A Model for Focusing Executives on Long-term Value Creation

October 28, 2011 Editor 0

This blog post is part of the HBR Online Forum The CEO’s Role in Fixing the System.

We believe that capitalism will not survive if it continues its trend towards the redistribution of wealth and away from creation of wealth. To reverse this trend, executive compensation plans have to be designed. The Wine Group’s plan can serve as a model for how to do that.

For several decades there has been an ongoing debate about how to get executives to focus on the long-term creation of value. Unfortunately, what has happened is perverse. The combination of stock options and ever-shortening “ownership” tenures has been toxic.

Options, as generally practiced, are problematic for two reasons: Their value increases with volatility, and they only reward value at a particular moment in time. Short-term holders of equity securities are simply expressing an opinion on the short-term price movement of the security. They are not owners and they merely redistribute wealth rather than create it as responsible competent owners do over the long term.

In contrast, the Wine Group has created an ownership/incentive system that fully supports long-term value creation. Its program is grounded in two simple but powerful tenets:

1. Monetizing what executives earn as active managers is dependent on the performance of their successors
2. Success must be measured over an appropriately long time frame

Origin of the Wine Group’s Plan

The Wine Group was founded in a management buyout in 1981. Today it remains independent, owned solely by current and former managers and directors. Since implementing its long-term ownership/incentive plan 20 years ago, its market share has tripled and the company is now the second-largest wine producer and the owner of the No. 1 wine brand by volume (Franzia). Revenue and earnings grew at over 12% CAGR over the last decade — accelerating though the recession. The Wine Group is now in the process of transitioning from its third generation of management to its fourth generation.

In its early days, the company’s founding partners defined objectives that came to be known as “the Recitals” for their position on the first page of the partnership agreement. The aim of the Recitals was to capture the core values of the founding partners and to describe a set of desired outcomes, related verbatim below:

1. To maintain an independent management owned private company that will prosper and remain competitively vibrant in the wine business;

2. To ensure that the Company remains in a healthy financial condition with a view to continued enhancement of the long-term value of the Company;

3. To motivate the owners to manage the business as stewards of the assets of the Company, not only on behalf of current owners, but also on behalf of future owners and other stakeholders in the Company;

4. To ensure that the current management aggressively develops successor management which is both skilled and committed to the objectives and principles embodied in these Recitals;

5. To provide appropriate mechanisms which will enable successor generations of management to become owners of the Company; and

6. Consistent with and promoting the objectives and principles stated above, to provide appropriate mechanisms for owners of long standing to redeem their interests in the Company.

The Recitals have remained unchanged over the years.

To create an executive-compensation program that supported the Recitals, the partners first had to develop an appropriate long-term value-measurement system. Measurement of the company’s valuation is based on a seven-year moving average. (Individual years are valued by using an EBIT multiple and then adding cash and subtracting debt.) Measuring worth over a seven year period accomplishes a number of things:

• Discourages taking long-term risks for short-term gain
• Makes it impossible to “kick the can down the road” — problems get dealt with quickly
• Largely removes the effect of industry cycles from company valuation
• Supports a focus on long-term value creation

The equity cycle from first grant to last cash for senior manager owners is a minimum of 20 years; in practice it is generally 25 years. The essence of the program is 10 years of earning value through participation in the increase of the seven-year average value of the company. After 10 years an owner can convert (generally at a rate of 10% per year over 10 years) his or her interests to a fixed-return security that is redeemed over five years. This lengthy period not only reinforces the effects cited above but also serves to ensure that:

• Management depth and talent is a relentless focus
• Organizational politics are not rewarded
• “Get rich quick” types self-select out
• Culture, values, and the Recitals are reinforced.

The Wine Group demonstrates that it is possible to structure a set of values and incentives that reward long-term sustainable value creation. While the Wine Group is a private firm, we believe that there are a number of steps that public companies can take to create a similar set of incentives. They include incremental rather than block option grants, minimum hold periods after exercise, and share disposition restrictions. Measurement periods should be appropriate for the company — there is nothing magic about 365 days.

For capitalism to survive we need corporate leaders at all levels to be focused on creating real long-term sustainable value, political leaders with the courage to work to create a tax and regulatory environment supportive of value creation, and the best and the brightest to return to the business of creating rather than redistributing wealth.

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Categories: Innovation

Tags: capitalism, executive, focus, long term, model, trend