One way to build value in your firm, a la executive compensation.

With the takeover market in temporary suspension, executives should seize the opportunity to reevaluate their organizations with the eyes of a raider and consider new value-budding techniques that will fend off future attacks. The best way to maximize shareholder returns is to "incentivize" management to make decisions that increase long-term value. Your first task, then, is to transform antiquated cash bonus or stock option arrangements into plans with incentives directly tied to proxies that create intrinsic share value.

Traditionally, the majority of an executive's total compensation is granted in salary, which is essentially a senior liability of the company. In a salary-based compensation structure, management in effect becomes quasi-creditors. Hence, it is not surprising that management's interests are much more closely aligned with the interests of the firm's senior creditors than with the interests of the residual equity holders. As quasi-creditors, management will rationally seek strategies-such as growth through diversification-that reduce risk for management. Somewhat riskier strategies and new products that can create value take a back seat.

Although bonus payments and stock options may appear to tie pay to performance by rewarding management for entrepreneurial action, they do not succeed in maximizing shareholder value. These performance incentive plans fail to impose a significant downside risk for poor performance. The executive can win, but not lose. And cash bonuses are usually too diminutive compared to relative salary to be effective, while stock options, which tend to be granted far too liberally, needlessly dilute shareholder claims. As a result, both cash bonuses and stock options encourage a very short-term perspective on corporate performance, while compromising a longer-term perspective on shareholder value.

The problems with cash bonuses and stock options can be easily overcome through new techniques that force management to focus on the principal determinants of shareholder value. The core principle behind these techniques is motivating managers to look beyond the short-term measures of "economic" performance by, essentially, turning management into owners. The most effective way of doing this is to devise compelling management incentives that closely replicate the equity interest received by operating managements in a standard LBO arrangement. In essence, that means performing what, on paper, appears to be a leveraged buyout but, in reality, has no recourse to the corporation.

Under this faux LBO scheme, key managers will be transformed into significant owners of the business units in which they work.

Rather, the power of entrepreneurial motivation will cause managers, as substantial shareholders, to make decisions in favor of maximizing shareholder value.

Nothing but the facts

Incentivizing management to increase shareholder value means nothing to management unless the executives understand how value is created. Shareholder value depends largely on two basic factors: (1) the rate of return earned on total investor capital relative to the required rate of return, known as the "cost of capital," and (2) the amount of investor capital tied up in the business.

Shareholder value is created only when the rate of return on capital (r) exceeds the cost of that capital (c). The precise amount of value added is equal to the amount of total capital invested (TC) multiplied by the difference between r and c. In essence, this is best described as "residual income"-the only internal measure of corporate performance to tie directly to value. We like to refer to it as economic value added (EVA).

Guided by EVA, operating managers have three important objectives that are not fully emphasized in most other performance measures. They are:

* To improve operating profits without tying up more capital;

* To ensure that additional profits earned by investing capital cover the charge for the additional capital;

* To pay down credit only when the earnings lost are more than offset by a savings on the capital charges. Perhaps the most important implication of EVA, however, is that corporate growth creates value for shareholders only if the return on capital exceeds the cost of the capital. If the return is less than the cost, then EVA is negative and becomes progressively more negative with each additional dollar invested. Hence, companies that demonstrate steady growth rates in EPS may actually be destroying shareholder value year after year as EVA becomes progressively negative. In cases such as these, the stock is likely to sell at a deep discount to the firm's potential value (often referred to by raiders as its "breakup value").

The essence of EVA bonuses is to pay management a percentage of both the total EVA and the change in EVA. Thus, even if EVA is negative, value is created by making the EVA less negative and management is rewarded for the improvement. However, only a portion of the EVA bonus is paid in the year it is earned. We prefer a three-year payout in equal installments, with the remaining two years' amount deferred in a bonus bank that is at risk, since it is subject to negative charges in future years if performance is inadequate.

How the new strategy works

Applied Power, a $420-million manufacturer of hydraulic equipment based in Butler, Wisconsin, used EVA as the foundation of its planning and incentive compensation system. The company, led by Chairman and CEO Richard Sim, doubled its net operating profit after taxes between 1987 and 1988 through EVA-based incentive plans. Sim wrote in his company's 1988 annual report: "While the Company recognizes that earnings per share is a widely used financial performance measure in the United States, we believe measures that compare cash and cash equivalent returns on operating capital to the minimum return expected by both equity and debt investors more effectively help management guide the performance of the Company. We use a concept . called Economic Value Added (EVA) for a multitude of analyses .... to measure our annual operating performance, to evaluate annual business plans, to create measures for management incentive bonuses, and to judge the merits of major capital investments."

Applied Power's common stock performance has closely tracked the improvement in the company's EVA. From August 6, 1987, when the company first went public, through October 13, 1989, Applied Power provided a 56.9 percent compound average annual return for investors (dividends and price appreciation) versus only 6.6 percent for the S&P 500.

Stock options based on EVA

One popular practice of boards of directors seems to be to grant new options typically with lower strike prices) when existing options expire unexercised. The problem with this practice, as mentioned earlier, is that nothing is really at stake. A new type of plan-one that simulates a manager's paid-for equity stake in an LBO-gives management a leveraged equity stake (say, a 9 to 1) without subjecting the firm to the debt burden of an LBO. We call this stock option plan a leveraged equity purchase plan (LEPP).

In order to ensure that management is earning an adequate return for shareholders, the exercise price on the options is increased annually at the required rate of return (or the cost of capital). Assuming the company's required return was 10 percent, the exercise price at the end of the first year of the program for an option bought for $2 on a $20 stock price, with a strike price of $18, would increase by 10 percent from, say, $18.00 to $19.80, and to $21.78 by the end of year two, and so forth. (The exercise price would also be adjusted downward for the amount of any dividends paid.)

You can adjust for economic forces beyond your control by moving the exercise price upward or downward for general price movements in the stock market. The life of the options could also be extended in the event of a clearly adverse business climate, which will help keep key executives on board through rough times. A company should also restrict management's ability to sell the stock acquired from exercising the options for, say, five years-another stratagem that emphasizes the company's long-term commitment to increasing shareholder value.

Clearly, the LEPP imposes considerably more risk than the traditional stock option plan. Executives would be understandably concerned that their share price might not increase and their "at risk" dollars would be lost. But purchasing options is a clear sign of confidence in the future performance of the company and would certainly prove to be a strong catalyst to increase the share price.

Further, LEPPs achieve two very important goals. First, the leveraged equity purchase plan creates demanding incentives that realign management's interests with shareholders' interests rather than creditors' interest. Because the exercise price increases at the cost of capital each year, management is rewarded only for value that grows at a rate faster than the required rate of return. Second, the LEPP is one of the only ways to get a substantial portion of equity into the hands of management without diluting the interests of shareholders. Combined, these factors create a direct and visible payoff for generating superior performance.

Michael Dingman, CEO of the Henley Group, a $1.06-billion manufacturer and distributor of medical and laboratory products, was one of the first CEOs to implement the LEPP form of plan. Mr. Dingman announced the plan in 1986, soon after he purchased a collection of 35 businesses that had been spun off by Allied-Signal. Under the Henley LEPP, management actively used $11 million of its own capital (along with $97 million in non-recourse notes from the company) to buy 10 percent of the company's stock (such a leveraged stock holding is equivalent to a holding of stock options). Following the LEPP distribution, the shares of the Henley Group rose by nearly 10 percent.

In summary, leverage plans can be effective at both the individual and at the corporate level. But, at the individual level, leverage permits companies to enjoy the motivational benefits of an LBO without compromising corporate growth or financial flexibility. By leveraging incentives, companies develop a closer tie to managers' actual performance and the creation of value. By using incentives proactively to increase value, management can divert pressure from corporate raiders and sidestep the quagmire of dealing with junk bonds.