How a Long-Term Incentive Plan (LTIP) Prevents Bad Profits

Are all profits created equal?

No, they are not. Some are good and some are bad. Years ago, in his book, The Ultimate Question, Fred Reichheld made the distinction: “Too many companies these days can’t tell the difference between good profits and bad. As a result, they are getting hooked on bad profits. Whenever a customer feels misled, mistreated, ignored, or coerced, then profits from that customer are bad. Bad profits come from unfair or misleading pricing. Bad profits arise when companies save money by delivering a lousy customer experience. Bad profits are about extracting value from customers, not creating value.” (The Ultimate Question, Fred Reichheld, Harvard Business School Publishing Corporation, 2006, 3-4.)

Although that statement may seem like common sense, too many businesses still haven’t learned the lesson Reichheld shared. If anything, since the time his book was released, the issue has gotten worse. Part of this is due to the increasing competition companies are facing and the impatience most organizations have to meet their growth goals. That mindset creates a short-sighted view that permeates their cultures and often induces a toxic reliance on ill-obtained income.

The problem with bad profits is that they are both seductive and addictive. All companies need good cash flow and capital to grow, so business leaders can easily rationalize they need to cut corners in order to…well, fill in the blank (hit revenue targets, please the bank or investors, achieve budget, etc.). The problem is, shareholders are (or at least should be) thinking longer term than just “this year” or “the next six months—or quarter.” And unless their key people are aligned with their thinking, they will behave in a way that benefits them the most—financially and otherwise.

The Role of Compensation in Profits

Most people are naturally disposed to think short-term. Part of this is simply human nature. We all want immediate results. But the other reason people focus on the short term is because the company they work for pays them to think that way. Really? Yes, really.

Think about it. Most organizations offer their employees (including key performers) a salary, an annual bonus, benefits and a retirement plan. The only part of that compensation package that is impacted by performance is the bonus, which is usually driven by quarterly, semi-annual or annual metrics. So where is the rewards component that tells the employee that he or she should think long-term? Don’t look too hard. There isn’t one. As a result, the company is literally paying its people to think short term.

This points out an issue too many business leaders miss. Pay should be used as a strategic tool. And one of the things it should communicate is the expectations associated with someone’s role. It should tell a person what outcomes their role exists to produce and how they will be rewarded if they achieve those results. As it relates to roles and outcomes, Ken Navarro, of Strategy+Business, once made this observation:

Peter Drucker…wrote that the manager’s job is to keep his nose to the grindstone while lifting his eyes to the hills. He meant that every business has to operate in two modes at the same time: producing results today and preparing for tomorrow.

If that’s true, then one of the important things rewards must reinforce is the priority that employees—especially top performers—stay focused on both short and long-term results. This means companies need a balanced value-sharing approach that rewards both short and sustained employee and company performance. This is one of the primary ways alignment with shareholders occurs.

How an LTIP Helps Profits

Enter the role of long-term value-sharing. Compensation needs to support the kind of vision Peter Drucker identifies. A pay offer represents the financial partnership company leaders want to have with employees. In addition, it should reinforce the kind of mindset shareholders want their employees to have towards their work. And since owners are thinking both short and long-term, they need their best people thinking the same way. The company rewards strategy needs to convey that.

As a result, a long-term incentive plan acts as a kind of insurance policy against bad profits. If the economic value of an employee’s relationship with a company is tied to both short and long-term value creation, that person can’t just focus on one or the other. He or she must pay attention to both. In other words, if employees produce “bad profits” by focusing solely on short-term outcomes (because they want to maximize this year’s income), they end up hurting themselves financially. They may get a big bonus payout, but it comes at the expense of the long-term growth of the company. If their long-term incentive plan is tied to business value increase (which it should be), then their short-term thinking doesn’t just damage the company, it damages their personal wealth accumulation capability as well.

At MPN Inc., we suggest companies adopt an overriding value-sharing philosophy (how the business defines value creation as well as how and with whom it will be shared) but create value-sharing plans that reward two distinct performance periods (less than 12 months and over 12 months). The primary metrics driving payouts under each plan should emphasize the focus owners want their employees to have–which is profits and growth. Therefore, we recommend that plans rewarding short-term results (12 months or less) should be tied to company profits. Plans that reward long-term results (over 12 months) should be tied to business value improvement. Those outcomes correlate. Profits are needed to drive company growth. So, if a company achieves its short-term metric, it is simultaneously driving the long-term results as well—if the focus is on good profits, not just any profits.

Ultimately, all companies should have some type of long-term incentive plan. And protecting against bad profits is a primary reason it’s important they do. So, the core question business leaders should ask is not whether they should have an LTIP. Instead, the question should be: “What kind of LTIP should we have?”