Value Based Incentives
As with Value Based management in general, the goal of Value Based incentive compensation is to ensure that companies are managed in such a way as to increase shareholder value. To do that, it makes sense to link executive compensation to performance on metrics that measure just that: increases in shareholder value.
For the purposes of incentive compensation, value increase is typically measured as an absolute value. In the case of executives responsible for the company as a whole, absolute value increase can be measured one of two ways. In an EVA-type bonus plan, value increase can be measured with Delta Value Added or some similar EVA substitute, in which case the bonus is a linear function of achieved Delta Value Added compared to a pre-set Value Added target. Alternatively, in a stock ownership or stock option plan, value increase can be measured simply by share price development. For business unit level and other operating managers, bonus targets can be based on one of the relevant value drivers, or sub-metrics of disaggregated EVA, such as Sales Growth, EBIT Margin or Invested Capital Turns.
Value Based incentives do significantly increase enterprise value. However, any bonus targets that use absolute values, including any of these Value Based performance metrics, still suffer from the same fundamental problems associated with other competitive compensation targets:
- Financial figures can be quite volatile, often due to external, macroeconomic factors beyond the control of operating managers.
- Additionally, performance pay runs the risk of encouraging short-sightedness in managers, where current performance may be achieved at the expense of long-term value creation.
For all of these reasons, vesting mechanisms are always recommended to withhold and distribute the bonus payout over a period of years. One popular such mechanism is the bonus bank. But bonus banks and other vesting mechanisms only partially solve these problems.
Finally, one recent approach to Value Based management that does recommend substituting relative performance measurement for absolute metrics in performance pay is called Beyond Budgeting. Obermatt's method of indexing operating performance achieves just that, quantifying relative operating performance as Operating Alpha, and using it for just this purpose in Obermatt's Operating Alpha Bonus Targets.
Value Based Incentives Improve Enterprise Value
Kleimann et. al. (Oakland University in California) have shown that value based compensation systems provide superior returns to the companies using them. 71 companies with value based compensation systems have been compared to peers without such systems.
Companies with value based leadership systems had an outperformance of 4.4% before introducing value based incentives. After the introduction, this outperformance increased to 28.8%. Thus, it is better companies that are more likely to introduce value based management, and when they do, they increase their returns even further.