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How to compensate employees to align incentives with shareholders

Posted by: admin 15 years, 9 months ago

There's been lots of discussions about bonuses recently, Merrill Lynch, AIG, on and on.  So many, I won't bother linking.  These bonuses are typical of what is known as an agency problem.  The executives are agents for the shareholders, but their incentives are not aligned.  You can imagine that the executives of a company that is about to be sold or taken over by the government are even more incented toaward legally binding bonuses before any transaction which might result in their termination.  I have a simple proposal to fix this (in the future):

The employee bonus pool is created from excess cash flow after an additional reserve is set aside based on the weighted average cost of capital of the firm, also known as the firm's economic profit or EVA (tm).  By paying the shareholders first (this money could be dividends or plowed back into the firm), the shareholders are taken care of first.  Employees must generate returns in excess of the cost of capital.

Second, the payouts from the bonus pool are smoothed over a number of years based on seniority or responsibility.  So the CEOs bonus would be spread over a very long time frame, say 10 years for most of the bonus and line managers over 2-5 years.  This helps mitigate agency issues.  Employees must generate returns in excess of the cost of capital over a period of time. 

Third, the bonuses are partially in the form of restricted stock, particularly for higher level managers.  Some of which would vest even after an executive leaves the firm or retires.  This mechanism further reduces the agency problem.  Executives must generate returns in excess of the cost of capital over a period of time and leave the company on sound footing.

For more information on economic profit, agency issues and compensation, I recommend the excellent Quest for Value. 

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