Shareholder Value Advisors is a consulting firm that helps companies improve performance through better performance measurement and better incentive plan design
The key to better performance measurement is taking account of opportunity cost to measure value added. Opportunity cost is what an investor or employee foregoes by investing in or working for a company. For investors, opportunity cost is the dollar expected return for investments of similar risk. For employees, opportunity cost is market rate of pay. Employee market pay takes account of position (e.g., CEO or CFO), industry and scope of responsibility.
Investor value added, often known as Economic Value Added or “EVA”, is after-tax operating profit minus a capital charge for the opportunity cost of equity and debt. Employee value added is the after-tax value of [actual pay – market pay]. The sum of investor and employee value added is the total value added of the company. Total value added can be calculated directly by deducting market, not actual, pay in calculating operating profit. It may be negative.
The key to better incentive plan design is fixed sharing in a value added measure
Employee pay plans have three basic objectives: providing strong incentives to increase value added, retaining key talent and limiting shareholder cost. These three objectives can be achieved by making pay equal to the sum of market pay plus a fixed and symmetric share of a value added measure.
A plan like this can create an equitable and sustainable labor-capital partnership. It’s equitable because investors earn a competitive return on the market value of their investment if and only if employees earn a competitive return in the labor market and both share in value added. It’s sustainable because both investors and employees get a competitive return before sharing in value added, and because value added can be measured at a local and controllable level, such as the business unit level, and distributed with fixed sharing to provide strong incentives.
A vital element of incentive plan design is a meaningful measure of incentive strength to ensure that the plan provides a strong incentive for employees. Employees, like investors, think of their wealth as the present value of their expected future cash flows; the best measure of incentive strength is “wealth leverage”, the sensitivity of executive wealth to changes in investor wealth.
