Management incentive plan. The owner gets exactly what he pays for

The owner set up a plan to keep the management board in place until the company was sold. He built it as simply as he could: whoever stays three years gets a payout. The people stayed. The company paid the bonuses down to the last zloty. Over those three years the business barely grew, because nobody received a single zloty more for building something in it. The plan paid for attendance. The owner got attendance.

I have changed the details so that neither the company nor the people can be identified.

The same management board, paid differently, could have worked to increase value. A plan that gives the management board 10 percent of the increase in the company’s value costs the owner PLN 6 million if the company grows from PLN 120 million to PLN 180 million. A plan that pays for reported EBITDA can leave the owner with a company worth the same as at the start, even though the bonuses have been paid.

The mistake comes from the first question the owner asks himself. He asks how to keep key people. He should ask what these people are meant to build in the company and how to make it pay off for them. The first question leads straight to a bonus for tenure. The second leads to a plan that changes what the management board works on in the morning.

Three instruments and their tax

A management incentive plan is the way an owner shares with the management board part of the value the board helps to build. In practice several instruments are used. They differ in how closely they tie the manager to the company’s value and in how they are taxed.

The simplest is a cash bonus, paid once a condition is met: on a sale, on reaching a result or after a period of service. It is easy to introduce and easy to understand. It ties the manager, however, only to the condition for payment. It is taxed like salary, under the progressive income tax scale. Above PLN 120,000 of annual income the rate is 32 percent, and on income above PLN 1 million a further 4 percent solidarity levy (danina solidarnościowa) is due. On top of this comes the health insurance contribution. With large amounts, the tax burden here is the highest.

The second form is a phantom share. The manager does not take up any shares. He receives a contractual right to an amount that changes together with the company’s value. He therefore benefits from growth in value like an owner. He does not, however, become a shareholder and has no voting rights. Such plans were sometimes taxed more favorably in the past. Since 2018 a payout from such a plan has, as a rule, been settled the same way as the manager’s remuneration, so the former tax advantage has largely disappeared. The outcome depends on how the agreement is structured, which is why the tax has to be calculated with a tax adviser before it is signed.

The third form is a real stake in the share capital, or the right to acquire shares at a price set in advance. In a joint-stock company (spółka akcyjna) this is done with options and subscription warrants, and in a limited liability company (sp. z o.o.) with a contractual right to take up or acquire shares. The manager either becomes a shareholder at once or receives the right to become one. This form ties him most strongly, because the manager has a direct share in the profit and in the sale price. He does, however, enter the ownership structure, with voting rights and shareholder rights. It also has to be agreed in advance what will happen to his shares if he leaves. A buyer often demands 100 percent of the shares, so the agreement must oblige the manager to sell his stake together with the owner.

For share-based plans, the Polish Personal Income Tax Act provides a special regime. Tax is paid only when the shares are sold, at the 19 percent rate that applies to capital gains. The regime applies only if the statutory conditions are met. Among other things, the plan must be based on a resolution of the general meeting of a joint-stock company or of its parent company. In a limited liability company this preference cannot be used directly. The tax authorities also examine whether the plan has a business rationale.

The instrument determines the tax and who becomes a shareholder. What the plan does to the company is determined by the metric it pays for.

What the plan rewards

A manager whose payout depends on a single number will organize his work so that the number comes out right. He is acting rationally. The owner does not run day-to-day matters for the management board, so he steers it through what he pays for. That is why the choice of metric decides what the management board will focus on for three years.

A plan that rewards tenure alone tells the management board one thing: it is enough not to leave. People will stay, do the minimum that does not put the payout at risk, and count the months to the deadline. In a company that only has to hold out until the sale, this can be exactly what is needed. In a company that is supposed to grow, it is the most expensive way of making sure nothing changes.

A bonus based on revenue produces revenue regardless of what it costs. The management board can then easily raise sales at the expense of margin, because the quickest way to win orders is a lower price. The company has higher turnover and can be worth less.

A bonus based on reported EBITDA, that is, operating profit plus depreciation and amortization, produces a result tailored to the metric. Repairs and development spending that would weigh on the current result wait for the next year and for the new owner. EBITDA rises, while the company quietly loses value. The same mechanism spoils the earn-out I wrote about a week ago. Here the owner pays for this mechanism himself.

A plan that pays for the company’s value at exit, that is, on a sale or on the entry of an investor, makes the management board look at the same thing as the owner. The manager’s payout grows when what the owner cares about grows. This metric has two conditions. The manager must have a real influence on this value, and he must believe that the exit will happen.

Four conditions for a plan that works

A well-chosen metric is only the start. Equally important is how the agreement is structured, so that it builds the manager’s trust and protects both sides. It rests on four principles.

Simplicity. A manager is motivated by what he understands. A plan whose rules fit on one page and can be explained in two minutes steers behavior. A plan spread across seven indicators with weightings and adjustments steers nothing, because nobody calculates in his head how today’s decision will translate into a payout three years from now. Complexity in a plan rarely comes from concern for precision. It usually comes from trying to anticipate every scenario, and the effect is the opposite of what was intended. The more conditions there are, the less the manager feels that the payout depends on him.

Transparency. The manager must know at any moment how close he is to the target. If only the owner’s finance department can calculate the result, and the management board learns it once a year, the plan stops motivating between one measurement and the next. The metric should be visible on an ongoing basis and calculated under a rule that both sides read the same way. Ongoing transparency prevents disputes better than elaborate clauses, because a dispute most often arises when each side has calculated the result in its own way.

Financial adequacy. The payout must be large enough to change the manager’s decisions and grounded in numbers the company can afford. If it is too small, it changes nothing. The manager will decide it is not worth the effort, and the plan will become a cost with no effect. If it is too large or detached from the company’s ability to pay, it creates its own risk, because it pushes the management board toward decisions that bring it a payout at the company’s expense. The amount should be meaningful for the manager and proportionate to the value he is meant to create.

Protection against abuse, in both directions. It should not be possible to improve the result with maneuvers that raise the number itself and harm the company. That is why the agreement defines the metric as carefully as in an earn-out: what goes into the result, what accounting policy applies and what must not be shifted in time. The agreement must also prevent the owner from evading the payout when the manager has done his part. A member of the management board can be dismissed at any time. Without a suitable clause, the owner can therefore easily avoid the payout. All he has to do is dismiss the manager before the manager reaches the target. The fullest protection comes from a provision that a manager dismissed without good cause before the end of the plan receives the full payout plus a premium for the lost chance of reaching the target. In the plans we prepare at Capital One Advisers, we write a closed list of good causes for dismissal into the agreement in advance, such as acting to the detriment of the company or breaching a non-compete obligation. If the plan pays out on a sale, the agreement must also set out the formula for valuing the company on the date of an earlier dismissal.

What it looks like in numbers

The company is worth PLN 120 million, has no debt and no surplus cash, and generates PLN 12 million of EBITDA a year, which gives a multiple of ten. The owner wants to sell it in three years.

In the first scenario, the plan rewards reported EBITDA and tenure alone. The management board raises EBITDA to PLN 15 million by putting off repairs and development spending. The buyer sees this in due diligence. He lowers the multiple from ten to eight, because he is taking over a company with deferred repairs and stalled development, so he pays PLN 120 million. At the old multiple he would have paid PLN 150 million. The management board received a bonus for higher EBITDA. The owner was left with a company worth as much as three years earlier, and he bore the cost of the bonus himself.

In the second scenario, the management board is promised 10 percent of the increase in the company’s value above PLN 120 million. The payout is made on a sale, provided the management board stays until the deal. The agreement defines precisely how this value is calculated. The management board knows that accounting tricks will achieve nothing, because what counts is the price the buyer will pay. It therefore watches the margin and invests where a buyer will value it. The company goes to market worth PLN 180 million. The management board receives 10 percent of the PLN 60 million increase, that is, a bonus of PLN 6 million. In practice the seller covers it, because a payout from the company’s money at closing lowers the price for the shares by the same amount. The owner gave up PLN 6 million of the PLN 60 million by which the value of his company grew.

The metric decided a PLN 60 million difference in the company’s value.

Where this argument ends

Value at exit has weaknesses too. It depends on multiples set by the market, so a manager may gain from a good market or lose from a bad one through no merit or fault of his own. If the exit is distant or uncertain, a payout several years away has little effect on today’s decisions. A plan is no substitute for choosing the right people. A weak management board with the best metric is still a weak management board. For many owners, a full payout if the management board is dismissed early is too great a risk. The parties then often adopt a middle solution and agree on a payout proportionate to the time served.

The heart of the matter

A management incentive plan sets the company’s direction. At the outset, you have to ask what these people are meant to build and whether the plan pays for exactly that. The question of how much to give them so that they stay comes later. At Capital One Advisers, when preparing a company for sale, we check whether the management plan rewards a metric that the buyer will challenge in due diligence.

The hardest case is when the owner does not know whether or when he will sell the company. A plan paid on a sale does the best job of ordering the management board’s priorities. It loses force, however, when the deal is far off. Some owners then combine it with a portion paid out of current profit. Others give managers real shares and accept new shareholders. The first solution keeps control in the owner’s hands, the second ties people to the company more strongly. The choice depends on whether the owner sees the management board as managers hired for a few years or as partners for many years to come.

Service: M&A advisory on a company sale