One way to build value in your firm, a la executive compensation.

• Author: Stern, Joel M.
• Position: Benefits

With the takeover market in temporary suspension, executives should seize the opportunity to reevaluate their organizations with the eyes of a raider and consider new value-budding techniques that will fend off future attacks. The best way to maximize shareholder returns is to "incentivize" management to make decisions that increase long-term value. Your first task, then, is to transform antiquated cash bonus or stock option arrangements into plans with incentives directly tied to proxies that create intrinsic share value.

Traditionally, the majority of an executive's total compensation is granted in salary, which is essentially a senior liability of the company. In a salary-based compensation structure, management in effect becomes quasi-creditors. Hence, it is not surprising that management's interests are much more closely aligned with the interests of the firm's senior creditors than with the interests of the residual equity holders. As quasi-creditors, management will rationally seek strategies-such as growth through diversification-that reduce risk for management. Somewhat riskier strategies and new products that can create value take a back seat.

Although bonus payments and stock options may appear to tie pay to performance by rewarding management for entrepreneurial action, they do not succeed in maximizing shareholder value. These performance incentive plans fail to impose a significant downside risk for poor performance. The executive can win, but not lose. And cash bonuses are usually too diminutive compared to relative salary to be effective, while stock options, which tend to be granted far too liberally, needlessly dilute shareholder claims. As a result, both cash bonuses and stock options encourage a very short-term perspective on corporate performance, while compromising a longer-term perspective on shareholder value.

The problems with cash bonuses and stock options can be easily overcome through new techniques that force management to focus on the principal determinants of shareholder value. The core principle behind these techniques is motivating managers to look beyond the short-term measures of "economic" performance by, essentially, turning management into owners. The most effective way of doing this is to devise compelling management incentives that closely replicate the equity interest received by operating managements in a standard LBO arrangement. In essence, that means performing what, on paper, appears to be a...