The fifth leadership fundamental
Editor’s note: Here is another valuable excerpt from the new success book by national business consultant Laurence B. Valant and partner Gayle W. Hustad, “Lead and Manage! The definitive guide for getting the results you want.”
Leadership Fundamental #5 -Create a Compensation Strategy
The primary objective of the leader is to grow the value of the enterprise in both the short and long run. The leader and his team must be rewarded for incremental growth in corporate value as measured by residual income (RI) and no other means. Other more commonly used measures such as EBITDA, external stock price, and other return ratios do not accurately measure how the leader and the team are doing in terms of meeting this primary objective because they do not track the true growth in economic value. Measuring the growth in enterprise value using RI is rigorous, quantitative and reflects reality.
Whether determining annual bonuses for top executives, profit-sharing for all employees or stock option plans, the compensation systems for an organization must be based on incremental growth in corporate value as measured by residual income. Such compensation packages will be based on achievement of specified RI goals for the five-year targets contemplated in the vision and specified in the strategic and business plans. If a company has two to three years of negative RI followed by two to three years of positive RI (impacted by the implementation of effective leadership fundamentals), the final years will achieve positive RI and therefore, the cumulative RI number will most likely be positive – or, at the worst, trending to positive.
Measuring performance based on the growth and value of the enterprise is simple, straight forward and absolutely irrefutable. RI as the performance measurement can be applied successfully to the private or public sector. More information about residual income can be found in Chapter 8, but for the time being, it is enough to say that RI is the single best measure of the true economic profit of an enterprise, both in the short and long run, and the best predictor of long-term company value.
The University of Chicago Graduate School of Business has for decades studied various financial and performance measures to identify the best predictor of long term company value. Researchers there found RI, or in their terminology, Economic Value Added (EVA), to have the highest reliability and validity as a predictor of long term company value regardless of company size, industry or economic sector. When rigorously applied, residual income not only provides a true and reliable measure of growth and company value, but also provides the best method for compensating management on an annual and long-term basis. Logically, it follows that RI is the best measure of leadership and management competence.
Guidelines for implementing a compensation system:
Establish financial goals that reflect value growth of the enterprise and can be measured quantitatively
Reward the CEO (and other relevant top management) for growing the value of the enterprise as measured rigorously by residual income
Provide a reward system that measures and evaluates performance quantitatively.
This system will include:
o Clarification and quantification of expectations for all staff
o Quantitative standards of performance
o A formalized approach to performance reviews
The leader/CEO must set targets for the following:
o Annual salary reviews to provide merit increases
o Promotional increases based on increased responsibility for contributing to residual income
o Annual bonuses based on overall corporate performance and specific business unit performance of each individual
Remember, a well thought out, fair compensation system will attract and retain quality people.