Venture Capital

Capital accumulation is a relatively easy matter for the self employed but it is almost impossible for the average man on the street to achieve out of income yet the desire for financial freedom is elemental to all. All employees have hopes and expectations participating in a company and as CEO you should acutely be aware to the reality of your employee’s needs. Often, employees rely on extra money and perceived changes in terms of something positive that they expect and a work force that always expects additional pay for additional progress can become a liability. This inflexibility is particularly problematic in the technology industry where companies need to continually innovate and improve efficiency just to stay competitive. Another disadvantage to the monetary incentives in a fast changing environment is that it may undermine your capacity as CEO to build trust and commitment unless you incorporate the honest discussion of mutual expectations, something that is very difficult to do.

Of the myriad of disadvantages small companies face, retaining talent is one of the toughest especially in the managerial roles. As CEO, you would have been told that the obvious solutions to retaining talent are to pay rich salaries, share the profits or share in the ownership. However, today in reality, many ambitious owner entrepreneurs don’t want to give away their shares and the younger Malaysian workforce hunger for monetary rewards as their lifestyle places immediate compensation as a true measure of success rather than slogging it out in the risky planes of building start-ups. Worse, CEO’s have to deal with an odd syndrome plaguing the Malaysian workforce that believes pay is an entitlement because of education and race. In reality, pay is as an important tool for communicating business priorities. So, how to strike the tenuous balance between maintaining employee’s and paying them reasonable rates? It boils down to the structuring of employment agreement where you need to use the right strategy to benefit all stakeholders.

I want to highlight here that this blog post is more focussed on small businesses as it faces unique challenges when considering strategies for linking pay to performance. One important challenge is specialized management skills associated with the atypical growth patterns of a small business. In smaller, start up organizations there is the potential that individuals will be required to perform multiple tasks. This could result in highly individualized responsibilities and functions. In addition, organizations experiencing extreme growth face tumultuous changes to keep pace with demand. This lack of standardization and frequent change can make it difficult to adequately define and measure performance or incentive goals. However, we will address some solutions in this write up and further strategies in ensuing write ups for more structured companies.

The precise combination of mechanisms appropriate for any individual company will depend on the complexity of its business, the specifics of its strategy, the key drivers of value creation in its industry, and the priorities of its investor base. Getting the balance right is a complex challenge that requires careful coordination and alignment across multiple high-level units: the board (of which a VC would partake), the senior management team and human resource (if you have one). It also requires good judgement. It is critical that you measure and reward the right things. Incentive programs have a negative impact on motivation when they measure the wrong things. Consequences of the wrong are that it can result in the destruction of long term motivation, handicap employee relationships and create an aversion to taking risks.

To the board, you will need to describe your process for ongoing reviews and modifications. Laying out a plan of action which can demonstrate your company’s responsiveness to shareholder concerns can pay your career as CEO dividends in the long run. You may need to address shareholder concerns head on in face to face meetings to assess their issues and concerns. You should constructively explore shareholders views on executive pay and to explain the rationale for your company’s executive pay policies and philosophy.

Basically, your strategies need to address two issues: designing compensation plans that enhance recruiting, retention and motivation, and enhancing corporate profitability so the company maintains financial stability and can grow appropriately. Your plans need to be tailored to your circumstances and your marketplace – you never want to copy plans that are working for another company as it may have a different cost structure than yours or face different competitive pressures. Furthermore, internal financial and operational metrics used to determine the annual bonus need to create value in the business. You don’t want managers rewarded for beating plan targets for, say, increasing sales, growing EPS, or improving P&L. Such metrics either reward growth irrespective of its impact on profitability or reward profitability without consideration of how much capital was invested to achieve that goal.

As a VC, I emphasize relevant value based metrics such as return on capital and free cash flow for compensation packages to executives. This is because I invest capital and ultimately, the goal of internal performance metrics is to make sure that managers are prudent stewards of the capital allocated to them. However, I know from experience that performance based incentives lead to changes in information processing behaviour and improvements in decision making, which fares well for my invested capital as companies become geared effectively and become driven by business necessity. Your role as CEO is to convince me that this would happen since from a value creation perspective, I would feel that there might be better uses for cash in the company, for example returning it to investors in the form of dividends.

Personally, the most straightforward way to make long term compensation a genuine incentive is to require executives to purchase company shares as a condition of participation in the long term incentive plan. Some companies, for instance, require executives to buy share’s equalling anywhere from two to four times their salary, depending on their management level. Some even provide loans to those who cannot afford the purchase on their own. Unlike options or grants, mandated share purchases require executives to put their own personal wealth at stake. This adds an element of risk to long term compensation and aligns the interests of executives more closely with those of shareholders.

Whatever approach or combination of approaches you decide is most appropriate to your company’s situation, it must make the criteria of its equity based compensation plan as transparent as possible – not only to employees but also to shareholders. The best designed equity based compensation program will have its limits because such programs are based on overall company performance and they become less relevant lower in the management ranks. What does become prevalent is pay and bonus.

Annual bonuses have two distinct advantages, it rewards performance on the basis of the internal financial and operational targets over which executives have direct control. And second, because of its tight link to what executives manage, in its regular frequency and the immediacy of payout, it can be highly motivating. The challenge is to retain this motivational impact while minimizing the short term thinking and behaviour that yearly bonuses encourage.

On parting, I wish to advice entrepreneur CEO’s to practice having employees sign employment agreements. You should have a non-competition clause or non-solicitation agreement for good measure. When hiring a new employee specify in the offer letter that employment is contingent on the signing of the non-competition agreement.