60 Minutes: JOEL STERN, MANAGING PARTNER, STERN STEWART & CO.

JOEL STERN, MANAGING PARTNER, STERN STEWART & CO.
"EVA-linked incentives make owners of employees"

If he's a rabid believer in Economic Value Added (EVA), it's because he invented it. Now, Joel Stern, Managing Partner of Stern Stewart & Co., says EVA-linked incentive schemes can help motivate employees to grow shareholder value year after year. In Bangalore recently, Stern took time off to speak with BT's Dilip Maitra on how to use EVA as a performance tool. Excerpts:

Eversince EVA was introduced by you in the early eighties, it has found numerous believers across the world. So, what makes EVA special?

A. EVA is a very simple concept. It is net operating profit of a firm minus an appropriate charge for the opportunity cost of all capital invested in it. So, EVA is an estimate of true ''economic'' profit, or it is the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders and lenders could get by investing in other securities of comparable risk. The capital charge is the most distinctive and important aspect of EVA. Under conventional accounting, most companies appear profitable but many in fact are not. Unless a business returns a profit that is greater than its cost of capital, which includes cost of equity capital and debt, its operations are at a loss, even though it may have a genuine profit. EVA corrects this error by explicitly recognising that when managers employ capital they must pay for it, just as if it were a wage.

We at Stern Stewart developed EVA to help managers incorporate two basic principles of finance into their decision making. The first is that the primary financial objective of any company should be to maximise the wealth of its shareholders. The second is that the value of a company depends on the extent to which investors expect future profits to exceed or fall short of the cost of capital. By definition, a sustained increase in EVA will bring an increase in the market value of a company and this, in turn, rewards share holders.

Can EVA be used as a tool to motivate employees?

The real magic in EVA comes from changing behaviour throughout an organisation, and that depends crucially on using it as the basis for incentive compensation. Most important, EVA initiates an internal system of corporate governance that motivates all managers and employees to work cooperatively and enthusiastically to achieve the very best performance possible. At heart, EVA isn't about finance or economics, it is about people. EVA is a means to unlock the potential for achievement that exists throughout every organisation. It is a management system that makes employees accountable for performance and properly rewards them for success.

Many employees in an enterprise are gifted with great ingenuity and an intense desire to succeed. The question is how to harness that ingenuity and desire and direct it in ways that maximise the success of both the individual and the enterprise. The answer lies in human nature: people do what you reward them for doing. If you link incentives with higher operating margins, you will get higher operating margins, even if it means sales fall off a cliff. Pay for sales increase, and you'll get more sales; pay for market share, and you'll get market share, but your profits may go out of the window. Thus, if you pay people for generating more EVA you will get it and with it, a higher share price and greater shareholder wealth. You also will get a more successful organisation that provides greater non-monetary satisfaction as well.

How is the EVA-linked incentive plan different from conventional incentives such as performance bonus?

The normal incentive compensation system in use today actually is a disincentive system. If you properly analyse the way incentives affect behaviour, you will find that the typical bonus scheme places far too much emphasis on the short term.

It provides little or no motivation for superior performance, causes managers to be excessively conservative, and encourages them to sit on their hands in boom times and bad times. In short, most incentive schemes drive companies to under-perform their potential.

Our EVA-linked incentive plan is radically different. It makes employees think like and act like owners by paying them like owners. We do that by calculating cash bonuses as a fixed percentage of increases in EVA. In other words, we give managers a piece of the EVA action keeping the rest in a ''bonus bank''. The scheme is called ''bonus at risk''. The bonus bank also guards against the temptation to gain by sacrificing the future for short-term benefits. It also gives managers a reason to work long hours to minimize the carnage in a business downturn. Having money at risk in the bonus bank is what turns managers into genuine owners and causes them to lengthen their horizons, constantly seeking out new sources of sustainable, long-term improvement. Managers with conventional incentive schemes typically try to negotiate modest, easily achievable profit plans in order to be sure of collecting their bonuses.

Typically, conventional schemes have a limit on payouts. Is there any such limit for EVA-linked bonuses?

No, that is the beauty of EVA bonus plans, there are no caps-neither upward nor downward. The more EVA increases, the bigger is the bonus, it is without limits. We are able to do away with upper limits because we only pay for sustainable increases in EVA. A portion of any exceptional bonus award goes into a ''bonus bank'' for payment in future years, and is forfeited if the EVA subsequently falls. So, if the EVA goes down, employees too take a hit. This also helps in aligning employees' interest with that of stakeholders' who will also be hit if share prices go down. Doing away with the conventional bonus cap gives a manager a strong incentive to continue striving for better and better performance even in boom years.

Does that mean EVA is a self-propelling tool?

Yes, and much more. The EVA financial management system shows managers which decisions will increase economic profits and generate the most wealth for shareholders. The bonus system acts as the owner's control mechanism by ensuring that it is in the manager's self-interest to pursue the shareholder's interest. At the same time, the bonus system puts the manager's wealth at risk and penalises him or her for failing to produce a minimum required rate of return. In essence, this is pay for results, not pay for performance.

Does the EVA-linked incentive scheme help in a recession when companies suffer for reasons beyond their control?

A company under EVA programme will certainly be better off in relative terms when the economy slows down. This is because of two things that happen. Number one, under the EVA programme, cost containment will already be an active management policy not only for the management but also for all the employees who are under the programme. So the company is already geared to reduce cost. The second thing is that a profit-sharing plan that goes down through all the employees make them give their best.

Will it work in public sector enterprises?

Oh yes, absolutely. I put EVA in place in the United States Postal Services, which is one of the most unionised organisations in the US. It was losing $2.5 billion every year, and three years after our EVA programme it started making profits of more than $1 billion a year. This proves that employees respond well if they are given the same type of incentives that works with people in the management.

You have also said that EVA-linked incentive is better than employee stock option schemes (ESOPs). Can you explain why?

ESOP is not a good incentive idea because except for corporate leaders, most managers have little influence on the stock prices. Besides, most people do not have any idea what drives stock prices. In the US, for three years in a row, stock prices went up at 33 per cent each year while going by the performance it should have gone up only 10 per cent. The whole idea of an EVA-linked incentive is to reward people based on actual performance and not for unusual booms in share price not linked to performance.

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