Wednesday, December 5, 2007

Strategic Planning Analogy #136: Your Stock is too High

Once upon a time, there was a man who owned an apple orchard. It was the beginning of harvest time. Unfortunately, the man heard a weather report which said there would be a hard freeze that night. If he did not get all of the apples picked before evening, he would lose the crop to the freeze.

Not wanting to lose his crop, the orchard owner went out to find as many people as he could to help pick the apples that day. He found a young man. The orchard owner told the young man, “For every bag of apples you deliver to me before nightfall I will give you one dollar.” The young man agreed to the offer.

Then the young man started thinking about what he agreed to. “The man wanted bags of apples, but did not specify the size of the bag. I will use the smallest bags I can find. The man did not say the bags had to be full to the top. He just said they had to be ‘bags of apples.’ Two apples per bag would satisfy being ‘bags of apples.’

“Finally, he didn’t say where the apples have to come from. I can fill a lot more bags a lot faster if I don’t have to waste time picking them. Therefore, I will buy pre-picked apples from his competitor. Even though I have to pay for them, it is still more profitable than picking them myself due to the time I save.”

Therefore, at the end of the day, the young man delivered 1,000 bags of apples to the orchard owner. Granted there were only two apples per bag and the apples did not come from his orchard. But the young man felt he had lived up to the offer as originally worded and demanded $1,000. The hard freeze came that night and destroyed the orchard owner’s crop.

In this story, the goal of the orchard owner was to get as many of his apples picked before the hard freeze came. However, the incentive program he set up with the young man did not cause his goal to be accomplished. As a result, the orchard owner was out $1,000 and still didn’t get his apples picked before the freeze destroyed the crop.

Be careful about how you set incentives. Incentives do not always lead to the desired consequences.

This is also true with strategies. One may have a strategic goal. However, if the incentives are set up improperly, the resulting activities may not lead to the desired strategic goal.

One of the tools often used to incentivize management is to reward them based on stock performance. Unfortunately, if the linkage to stock performance is set up loosely like the incentive program set up by the orchard owner, the resulting behavior may indeed raise the stock price in the short term, but have no connection to achieving the strategy.

Just as there are many ways to deliver bags of apples, there are many ways to raise a stock price. And in both cases, people can find ways to greatly benefit from the incentive without achieving the desired company goal.

The principle here is that incentives often have a greater impact on determining your true strategy than any amount of strategic planning or mission statement building. Your true strategy is not what you say you will do. In reality, your true strategy is what you end up setting out to actually do. If management sets out to get a big personal reward from their incentive, then your true strategy is to maximize that reward.

The hope is that there is enough linkage between the reward and the strategy that the true strategy will end up being about the same as the stated strategy. However, this will not happen unless two events occur:

1) The setting of incentives is treated as an integral part of the strategic planning process.

2) Incentives are carefully designed so that rewards are maximized only if the strategy is successfully pursued.

Otherwise, employees will be like the young man in the story and find ways to maximize their rewards without achieving the desired goal of the one who developed the incentive. Never underestimate the cleverness of people to find ways to beat the system and reap high personal rewards without bothering to do the hard work of advancing the stated goals of the strategy.

Take stock options, for example. Rather than focus on ways to raise the future stock price through strategy implementation, management in many companies instead focused on how to backdate the option granting date so that they started with the easiest possible goal.

Even if you leave out the problem of backdating, there are lots of ways to raise a stock price near term that have nothing to do with achieving the desired long-term strategy.

1) One can buy back shares.

2) One can make outlandish promises which cause the stock price to go up near-term, but falls back down later after you fail to deliver on those promises.

3) One can cut back on maintenance investments, which boost profits in the near-term, but may cripple the company long term when everything falls apart.

4) One can raise profits near-term by cheapening the offering to the consumer. It may take awhile for the customer to realize the decline in quality, so in the near-term there is a benefit. However, once the customer realizes the value has been lowered, they will likely take their business elsewhere.

5) One can take the money earmarked for investing in a strategic transformation and not spend it, hoping to coast for one more year on the old strategy. You may increase profits in the current year by doing this, but once the old strategy winds down, you are left with nothing, because you did not invest in the future.

6) One can confuse the market through a lot of complicated financial maneuvering, which makes it difficult to see how poorly a company is doing. There are lots of ways to do this, including complex financing, complex intertwined ownership, off-balance sheet activity, and so on. To quote one CEO I knew, “It looks like we are going to have a tough year, so make a big acquisition in order to no longer have comparable financials to last year.”

Over my many years in business, I have seen pretty much all of these activities take place in some form or other. If left to continue in this fashion, one’s true strategy becomes destroying the long-term viability of the company.

After Enron fell apart, I got to talk to a few of the former employees. They told me about how the incentive program worked. Every quarter there was a review of performance. If you improved the earnings of the most recent quarter, you got a ton of stock options. If you did not improve the earnings of the most recent quarter, there was a good chance you would be fired. These are the types of incentives which lead to the behavior which destroyed Enron. Based on these types of activities, the value of the stock becomes too high, too soon and eventually implodes.

Here are some suggested incentives which may improve the link with achieving a long-term strategy:

1) Link bonuses to achieving specific strategic business objectives.

2) Hold back some of the incentive until a multi-year strategic objective is fully achieved.

3) Rather than measure stock price, measure the components which determine stock price, such as changes in return on capital, changes in market share or growth projections.

4) Link bonuses to customer feedback.

Although these approaches are an improvement over mere stock price, even these factors can be manipulated in ways that are counterproductive (although it is more difficult). Therefore, to overcome the “gaming” of formulas, one may want to have part of the incentive be without a formula—a judgment call by the superior on one’s efforts to achieve long-term strategic goals.

You can spend months creating an elaborate strategy to a wonderful future. However, if the incentive program is not linked to that strategy, then you have wasted your time. Stock prices can be manipulated in ways that are beneficial in the short run but destroy a firm’s long-term strategic viability. Therefore, be careful in how you use stock as an incentive. Finally, make sure that discussion of incentives and strategies occur at the same time.

Employees may feel all fired up at the end of a big strategic planning summit and start chanting the mantra of the strategic mission. However, this is not the point at which you can gauge success. Success is measured weeks or months later when one sees whether the day to day actions are moving in the direction of the mission. If they are not, a good place to start in trying to fix the situation is to look at how people are incented.

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