Few Thoughts About Incentive Compensation
When I was 12, I lived with my grandfather for about four
months. A grocer by trade, he was also working on a book and
each night he dictated a few pages to me. The title - brace
yourself - was “How to Run a Grocery Store and a Few Things I
Have Learned About Fishing”. My grandfather was sure that
interest in these two subjects was universal and that the world
awaited his views. You may conclude from this section’s title
and contents that I was overexposed to Grandpa’s literary style
(and personality).
I am merging the discussion of Nebraska Furniture Mart,
See’s Candy Shops, and Buffalo Evening News here because the
economic strengths, weaknesses, and prospects of these businesses
have changed little since I reported to you a year ago. The
shortness of this discussion, however, is in no way meant to
minimize the importance of these businesses to us: in 1985 they
earned an aggregate of $72 million pre-tax. Fifteen years ago,
before we had acquired any of them, their aggregate earnings were
about $8 million pre-tax.
While an increase in earnings from $8 million to $72 million
sounds terrific - and usually is - you should not automatically
assume that to be the case. You must first make sure that
earnings were not severely depressed in the base year. If they
were instead substantial in relation to capital employed, an even
more important point must be examined: how much additional
capital was required to produce the additional earnings?
In both respects, our group of three scores well. First,
earnings 15 years ago were excellent compared to capital then
employed in the businesses. Second, although annual earnings are
now $64 million greater, the businesses require only about $40
million more in invested capital to operate than was the case
then.
The dramatic growth in earning power of these three
businesses, accompanied by their need for only minor amounts of
capital, illustrates very well the power of economic goodwill
during an inflationary period (a phenomenon explained in detail
in the 1983 annual report). The financial characteristics of
these businesses have allowed us to use a very large portion of
the earnings they generate elsewhere. Corporate America,
however, has had a different experience: in order to increase
earnings significantly, most companies have needed to increase
capital significantly also. The average American business has
required about $5 of additional capital to generate an additional
$1 of annual pre-tax earnings. That business, therefore, would
have required over $300 million in additional capital from its
owners in order to achieve an earnings performance equal to our
group of three.
When returns on capital are ordinary, an earn-more-by-
putting-up-more record is no great managerial achievement. You
can get the same result personally while operating from your
rocking chair. just quadruple the capital you commit to a savings
account and you will quadruple your earnings. You would hardly
expect hosannas for that particular accomplishment. Yet,
retirement announcements regularly sing the praises of CEOs who
have, say, quadrupled earnings of their widget company during
their reign - with no one examining whether this gain was
attributable simply to many years of retained earnings and the
workings of compound interest.
If the widget company consistently earned a superior return
on capital throughout the period, or if capital employed only
doubled during the CEO’s reign, the praise for him may be well
deserved. But if return on capital was lackluster and capital
employed increased in pace with earnings, applause should be
withheld. A savings account in which interest was reinvested
would achieve the same year-by-year increase in earnings - and,
at only 8% interest, would quadruple its annual earnings in 18
years.
The power of this simple math is often ignored by companies
to the detriment of their shareholders. Many corporate
compensation plans reward managers handsomely for earnings
increases produced solely, or in large part, by retained earnings
- i.e., earnings withheld from owners. For example, ten-year,
fixed-price stock options are granted routinely, often by
companies whose dividends are only a small percentage of
earnings.
An example will illustrate the inequities possible under
such circumstances. Let’s suppose that you had a $100,000
savings account earning 8% interest and “managed” by a trustee
who could decide each year what portion of the interest you were
to be paid in cash. Interest not paid out would be “retained
earnings” added to the savings account to compound. And let’s
suppose that your trustee, in his superior wisdom, set the “pay-
out ratio” at one-quarter of the annual earnings.
Under these assumptions, your account would be worth
$179,084 at the end of ten years. Additionally, your annual
earnings would have increased about 70% from $8,000 to $13,515
under this inspired management. And, finally, your “dividends”
would have increased commensurately, rising regularly from $2,000
in the first year to $3,378 in the tenth year. Each year, when
your manager’s public relations firm prepared his annual report
to you, all of the charts would have had lines marching skyward.
Now, just for fun, let’s push our scenario one notch further
and give your trustee-manager a ten-year fixed-price option on
part of your “business” (i.e., your savings account) based on its
fair value in the first year. With such an option, your manager
would reap a substantial profit at your expense - just from
having held on to most of your earnings. If he were both
Machiavellian and a bit of a mathematician, your manager might
also have cut the pay-out ratio once he was firmly entrenched.
This scenario is not as farfetched as you might think. Many
stock options in the corporate world have worked in exactly that
fashion: they have gained in value simply because management
retained earnings, not because it did well with the capital in
its hands.
Managers actually apply a double standard to options.
Leaving aside warrants (which deliver the issuing corporation
immediate and substantial compensation), I believe it is fair to
say that nowhere in the business world are ten-year fixed-price
options on all or a portion of a business granted to outsiders.
Ten months, in fact, would be regarded as extreme. It would be
particularly unthinkable for managers to grant a long-term option
on a business that was regularly adding to its capital. Any
outsider wanting to secure such an option would be required to
pay fully for capital added during the option period.
The unwillingness of managers to do-unto-outsiders, however,
is not matched by an unwillingness to do-unto-themselves.
(Negotiating with one’s self seldom produces a barroom brawl.)
Managers regularly engineer ten-year, fixed-price options for
themselves and associates that, first, totally ignore the fact
that retained earnings automatically build value and, second,
ignore the carrying cost of capital. As a result, these managers
end up profiting much as they would have had they had an option
on that savings account that was automatically building up in
value.
Of course, stock options often go to talented, value-adding
managers and sometimes deliver them rewards that are perfectly
appropriate. (Indeed, managers who are really exceptional almost
always get far less than they should.) But when the result is
equitable, it is accidental. Once granted, the option is blind
to individual performance. Because it is irrevocable and
unconditional (so long as a manager stays in the company), the
sluggard receives rewards from his options precisely as does the
star. A managerial Rip Van Winkle, ready to doze for ten years,
could not wish for a better “incentive” system.
(I can’t resist commenting on one long-term option given an
“outsider”: that granted the U.S. Government on Chrysler shares
as partial consideration for the government’s guarantee of some
lifesaving loans. When these options worked out well for the
government, Chrysler sought to modify the payoff, arguing that
the rewards to the government were both far greater than intended
and outsize in relation to its contribution to Chrysler’s
recovery. The company’s anguish over what it saw as an imbalance
between payoff and performance made national news. That anguish
may well be unique: to my knowledge, no managers - anywhere -
have been similarly offended by unwarranted payoffs arising from
options granted to themselves or their colleagues.)
Ironically, the rhetoric about options frequently describes
them as desirable because they put managers and owners in the
same financial boat. In reality, the boats are far different.
No owner has ever escaped the burden of capital costs, whereas a
holder of a fixed-price option bears no capital costs at all. An
owner must weigh upside potential against downside risk; an
option holder has no downside. In fact, the business project in
which you would wish to have an option frequently is a project in
which you would reject ownership. (I’ll be happy to accept a
lottery ticket as a gift - but I’ll never buy one.)
In dividend policy also, the option holders’ interests are
best served by a policy that may ill serve the owner. Think back
to the savings account example. The trustee, holding his option,
would benefit from a no-dividend policy. Conversely, the owner
of the account should lean to a total payout so that he can
prevent the option-holding manager from sharing in the account’s
retained earnings.
Despite their shortcomings, options can be appropriate under
some circumstances. My criticism relates to their indiscriminate
use and, in that connection, I would like to emphasize three
points:
First, stock options are inevitably tied to the overall
performance of a corporation. Logically, therefore, they should
be awarded only to those managers with overall responsibility.
Managers with limited areas of responsibility should have
incentives that pay off in relation to results under their
control. The .350 hitter expects, and also deserves, a big
payoff for his performance - even if he plays for a cellar-
dwelling team. And the .150 hitter should get no reward - even
if he plays for a pennant winner. Only those with overall
responsibility for the team should have their rewards tied to its
results.
Second, options should be structured carefully. Absent
special factors, they should have built into them a retained-
earnings or carrying-cost factor. Equally important, they should
be priced realistically. When managers are faced with offers for
their companies, they unfailingly point out how unrealistic
market prices can be as an index of real value. But why, then,
should these same depressed prices be the valuations at which
managers sell portions of their businesses to themselves? (They
may go further: officers and directors sometimes consult the Tax
Code to determine the lowest prices at which they can, in effect,
sell part of the business to insiders. While they’re at it, they
often elect plans that produce the worst tax result for the
company.) Except in highly unusual cases, owners are not well
served by the sale of part of their business at a bargain price -
whether the sale is to outsiders or to insiders. The obvious
conclusion: options should be priced at true business value.
Third, I want to emphasize that some managers whom I admire
enormously - and whose operating records are far better than mine
- disagree with me regarding fixed-price options. They have
built corporate cultures that work, and fixed-price options have
been a tool that helped them. By their leadership and example,
and by the use of options as incentives, these managers have
taught their colleagues to think like owners. Such a Culture is
rare and when it exists should perhaps be left intact - despite
inefficiencies and inequities that may infest the option program.
“If it ain’t broke, don’t fix it” is preferable to “purity at any
price”.
At Berkshire, however, we use an incentive@compensation
system that rewards key managers for meeting targets in their own
bailiwicks. If See’s does well, that does not produce incentive
compensation at the News - nor vice versa. Neither do we look at
the price of Berkshire stock when we write bonus checks. We
believe good unit performance should be rewarded whether
Berkshire stock rises, falls, or stays even. Similarly, we think
average performance should earn no special rewards even if our
stock should soar. “Performance”, furthermore, is defined in
different ways depending upon the underlying economics of the
business: in some our managers enjoy tailwinds not of their own
making, in others they fight unavoidable headwinds.
The rewards that go with this system can be large. At our
various business units, top managers sometimes receive incentive
bonuses of five times their base salary, or more, and it would
appear possible that one manager’s bonus could top $2 million in
1986. (I hope so.) We do not put a cap on bonuses, and the
potential for rewards is not hierarchical. The manager of a
relatively small unit can earn far more than the manager of a
larger unit if results indicate he should. We believe, further,
that such factors as seniority and age should not affect
incentive compensation (though they sometimes influence basic
compensation). A 20-year-old who can hit .300 is as valuable to
us as a 40-year-old performing as well.
Obviously, all Berkshire managers can use their bonus money
(or other funds, including borrowed money) to buy our stock in
the market. Many have done just that - and some now have large
holdings. By accepting both the risks and the carrying costs
that go with outright purchases, these managers truly walk in the
shoes of owners.
