered in employees who feel they are being forced to buy the stock at inflated prices?

The next important question is: Regardless of the price that is determined, where is the money going to come from for the ESOP trust to buy the stock from current owners? The company is obligated to make annual contributions to the ESOP and these funds are used to purchase the stock, but from the viewpoint of existing owners it could take years for them to receive the value for selling their shares. Not something they are likely to want to do.

To solve this problem (it is really only a problem for existing shareholders) about 70 percent of all established ESOPs “leverage” the purchase of the stock by taking a loan against the stock. This works well for existing shareholders because they can put cash in their pocket now, while the ESOP must use future contributions to re-pay the loan. There is nothing inherently wrong or immoral with this approach, but it does Pay-Daycreate a potential conflict of interest and the actual interests of the selling shareholders and employees participating in the ESOP are not truly in parallel going forward. One side has received their reward, while the other side has the promise of reward in the future.

Another potential conflict of interest arises when it comes to voting the shares of stock. Even though current shareholders have been paid for their stock, management of the company often controls the voting power of shares held by the ESOP but not yet allocated to participants, and that action that could take years. Again, there is nothing illegal in this type of structure, but when thinking of parallel interests and the motivation that real ownership provides, it leaves a lot to be desired.

If the existing owners of a company are seeking a way to cash out or create liquidity in the most tax-advantaged way, then an ESOP is the answer. But if management really believes that the way to enhance the total value of the company is by putting the interests of the employees in parallel with the interests of the company, then there are simpler, easier and more effective ways to accomplish that objective than using an ESOP.

So what are some of the ways to build real parallel interests between company founders, the company and employees?

First off, at LifeUSA, all employees and sales representatives as a condition of employment were required to use 10 percent of their gross pay to purchase new stock issued by the company. If someone was making $25,000 they were required to buy $2,500 of LifeUSA stock. Since the stock of LifeUSA was not publicly traded, the cost of this new stock was pegged at the same price the founders of the company paid for their stock.

Second, there was only one class of stock – common voting stock – for all shareholders. This meant the CEO of the company and the newest employee both owned the same class of voting stock, purchased at the same price. The CEO could not benefit from his stock unless everyone in the company could also benefit from owning their stock.

Thirdly, the happy outcome was that everyone working at LifeUSA was a real, direct, individual owner of the company. This may not have been the most tax-efficient way to spread ownership in the company, but it was simple, easy to understand and in pure parallel.

Just in case you might wonder, LifeUSA moved from being a start-up company in the life insurance industry to one of the fastest growing and most successful companies of the 1990s—a vivid testament that true employee ownership does, in fact, motivate employees to work harder and produce stunning results. In 1999 — 12 years after its founding — Allianz SE purchased LifeUSA for a value of $540 million and every single one of the 800 employees working at LifeUSA received a share of that purchase price. l

More times than I would like to count, I have been told that the LifeUSA model would not work for other companies. I agree that it would not work if you did not really believe in the concept of true shared parallel interests and didn’t want to work at it. But for the most part those comments come from the non-believers, the greedy and the lazy.

There are other ways a company can gain the benefits of parallel interests created by employee ownership without taking on the complexities, complications and potential problems of an ESOP. From my perspective and experience, the best way to motivate employees to work hard for the success of the company is to develop a plan that gives the employee both the feeling and the benefits of being an owner. And the best way to do that is make them real owners.

And the Moral of the Story …

I recognize that reading the ins-an-outs of an ESOP plan can be tedious and boring, but that’s the point. If you are an owner of a company and, deep in your heart, you really want to find a way to create liquidity for yourself and even create an exit strategy, then the path for you is to pretend that your motive is altruistic and that you want every employee to enjoy the benefits of ownership. And the best way to do that is to create an ESOP.

On the other hand, if you really believe that you will gain more value by sharing value; if you believe that building true parallel interests means creating a plan under which no one benefits unless all benefit, then you will eschew any thoughts of the fable called ESOP.




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Create an Incentive Plan That Delivers More Than it Promises

June 22nd, 2014 · Building Better Business Managers, Business Management, Employee compensation

Four Steps to Encourage Employees to be More Productive and the Company More Profitable

Last week’s blog reviewed the efficacy of compensation plans that are intended to incent employees to make the extra effort to add value to the company, by allowing them to share in a piece of the value created.  In theory, that makes sense because it aligns the interests of participating employees with those of the company. But the post also pointed out that many plans fail for a number of reasons:

  • They are often “cookie-cutter” plans developed by outside consultants who don’t understand the specific company’s value drivers;
  • Plans are often complicated, convoluted and difficult to understand;
  • Frequently they are structured for only the top executives;
  • The plans are based on targets that participants feel they have little power to influence;
  •  The “value drivers” that ultimately create increased value are not properly identified.

As mentioned in the previous post, years of experience has taught me that the concept of sharing value is by far the most effective way to motivate those who have the ability to add value to a company to actually do so. However, fair and effective compensation plans must be properly structured, implemented and supported. Here are the steps that I learned work best:

1.  Create, Don’t Copy

Management – with the approval of the board – must assume direct responsibility for developing the plan, because the foundation for any successful incentive compensation plan is that it is based on company-specific objectives, culture and value drivers. Only the management of a company has (or at least should have) intimate knowledge of these factors.

Admittedly, it is hard work to develop an effective company-specific incentive plan, so there is a tendency to abdicate this responsibility to outside compensation consultants. The rationale is that they have experience creating plans for other companies, and can give management numerous options from which to pick. The problem is that companies end up with cut-and-paste plans that are simply a copy-cat version of what other companies are doing, with very little sensitivity to the subtle nuances of their company’s culture and objectives. As such, they are significantly less effective.

2.  Design from the Bottom Up, Rather Than the Top Down

Unfortunately, most incentive compensation plans are predicated on the basis that only the CEO and senior management have the understanding and ability to add value to the company, so they are the only ones invited to participate.  However, to be truly effective, incentive plans should include all members of the organization, starting at the bottom and working up to the executive suite.Power

In reality, creating real value starts at the bottom of the organization, and is based on completing specific activities that, when taken together and multiplied, form the ultimate basis for increased value. That’s why the CEO and senior executives should be the last to receive the rewards of the plan, and their reward should be based on what others receive. A bottom-up structure provides incentives for everyone in the organization to make the extra effort that builds value.

Moreover, it incents management to support the efforts of those who have the power to increase value, because their own rewards are tied to what others receive.  An often-heard excuse for not including everyone is that “it would be too expensive.” This is such a lame (dishonest) excuse. If payouts are truly based on “new value created,” a plan that is inclusive and generates benefits from the bottom up may pay out more, but only if more value is created.

3.  Base Benefits on What Drives Value

Most employees don’t understand how macro values are created, and don’t believe they have the power to influence them. But most do understand their jobs, and if they are incented to do a better job, then ultimately increased value will be created.

The CEO and senior management must identify the specific activities that ultimately drive value. (If they don’t know what those value drivers are, they probably should not be in charge.) Management should also be able to calculate how much increased value is created when the performance of these specific activities is enhanced. For example, if “customer loyalty” is identified as a “value driver,” then those who have the power to positively influence customer loyalty should be rewarded for doing so.

The benefits for these specific activities should be identified and “pooled” during the course of the year, and then distributed among the various groups that created them. This provides a constant reminder and incentive, because individuals can see just how much value they are building for themselves.

These benefits are triggered when the company reports higher revenues, profits or equity. Benefits could be reduced or increased based on controlling expenses and higher than anticipated revenues or profits. Those in support positions, such as IT, legal and administrative, would be rewarded for supporting those charged with performing specific value driver tasks, by receiving a percentage of the benefit pool.

At the end of the year, the CEO and senior management would receive a factor of the total benefits paid to all others. For example, if the total “pool” for specific value driver activities is $3 million, management could receive an additional 50 percent of that amount as their benefit pool. This encourages management to focus on those who are creating the real value. The more others receive, the more management will receive.

At first glance, this approach to incentive compensation may seem complicated, but in reality it is very simple and easy to understand. That’s because the actions that drive value are broken down to simple, specific actions that all employees can understand and believe they have the power to influence.

4.  Make Incentive Payments Just Once

Of course, no benefits should be paid if value does not increase, but there also need to be benchmarks that trigger benefits. For example, profits must increase by 10 percent to trigger 50 percent of the benefits, and by 15 percent to trigger a full payout. This ensures that the cost of the incentives paid out is fully covered by the company’s increase in value.

The newly created value becomes the baseline for the next year’s incentive compensation plan. This prevents paying twice for the same value.

And the Moral of the Story …

Incentive compensation plans are a great idea and they work well when they are structured properly. To achieve this end, the plan must be developed by management and the value drivers must be company-specific. One size does not fit all.

The plan must be all-inclusive and benefits should be driven from the bottom up, where true value is created. Benefits should be determined by specific activities that drive value, and activated by the actual value created.

This approach is equitable, creates parallel interests and is easy for employees to identify with and understand. Most important of all, it provides real incentive for everyone to make the extra effort and add value for the company.

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Incentive Compensation Plans Promise More Than They Deliver

June 15th, 2014 · Business Ethics, Business Management, Effective Leadership

A promise not met is worse than no promise at all

While it may seem like only yesterday, it was 60 years ago or so when companies began to introduce what was then considered a revolutionary new management concept: “incentive compensation.” That’s an eternity, especially in the fast-changing business world where change can happen faster than you can say, “disruptive innovation.”

The theory behind these plans was simple: Incent employees to work harder to add value to a company by paying them increased financial rewards when they do so. The idea seemed to embrace faultless psychological wisdom: If an employee is allowed to share in a piece of the value they create for the company, it would in their own self-interest to work harder to create that value.

But premise and practice are two different things. Once a handful of early-adopters instituted incentive compensation plans, the herd mentality of the Rewardscorporate mind took hold, spreading through the corporate universe like a virus through a first-grade classroom. And true to the mindset of corporate leaders who believe they — with their exalted rank — are the only ones who can add real value, participation in these “incentive compensation” plans became the corporate equivalent of a baseball “shutout” where one team – the top execs – prevents the other team, the lowly teams players known as rank employees, from scoring anything. It’s a major league blowout strictly favoring the corporate bigwigs.

Before long, these one-sided incentive plans became institutionalized in the ethos of corporate compensation. Today it is virtually impossible to find a corporation of any reasonable size that does not have some form of “incentive compensation.” And with the corporate rush for compensation plans grew an almost equally large coterie of independent “compensation consultants” who collect millions of dollars in fees for offering their “expertise” in designing incentive plans.

Are Incentive Compensation Plans Delivering on the Promise?

Since the idea for incentive compensation originally began to take root back in the 1950s, passing time seems to have fostered some welcome new thinking about the actual effectiveness of these plans. An increasing number of savvy business critics have come to the conclusion that these plans don’t work as intended and have become nothing more than an institutionalized boondoggle for senior executives, creating more waste than value. Count me among that group.

But don’t get me wrong; I have a deep conviction – gained from years of experience – that the concept of sharing value with those who create value is by far the most effective way to motivate fellow employees to do so. What has soured me on the effectiveness of current incentive compensation plans is that they have become so complicated and convoluted they no longer provide clear incentive. Indeed, the very concept of “incentive compensation” seems to have moved from the realm of compensation earned into “entitlements” that are mere “gimme” parts of the “pay-package” awarded for simply showing up and doing the job.  And that runs afoul of the basic reason for having an incentive plan in the first place.

Getting it Wrong Right from the Start

Specifically, there are four fundamental reasons why most of the current incentive compensation plans fail to deliver on the promise of increased effort to add value, causing the plans to be more cost than benefit:

  1. The vast majority of plans are developed by outside “compensation consultants.”
  2. The plans are complicated and convoluted to such an extent that very few can understand how they actually work.
  3. The plans are structured based on a top-down (or top-only) philosophy.
  4. The specific “value drivers” that create increase value are not identified.

Outside Consultants Offer no Inside Knowledge

Paying huge fees to outside consultants to develop an incentive compensation plan for a company has strong appeal for corporate leaders. The contention is that forking over exorbitant fees gives them more options. In reality it’s a blatant cop-out of their responsibilities, and a supreme example of laziness for shirking the hard work necessary to develop a company-specific plan.

For an incentive compensation plan to be effective, the triggers for benefit payments must be based on the unique value-drivers of each company. Bringing in an outsider who has little knowledge of the inner workings of the company and less concern for its success is a recipe for a complicated, copycat ineffective incentive plan. What company managers receive from an outside consultant is a cut-and-paste template like the plans adopted by “peer-group” companies. Management is led to believe that because other companies have implemented similar plans, they must be effective.

There is another, more insidious, reason why many companies use outside consultants to develop their incentive compensation plan. Because most of the incentive compensation is intended for the pockets of corporate bigwigs, using an outside consultant allows senior management and the board of directors to hide in the security of the herd. The notion is that if the plan adopted is similar to the plans of other companies, then it must be the right thing and protects management (the primary beneficiaries of the plan) from the criticism (and legal action) of being self-serving. None of these are good reasons to pay huge fees to outside compensation consultants, but it is an easy way out.

If It’s Complicated it Must be Better

A big problem with most incentive compensation plans is that they are so complicated that even those allowed to participate are unable to understand exactly how they work. In addition, many of the “trigger-targets” are based on results that the participants feel they have little power to directly impact. If participants are unable to decipher the details of the plan and don’t feel they have the power to effectively influence the outcome, the plan does not offer much incentive.

When I was CEO of Allianz Life of North America, I was among a limited number of executives who were graced with an incentive Complicationscompensation plan of the parent company, Allianz of Germany. I remember receiving a packet of information about the plan that ran to something like 15 to 20 pages of excruciatingly detailed explanation. It was wall-to-wall charts, graphs and nebulous “what ifs.” I kid you not, reading engineering plans for nuclear fission would have been easier to fathom than this plan.

Worse, the “triggers” of the plan were based on the international results of Allianz; 99 percent of which I had absolutely no power to influence or control. Like many who are “enrolled” in these types of complicated plans, I tossed the packet in a bottom drawer and forgot about it.  The Allianz plan (developed by outside consultants) was more like a crapshoot using someone else’s money. If I won, that was fine, but if not, then no big deal. Certainly there was not much incentive generated and if Allianz ever did pay anything out under its plan, it would be wasted money.

The Trickle-Down Theory of Incentives

Without a doubt, the principal complaint I have with current incentive compensation plans is that they are structured in a top-down format. These plans start with the CEO and then trickle down to upper levels of management, beyond that, most are cut off from participation. The justification for this methodology is that only the CEO and senior management are capable of adding value to the company. Evidence and experience has led me to believe that this is a flawed theory and even more, that it is dishonest.

My belief is that the CEO and senior management set the vision and direction of the company, but true value creation comes from the bottom up—not the other way around. To be truly effective, incentive compensation should start at the lowest levels of the organization and work its way to the top. The CEO and senior management should be the last ones – not the first – to receive incentive compensation; and the compensation paid to senior management should be a factor of what others have received. Under a well-constructed plan of this sort, the CEO and senior management of a company could ultimately receive more, not less in rewards.

The chief weakness of a top-down incentive plan is that most employees are not participants and have zero incentive to make the extra effort to add value. Even when those at lower levels of the organization are allowed to participate, more often than not, the incentive payments are based on objectives over which they feel there is little power for them to influence; this can result in even negative incentive.

Focus on Small Steps Rather than Big Leaps of Faith

Another glaring weakness of current incentive compensation plans is that payouts are based on broad, general results such as increased revenue, improved return on investment, increased shareholder equity and/or stock value. Certainly these results are important, but very few individuals in any organization understand how these objectives are achieved or believe that they have the direct power to favorably impact the results. Because of this, the plans offer very little, if any, incentive for individuals to make the extra effort to add value.

Instead, incentive plans should focus on the incremental “value drivers” that each individual, department or division can understand and have the power to influence. Taken together and coordinated, these individual value drivers will ultimately result in improved revenues, increased profit, enhanced return on investment and greater shareholder equity. When incentive payments are based on those individual efforts that drive value, incentive is achieved and value is added.

And the Moral of the Story …

Each one of the individual problems mentioned in the body of this piece can reduce the effectiveness of any incentive compensation plan, but when all four flaws creep into a plan – as is the case with most current plans – any hope for actual incentive is totally destroyed. At best these plans simply become a boondoggle for senior management (maybe the intended ultimate result) that increases costs, wastes corporate resources and fails to deliver on the promise of increased incentive for increased value.  This is good reason to junk current plans and develop a new type of incentive plan that allows all members of the organization to be in “incentive parallel” and deliver even more than it promises.

(This article has focused on the structural failure of existing incentive compensation plans, but it was not meant to suggest that the concept itself is flawed. It is the way the concept is implemented that is flawed. Next week, we will offer suggestions as to how incentive compensation plans can be structured to deliver on the promise of increased incentive to add value.)
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