The Dutch East India Co. chartered in 1602, a steel engraving by Cool and Rennefeld, Leiden, c. 1880 (Source: Wikimedia Commons)
Ideas for Leaders #562

Why Equity-Based Incentives Work Below the C-Suite

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Key Concept

Many companies fear offering equity-based incentives for business unit managers. They believe that compensating business-unit managers based on corporate-wide results will hurt local business unit results. New research shows these fears to be unfounded, and that the right balance of equity-based and profit-based incentives increase results at both the corporate level and the business unit level and increase cross-business-unit collaboration.

Idea Summary

Equity-based incentives, such as restricted stock grants or options, are common for C-suite corporate executives. This is not surprising as they have corporate-level responsibilities. For business-unit managers in decentralized corporations, however, the practice has been less common. The preference in the past was for business unit-level incentives — that is, compensation tied to business unit-level results. This ensured that business unit managers stayed focused on local results. Equity-based incentives (based on the valuation of the entire company) and company-level profit-based incentives were to be avoided.

Two Canadian-based researchers, however, have developed a theoretical model that reveals the fallacy of this conclusion. Through their model, the researchers show that a balance of equity-based incentives, corporate-wide profit-based incentives, and business unit-level profit-based incentives yield better results at both the corporate level and the business-unit level.

This is particularly true in a corporation in which there is related diversification — in other words, a corporation in which the activities of the business units are related and thus cross-business-unit collaboration is more important to the success of the entire company. In corporations that follow a strategy of unrelated diversification, the benefits of offering equity-based incentives is less effective: a corporation in which the various business units have little to do with each other is better served by keeping the focus of the business unit manager squarely on the business unit.

In addition to proving the effectiveness of equity-based incentives in firms built on related diversification, the theoretical model also indicates that such incentives are more effective in bull markets, and in companies that benefit from less stock market volatility. Equity-based incentives are, intuitively, less effective if the valuation of the firm is uncertain.

Another interesting insight from the model is the power of equity-based incentives for new economy firms. New economy firms are characterized by uncertain current profits but potential long-term growth (think Amazon). Under these circumstances, equity-based incentives are more effective than profit-based incentives.

Business Application

Research into the effectiveness of diversification as a strategy is mixed. For some academic researchers, diversification increases results; others have shown that diversification can lead to decreased performance.

The lesson of this research is that the problem may not be with the strategy, but with the implementation of the strategy, specifically the lack of collaboration among business units. Cross-business-unit collaboration is key to reaping the synergies or economies of scope that are the core justification for diversification strategies.

Equity-based incentives, according to the research model, appear to be more effective than profit-based incentives in increasing the business unit manager’s efforts (as measured, for example, in productivity and growth) at both the business-unit level and the company level (through collaboration).

Some companies may need to overcome the assumption that equity-based incentives are for C-suite executives only. Another barrier is the fear that corporate-wide incentives will draw the attention of business unit managers away from their business units. This research proves otherwise.

When collaboration is an important element of a decentralized company’s success, equity-based incentives can align a business unit manager’s efforts with the success factors of the entire company. Such incentives can even be applied selectively — for example, linked to activities, such as R&D, that specifically require cross-business-unit collaboration.

Equity-based incentives for managers below the C-suite are on the rise — and for good reason.

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Authors

Institutions

Source

Idea conceived

  • June 2015

Idea posted

  • October 2015

DOI number

10.13007/562

Subject

Real Time Analytics