Is Value Management The Answer?
December 1 1996 by John S. Shiely
Peter Drucker once said that the most successful companies are those in which “everyone in the joint knows what they are being paid to do.” At Briggs & Stratton, we believe the primary obligation of all our employees-from senior managers to workers on the shop floor-is good capital stewardship, and we try to reward ourselves commensurate with our success in achieving that shareholder imperative.
This strategy of “shareholder value” management already has been adopted by many companies and is an issue currently generating a great deal of discussion in business circles. For example, Economic Value Added (EVA), a financial system that measures how-and if-a company creates shareholder wealth, was debated in a CE article earlier this year (CE: January/February 1996). Our decision to implement an EVA program was prompted by the fact that our stock price languished throughout the 1980s, and we lost $20 million in fiscal 1989. In the ensuing five years, our stock price more than tripled.
Our “Managing for Value Creation” strategy uses the EVA calculation developed by the Stern Stewart organization as a measure of annual performance and an indicator of long-term value. Under value management, a significant portion of total compensation for key executives is tied to stock performance. At Briggs & Stratton, leveraged stock options (LSOs) are a linchpin of this incentive-based compensation program. Awarded to certain executives-primarily corporate officers-who have been designated “senior executives” by the board committee that handles compensation, these options are designed to reward key employees when the company’s stock performs exceptionally well-thereby providing them with an additional incentive to maximize stock performance. If the stock price does not exceed a deemed cost of capital return for the five-year option period, the options are worthless.
Our approach to value management has continued to evolve over the last few years. We have come to see the issue as extending beyond which method of measuring value creation is best, to encompass how effectively the concept of good capital stewardship is integrated into the organization. Our experience suggests that the key factors in meeting that challenge are:
- An insightful and committed expertise in economic value measurement.
- EVA-based incentive compensation plans.
- EVA training programs.
- Adequate systems to support EVA performance measurement.
- Internal EVA “consultantvalue management principles and how they apply to the company.
OPTIONS TO GROW ON
Our LSO program is linked to the company’s EVA Incentive Compensation Plan (EVA Plan)in that the number of LSOs granted in a given year is directly related to the EVA bonus payout for that year. The EVA plan sets annual performance goals and target incentives that together determine bonus payouts for that year. Target incentives for key executives range from 20 percent to 80 percent of base salary, depending on the executive’s position. Whether an executive’s actual bonus is more or less than this target percentage depends largely on whether the EVA performance goals are achieved by the corporation overall and by that particular executive’s operating division. Corporate and divisional performance factors each determine about half the potential bonus (see Figure 1).
Should the bonus for a given year exceed the targeted incentive, any amount over 125 percent of the targeted figure is “banked.” In any given year, if there is a positive balance in the bank, one-third is paid out. In the next year, and all subsequent years, if there is a positive bank balance, one-third of the remaining balance is paid. However, during these subsequent years, the banked bonuses are subject to forfeiture should a “negative bonus” be accrued due to unsatisfactory performance in achieving targeted EVA goals. So far, we’ve exceeded the 125 percent figure in one of the three years we’ve had the program.
Once a bonus amount has been determined, in addition to the cash bonus, each senior executive receives premium, or out-of-the-money, options with a five-year term on stock with a current market value equal to 10 times the amount of the EVA bonus payout. These LSOs become exercisable at the end of three years. In effect, the senior executive receives double the EVA bonus payout with the requirement that half be invested in a 10-to-1 leveraged stock investment. This matching grant approach allows the executive to avoid current income tax liability on the “reinvested” portion of the bonus.
The final piece of the incentive-equation puzzle is determining the exercise price at which the LSOs will be in-the-money. Given that the principle here is to reward only stock performance that exceeds the minimum acceptable return to shareholders, executives should profit only from exceptional performance. Therefore, the LSOs go in-the-money only when the stock price exceeds a deemed cost of capital return for the five-year option period.
Under our plan, the deemed cost of capital figure is calculated by taking the risk-free interest rate (the current rate on 30-year U.S. Treasury Bonds), plus an equity premium (historically about 6 percent for companies of average risk), and then discounting for anticipated annual percentage dividend yield and for a risk factor for the illiquidity and undiversified nature of the options. For example, Briggs & Stratton had an anticipated annual dividend yield over the option period of about 3 percent. Therefore, assuming a 7 percent risk-free rate at the time of the grant, our deemed cost of capital return would be as follows:
As the latter three elements of this equation are assumed to remain constant over the option period, the only variable is the risk-free rate. Therefore, we can state the deemed cost of capital return in short form as the 30-year U.S. Bond Rate plus 1 percent.
Under this plan, management will not get a penny in value from these LSOs until we have provided our shareholders with the cost of capital return they have a right to expect. However, if we exceed our shareholders’ expectations, and provide them with an exceptional return, due to the leveraging feature, our executives will be similarly well-rewarded (see Figure 2).
STOCKING UP ON VALUE
Ultimately, we believe management’s long-term performance is best measured by Market Value Added (MVA), the amount by which the market value of the firm exceeds the capital invested in it. LSOs contribute effectively to this MVA imperative by offering strong incentives in support of our Managing for Value Creation program. We are familiar with the argument that all equity-based incentives are flawed in that so many “uncontrollable” factors drive market value that any incentive realized by executives will be more related to luck than performance. But we believe an executive’s response to uncontrollable events is fundamental to value creation. The market’s digestion of negative and positive uncontrollable events will ebb and flow. Therefore, an executive who effectively plays the cards he or she is dealt will show a superior MVA over time.
For example, our primary business (power for lawn and garden equipment) is intensely seasonal and is further exacerbated by weather patterns. Clearly, these are all out of our control. There are two generic ways to meet the demands of this market. One is to build enormous amounts of inventory on a relatively level schedule (higher working capital solution). The other is to pursue a “chase” strategy (higher operating capital and employee redundancy costs). Creative value managers are most effective in analyzing which of these approaches (or combinations thereof) will deliver the highest EVA, given their competitive and operational challenge. Tactics such as creative plant architecture and alternative work forces will give managers a “value edge” in dealing with the uncontrollable aspects of their business.
For many businesses, interest rates are the most critical uncontrollable variable. The timing and nature of capital expenditures is a key response area significantly affecting EVA.
Another criticism is that there is too much focus on short-term performance. It is well-known that the value of any capital asset is the present value of the future cash flow that can be derived from it. And, of course, the mechanics of calculating present value award greater weight to cash flow produced in the here and now. Our program requires superior annual performance in delivering value to “earn” the high-side ride. Long-term value ultimately arrives with consistent delivery of strong annual EVA performance. Thus, the central element of our LSO program is in incentives structured to reward the maximization of both short-and long-term performance.
Executives of companies experiencing significant growth in revenues, but less than stellar stock performance, often voice the criticism that value management is anti-growth or anti-innovation, and that capital will be “managed down” for maximum return. However, most of these companies have at-the-money option programs with constant exercise prices.
With our EVA plan, formula-driven growth targets determine the EVA bonus payouts, which, in turn, determine the number of LSOs granted. Since the LSO program is structured to require a cost of capital return before the options are in the-money, the plan also rewards growth in Economic Value Added, so that without developing a high-value growth strategy, management can have little expectation for a payoff. In other words, the plan recognizes that growth without capital discipline destroys value, and it rewards only value-creating growth.
At-the-money option programs, on the other hand, can provide handsome returns to executives employing maintenance or revenue growth strategies, even when they fail to deliver on shareholders’ legitimate demand for a cost of capital return.
THE VALUE PAYOFF
At Briggs & Stratton, our 1995 LSOs had a Black-Scholes disclosure value of only 14.8 percent of the then-current stock price. An at-the-money option with similar terms would have been valued for disclosure purposes at 25.1 percent of the current stock price. So a great deal more high-side ride, or options on far more shares, can be delivered to executives for the same amount of Black-Scholes shareholder cost. Furthermore, due to the relatively low cost per share of five-year premium options, the program was able to meet the “wealth transfer as a percentage of shareholder value” guidelines used by Institutional Shareholder Services, even though the option reserve exceeded 10 percent of outstanding shares.
On the flip side, when our premium option program replaced a prior at-the-money program, the initial response from some quarters of the senior executive group was somewhat less than enthusiastic. That reaction subsided when-less than three years into the program-the stock price rose to within a few dollars of the exercise price. Still, a company considering this type of program should be aware that retention risk is a real issue, particularly when there are plenty of companies out there offering straight or even discounted options.
However, for that same reason, the premium option approach helps redefine the character of the executive group. To attract and keep management talent optimistic about their ability to deliver high value growth, LSOs are the ticket.
IS VALUE MANAGEMENT FOR YOU?
Introducing an effective value management program requires reviewing the unique competitive and operational challenges to value creation faced by your company and then crafting program features calculated to deliver value in your particular environment.
To be most effective, some of the features of the LSOs discussed here may require adaptation or phase-in timetables. For example, in the case of a small drug company with high value potential, but with most of its key products still under review by the FDA, the feature requiring that LSOs be earned through EVA improvement may be modified.
There is no cookie-cutter value management program. A successful effort requires not only an excellent understanding of the dynamics of value creation, but the input of a company’s most insightful managers. Given these key components, we believe a value management program with equity-based incentives can be an effective tool in developing an organization where everyone in the joint knows what they are being paid to do.
John S. Shiely is president and chief operating officer of Milwaukee, WI-based Briggs & Stratton, a $1.3 billion producer of air-cooled gasoline engines for outdoor power equipment. Al Ehrbar and Stephen O’Byrne of Stern Stewart & Co.; and Frederick Stratton Jr., Robert Eldridge, James Wier, and Kasandra Preston of Briggs & Stratton contributed to this article.