Mar 13th, 2007 by Martin Lee
Compensation For Managers
Today’s post is about Warren Buffett’s views on how managers should be compensated.
First of all, their compensation should be tied only to the results of the operation they are in charge of and control. For example, it makes no sense to tie the compensation of Ralph Schey (who runs Cott Fetzer) to the results of Berkshire.
Secondly, if capital invested in an operation is high, managers are charged a high rate for incremental capital that they use. Conversely, they are credited with an equally high rate for capital that they release.
A meaningful hurdle rate on the earnings of additional capital employed is also set and compensation increases when the target is met. The calculation is symmetrical and if incremental investment yields are sub-standard, it will be costly to the manager.
Using this arrangement, managers have an incentive to send back to Berkshire any cash that they can’t employ advantageously.
The use of stock options does not really align management’s interests with that of shareholders. Rather, it is like a “Heads I win, tails you lose” situation.
Furthermore, the exercise price of the option does not increase to take into account the fact that retained earnings are building up in the company. Even if a manager adds absolutely no value to a company, a policy of low dividend payouts and compound interest will ensure that earnings (and subsequently share prices) increase.
You can even say that by withholding cash to the shareholders, the profit to the option-holding manager increases.
In all cases, Warren Buffett works out the compensation of his managers in a rational and simple way. There is no need of consultants or lawyers to work out complicated compensation plans. The compensation arrangement with Ralph Schey was worked out in about five minutes, and has never changed.