Redesign compensation to drive innovations

posted by Ravi Arora October 13, 2015

In the recent years, there has been a lot of debate about the management of companies being too (over) focused on short term results to meet the expectations of stock market. People who support this view believe that this overt/intense focus by companies on short term is the key reason for companies to miss out on many innovative ideas that are picked up by individuals who give them life through the startups.

I too agree with this and let me present my argument in a rather simple manner.

Stock markets reward companies based on the quarterly and annual performance. Companies, in turn, starting from their boards, reward their management based on annual performance. Stock markets neither have patience nor are they forgiving for unfavorable results; they penalize companies immediately if they fail to meet the expectations in one quarter. Companies too penalize their managers for poor performance, which usually happens with a lag. The speed and quantum of penalty given to managers depends upon many factors- the reaction of investors and stock market being the key. Interestingly, this penalty also depends upon the level/tenure/experience of the manager who is being penalized. We all know that compensation and penalties drive behavior, not always due to financial gains/loss for the manager but mainly due to strong correlation that exists between compensation and social status.

In most cases, companies try to set the expectations of the shareholders proactively by providing their outlook for future and predicting their performance for the next quarter (Guidance: http://www.investopedia.com/terms/g/guidance.asp). These predictions are mostly a linear revenue growth with similar or improved profitability and is aligned to support the achievement of annual predictions and is usually comparable with respect to previous years and with competition. This trend of providing linear growth guidance is quite acceptable to the investors. Stock markets not only expect certainty in the absolute performance as predicted by the company but also expect a similar or better comparative performance and decide to reward and penalize.

As a result, companies are intensely focused on the next quarter. Resources are deployed to achieve the guidance numbers and most decisions taken by management are those that support achievement of results for the next quarter or the current year.  The management, no doubt, takes some decisions to meet the long term plans committed to the board and investors. Interestingly, if one observes carefully, many of these long term plans are usually made to set and meet the long term linear expectations of the investors. The high gestation period of investments (eg. putting a new factory) makes it necessary for management and board take investment decisions early.

One common attribute for almost all of these decisions is that they have less uncertainty about the outcomes (not necessarily the returns). Most innovations, unfortunately, have uncertainty of outcomes also.  In such a situation, promising a non-linear performance triggered by innovations in the next quarter or in the year is seen as very imprudent by the managers and board.

This intense focus of companies in achieving the predicted performance that is better than the competition every quarter, is the key reason that blinds the management from disruptive innovations and also makes them slow to react when such innovations are visible.  In the last few years, these disruptive innovations are increasingly coming from the new competitors (startups) mainly due to innovative business models or a radical new technologies.

‘Comparative performance’, one of the factors that determines the expectations of shareholders is gradually gaining dominance in the last few years. With more distributed financial and intellectual power and increased intensity of technology development, newer business models and radical new technologies have been developed by startups who sometimes outperform the incumbent large companies and erode their financial performance. This has led to established companies getting more and frequent penalty from the stock markets. The research also shows that the life of Fortune 100 companies is diminishing. As compared to 2010, the number of interventions by activist shareholders seeking board representation, share buybacks & CEO removal increased by 88%.

One could argue that this increasing pressure and demand for short term results actually reflects the low confidence of shareholders on the ability of the company to make long term investments, which unfortunately includes innovations. I believe that the intention of this quarterly performance report or results was not to control, pressurize, or scrutinize the management but perhaps would have started as a confidence building measure and to create an opportunity to have frequent dialogues between the investors and management.

Who is at fault? Is it the stock market which evaluates the company every quarter and decides the reward and penalties? Or is it the board and management who has created mechanism to immediately transfer these rewards and penalties of stock market to operating managers. I think it is both and we need to make some corrections. Imagine a bus ride with no shock absorbers? Where are the shock absorbers between the stock market jolts and the bumps felt by the managers?

Many boards have stared compensating executives for Long Term value creation but unfortunately this is still based on the aggregation of multiple instances of Short term results which has a very limited contribution in solving our problem.

The question at hand is: How do we raise the discussions in the board room to a much more strategic level that has a substantial bearing on longer term without any adverse impact in short-term performance. By making this suggestion, I am not referring to hire a bold, innovative and charismatic CEO, which has been found as the main source of innovations in large companies by many researchers. We need a process that will make it happen sustainably regardless of the personal charisma of the CEO/Chairman.

This problem could be resolved by designing a compensation that drives the board and management to not only think about all possibilities of future (including innovations of all types) but also forces them to make choices of investing in them for a longer duration or divesting from them timely. The extent to which the compensation would take into account this long term view depends upon the confidence that board has on this process (shock absorbers) and a few attributes of the industry and market.

To operationalize such a compensation, we will need a method to measure management on three factors: (a) their thinking/imagination about future innovations, (b) making their choices and planning to invest on them (c) actually investing in the choices. This surely seems to be a complex problem of measuring such subjective things. What if I suggest to record their behavior on these aspects for a substantial time and then measure their performance in future using these past recordings! It looks quite simple and sounds interesting?

It is somewhat like a large treasure hunt which has many treasures and many clues with no fixed route. The winning team could be identified by the treasure they found but the confidence on their ability to win it repeatedly can be developed by analyzing their behavior and decisions while they were busy hunting the treasures. And for investors, it could be like participating in a sports bet (but not a lottery ticket) that needs knowledge, experience, risk taking and of course some chance. Unless the game is complete and winners are known the betters fate is not decided. And very similar to (ideal condition) sports bet, the investor should have no control/influence on the player(s) once the game has begun.

In other words, I am suggesting that the compensation for driving innovations in the current year should be decided in future when the outcomes of innovation projects are known to all. This means that every year the board and management would continue to receive compensation for driving the annual performance of the current year but will now get an additional compensation for their performance in driving innovations in the previous 2-4 years, the outcome of which would have resulted in innovations in the current year. Both these components have an element of comparative performance with the current and new competitors (including the start-ups!).

In order to introduce the second component of driving innovations in the compensation, every company needs to initiate a few simple systems somewhat similar to those explained below to capture and record a few things and events which will be needed for the measurement system:

  1. Maintaining an inventory of innovations that are likely to happen in future which might affect its market performance in medium or long term. This will be used to assess how soon the management is able to predict and contemplate the future innovations. This measurement will drive the company to actively look for weak signals through technology trends, customer behavior, competitive intelligence and creative thinking.
  2. The choices made by the company along with reasons to invest or not to invest in the innovations that are likely to happen in future. For those innovations that company decides to attempt, details of their investment plans in the current year in terms of financial and human resources need to be captured. The changes made by the company on these choices and investment plan quarter after quarter or year after year should also be captured (As per IBM’s CEO, Lou Gerstner, ability to change is a key ingredient for longevity).
  3. The actual investments made by the company in that year on every innovation that it chose, year after year to accomplish or progress. This should have the details including the quantum of effort and investment.
  4. The final outcome of its choices and also the outcomes of the choices the competition must have made in the same period (These would be visible in the form of innovations).

The above four systems can be used to assess the three factors that are needed to decide the compensation for driving innovation. The next question could be- ‘Why should board introduce such a system?”

The core aspect of the fiduciary duty of directors in the board is ‘Loyalty’ and ‘Prudence’. To help directors successfully accomplish their role and also help the company thrive for several years instead of becoming a source for quarterly pressure, the above change in compensation structure would be useful. We would like management and board to keenly discuss disruptive and radical innovations in board meetings (similar to what the founders of startup would do in early stage) as against staring at numbers of the past and next quarter.

I also recommend that every company should start sharing with investors their 3-5-7 year results on key predefined measures, some of which would also reflect their innovation and owner mindset. This will give investors a sense of ownership and the investment mindset.

Prof Jeff Dyer has introduced the concept of two types of mindset: Delivery and Discovery. The expectations of stock market and promises made by the companies to grow linearly supports the advancement of people with Delivery mindset and hence one could find that many senior management team in most companies is Delivery driven. Discovery mindset is considered critical for a new start-up but I feel that it is even more critical for an established company to guard against the threats of disruptive innovations. Board members and executives with a dominant Discovery mindset will be more than keen to experiment with the new concept of introducing a change in the compensation to drive innovations as explained above.

I will leave with one question at the end – We discussed that established companies are focusing on short term because of the pressure of investors and stock markets.  If this behavior is leading them to miss the opportunities of longer term, what is the problem? The opportunities missed by them, are grabbed by startups! The consumers are still getting innovations. Some (Smart?) investors are still making money and lots of it! Is it eroding the wealth of the system or is it an inefficient economic model?

  1. http://www.aei.org/publication/fortune-500-firms-in-1955-vs-2014-89-are-gone-and-were-all-better-off-because-of-that-dynamic-creative-destruction/
  2. http://www.businessweek.com/chapter/degeus.htm
  3. http://www.wsj.com/articles/SB10001424052970203391104577124243623258110
  4. https://www.grantthornton.com/staticfiles/GTCom/Grant%20Thornton%20Thinking/Surveys/Performance_Based_LTI_Plans_Reprint.pdf
  5. https://hbr.org/2015/01/where-boards-fall-short
  6. https://hbr.org/2014/01/focusing-capital-on-the-long-term
  7. http://www.fclt.org/content/dam/fclt/en/ourthinking/%27FCLT_A%20Roadmap%20for%20FCLT%27.pdf
  8. Jeff Dyer, Hal Gregerson, and Clayton Christensen, The Innovator’s DNA: Mastering the Five Skills of Disruptive Innovators (Boston: Harvard Business Review Press, 2011)