By Karen E. Klein Q: My company sells safety-training videos to corporations. Our annual sales were $5.5 million throughout the late 1990s and have been about $2.5 million since 2001. I want to give bonuses to two vice-presidents after I get a certain return on equity, but I'm not sure how to structure the bonus plan. My balance sheet shows $600,000 in liquid equity, and I'd like to include at least $500,000 to $1 million extra in "goodwill." What percent return on equity should I reach before paying bonuses to my managers?
-- B.S., Durham, N.C.
A: Basing executive bonuses on return on equity (ROE) can prove surprisingly tricky, compensation experts say. First, determining industry averages can present a challenge. Obtaining the data will likely cost you money and research time. Also, your business could be overcapitalized or undercapitalized for its revenue size, which would mean that the ROE figure might inaccurately reflect your company's health. Another problem: You might achieve ROE in a given year but not experience profit growth -- which would mean a poor performance.
The other problem, which you've already discovered, is determining what the equity represents on your balance sheet. "I recommend against an arbitrary assignment of goodwill value, since it may be perceived as unfair by the bonus-plan participants," says Mae Lon Ding, president of Personnel Systems Associates in Anaheim Hills, Calif. "This has the possibility of demotivating the participants instead of motivating them."
RELEVANT AND STRAIGHTFORWARD. Companies generally base incentive compensation upon reaching industry average or turning in better performance. Where you set the goal depends on what qualifies as a reasonable stretch for your particular business situation.
If you really want to use ROE as your benchmark, you can determine prior-year industry averages and 75th-percentile return on equity via business research groups like Robert Morris Associates. "Their reports can be purchased for less than $100 via the Internet," Ding says. "There are many other sources of data depending on the industry."
You will encounter many different views regarding how to set an ROE threshold. It's often set at the "risk-free" rate of return, says Martin Kenny, managing director of Baker, Thomsen Associates, a compensation and benefits consulting firm based in Newport Beach, Calif. "The concept is that the owners should receive at least as much as if they had put their money in a CD -- currently perhaps 5% of the owners' equity -- before the executives receive bonuses above base salary."
If you choose to set your performance targets using a different parameter, you might rely simply on profit, suggests Theo Sharp, managing director of Pearl Meyer & Partners, a compensation consultancy based in Marlborough, Mass. "Profit is typically the most relevant financial consideration for small private companies," Sharp notes. Another plus: It's typically a straightforward measurement easily understood by employees.
REWARDING HOME RUNS. To use profit as a target measurement, set a reasonable level of profit that you would think makes a good year for your company. Next, determine an acceptable bonus amount for the vice-presidents in such a year -- perhaps 15% to 20% of base salary, Sharp says. If you attain that profit level, you can pay executives the bonuses and give the shareholders their required "good year" profit. Remember that the profit target must take the bonus payout into consideration!
"If you want to get more sophisticated, you can also calculate what you'd consider a minimum level of profit vs. "home-run" profit," Sharp says. "At the minimum profit level, pay a smaller bonus, such as half what you would pay in a good year, and in a home-run year, pay above and beyond the target -- say 150% of the good-year bonus."
Make sure that the minimum level of profit doesn't dip too far below the good-year figure and that the home-run level represents a stretch, but a reachable one. "We often see 90% of good year as the minimum, and 110% as the home-run figure," he says.
ASK A PROFESSIONAL. Whatever benchmark you decide to use, make sure that the aggressiveness of the performance objectives and the size of the bonuses balance out. "Modest goals deserve modest bonuses. Aggressive goals deserve higher bonuses," Ding cautions. Bonus plans also work best when the owners set targets in advance, the goals quantify key end-results under the executives' control, and an explicit link exists between performance and bonuses, Kenny adds.
You may also want to seek professional assistance in setting up your bonus plan, because a poorly designed one may prove inefficient and counterproductive -- or lead to inappropriately high or low payouts. You can find additional information, surveys, and tips at the Web site of Personnel Systems, and search for a consultant in your area at the Web site of WorldatWork (formerly the American Compensation Assn.).
Putting some effort into designing a fair and appealing bonus plan now will likely pay off handsomely in the long run.
Have a question about your business? Ask our small-business experts. Send us an e-mail at Smart Answers, or write to Smart Answers, BW Online, 45th Floor, 1221 Avenue of the Americas, New York, N.Y. 10020. Please include your real name and phone number in case we need more information; only your initials and city will be printed. Because of the volume of mail, we won't be able to respond to all questions personally. Klein is a Los Angeles-based writer who covers entrepreneurship and small-business issues