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Bonuses or Shareholder Distribution — Which Should Take Priority?

Occupy Wall Street protesters rejoice! The New York Times reported this weekend that 2011’s bonuses for the top investment banks are likely to be down 15-30%. But before you shed a tear for those downtrodden bankers, reflect on the fact that the average total compensation per employee of Wall Street banks such as Goldman Sachs and JP Morgan Chase will still be on the order of $300,000, with bonuses for managing directors typically measured in seven figures.

Unfortunately, even in their best years the typical A/E firm couldn’t even dream of having such a level of discretionary profit to throw around. Median profit margins in this industry (before taxes and discretionary bonuses) tend to range between 8% and 12% of net service revenue. With a relatively modest profit pool to work with, management is often faced with a difficult decision at year end—how to divide up the pool between bonuses and shareholder distributions in a way that keeps everyone happy.

There are two primary questions here:

  1. Should priority be given to incentive bonuses or to shareholder return on investment?
  2. What sort of return on investment should an owner in an A/E firm expect?

Where should the priority be?
I’ve heard many managers, consultants and advisors suggest that incentive bonuses always be given priority over shareholder distributions. The frequent refrain goes something like, “You’ve got to reward your top performers with sufficient bonuses to continue to motivate and retain them.” There are a number of problems with this philosophy. To begin with, your top performers—the people that create real value in your organization, should be the owners. If you have good alignment between the ownership of your company and the people that create value for the company, then the question of how to prioritize profit distribution is moot. If this is NOT the case in your firm, aligning ownership with the top talent and leadership should be your first task.

Secondly, there is the matter of ownership transition planning. A frequent challenge for A/E firms is how to encourage investment by prospective owners, or further investment by younger existing owners. In order for retiring owners to be able sell their shares, the younger generation must have a healthy appetite for the company’s stock. The best stimulant for this sort of appetite is a strong return on investment. However, if profits are directed first to incentive bonuses, with whatever’s left over (if anything) going to the shareholders, you’ll never be able to provide a sufficient return on investment.

I’d also offer this observation. In companies I’ve worked for and in many client firms, I’ve seen highly valued employees resign days after receiving hefty incentive bonuses. So be careful not to assign too much value to such bonuses as a key employee retention tool.

What sort of return should an owner expect?
If we can agree that priority should be given to shareholder return on investment, then the next question becomes what that return should be. Return on investment is defined as the total amount that an investment appreciates over a period of time (e.g., a year) plus any distribution paid to the shareholders over that time, divided by the value of the investment at the start of the period. Take the example of a firm with a stock value of $10 million at year-end 2010. If the firm’s value at year-end 2011 increases to $11 million, and over the year it pays distributions to its shareholders totaling $800,000, then the shareholders return on investment would equal 18%.

Stock Appreciation: $11,000,000 – $10,000,000 = $1,000,000
Shareholder Distribution: $800,000
Total Return: $1,800,000 / $10,000,000 = 18%

The first element of the return on investment, the stock price appreciation, will be determined based on the method you use to value your stock and the firm’s performance over the year. It’s the second element, shareholder distribution, which falls to the discretion of management.

I would argue that there should be a minimum targeted return on investment, but not necessarily a ceiling. The firm’s owners have invested real money; they risk the potential loss of their capital, and sometimes they even guarantee the firm’s debt. With the potential downside risks that the owners are subject to, they deserve to enjoy the upside when the firm does well.

Various models exist for estimating required rates of return for equity investors. These include the capital asset pricing model (CAPM), Ibbotson build-up method, and other models that look to public market pricing of stocks relative to the current interest rate environment. These models typically point to a required rate of return in the 17% to 25% range. Adjusting for the lack of marketability of privately held stock (because the above models are based on data from publicly traded firms) this range increases to 22% to 32%.

For that reason we advise clients that their target return on investment should be somewhere around 30%. You may not achieve this target every year, but you might also exceed it some years. In the example above, the firm’s distribution would need to be $2 million rather than $800,000 in order to provide a 30% return to its shareholders.

Sharing the wealth
Of course management will always need to exercise a healthy degree of discretion when it comes to profit distribution, and the thinner the profit pool, the tougher the decisions will be. Profit sharing and incentive bonuses still have their place, and owners should be willing to share the wealth. Just remember that the long-term viability of your firm requires having good people that are truly vested in its success. These are (or should be) your owners and providing them with a strong return on investment is priority number one.