FOOL ON THE HILL
Compensation Affects Profits

It's critical that companies create and maintain strong corporate cultures, as employee retention rates can directly impact profits. Last week, Whitney Tilson cited a number of examples of how some companies do this by establishing values, trusting employees, giving them responsibility, and so forth. Today, he discusses the importance of compensation in motivating employees.

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By Whitney Tilson
August 28, 2001

In last week's column, I argued that companies can gain a meaningful, lasting competitive edge by developing and nurturing a strong corporate culture. Since then, I've discovered even more data to back up this argument: In Frederick Reichheld's new book, Loyalty Rules!, he shows that 5% swings in employee retention rates result in 25% to 100% swings in earnings -- in both directions. 

Despite the tremendous importance of employee loyalty, most companies don't have it, according to Reichheld's studies. As a result, says Reichheld (as summarized in a recent Business Week article), "U.S. corporations lose half their customers in five years, half their employees in four, and half their investors in less than one."

It's clearly critical that companies create and maintain strong corporate cultures. Last week, I cited a number of examples of how some companies do this by establishing values, trusting employees, giving them responsibility, and so forth. Today I'd like to discuss the importance of compensation in motivating employees. It is far beyond the scope of this column to dive into details -- compensation consulting firms earn millions in fees for developing incentive compensation programs -- but I'd like to share some high-level thoughts and give two examples of companies that have done innovative things in this area.

Show me the money!
At firms with strong corporate cultures, I find that employees care about the company, each other, and customers. They share information and cooperate. They feel good about their jobs and are willing to go the extra mile. I doubt that money, by itself, will motivate such behavior. By the same token, however, a company may find that its employees don't care very much about its success if it doesn't link their financial fortunes to its own. There are two primary ways in which companies achieve this: paying cash or paying equity, the latter in the form of either stock or stock options.

The latter have become increasingly popular in corporate America over the past few years. And no wonder: As Warren Buffett noted in his 1998 annual letter to Berkshire Hathaway (NYSE: BRK.A) shareholders, "existing accounting principles ignore the cost of stock options when earnings are being calculated, even though options are a huge and increasing expense at a great many corporations. In effect, accounting principles offer management a choice: Pay employees in one form and count the cost, or pay them in another form and ignore the cost." 

Though their cost may not be readily apparent, Buffett noted that options can be "inordinately expensive for shareholders" due to the impact of dilution: Technology companies are good examples. 

In addition, I'm not persuaded that stock options are particularly effective in creating the right incentives for employees. (Nor is Buffett, who argued that options are "often wildly capricious in their distribution of rewards [and] inefficient as motivators." Berkshire, notably, issues bonus payments in cash only.) Employees often view options like lottery tickets because there are so many factors outside an employee's -- or even a company's -- control that can affect a company's stock price five years (the typical vesting period for a stock option) hence. 

The employee might do excellent work, but the company could do poorly. Or even if the company did well, the stock might not, due to the vagaries of Wall Street. I believe the best incentive plans pay cash, based on the performance of either the individual or a small group. 

AAON
Let me give an example of a company with a particularly innovative cash bonus program. AAON (Nasdaq: AAON), a company I discussed in the July issue of The Motley Fool Select, specializes in manufacturing commercial rooftop heating, ventilation, and air conditioning units. It's in a mundane industry, but it's a gem of a business, which is why I own the stock. Regarding compensation, AAON's CEO, Norman Asbjornson, told me:

"One of the problems I've seen in big corporations has been a very noticeable difference between hourly and salaried employees. I've worked to break this down in a number of ways. Take our bonus plan, to which we contribute 10% of pretax profits each month. 

"At most companies, this money would be divided among employees based on their pay, so higher-paid management would get more than lower-paid hourly employees. At AAON, in contrast, the pool is divided evenly among all qualifying full-time employees. There is no distinction by hours, work, or salary. I get the same bonus as the lowest-paid employee. No one feels abused.

"The plan has an unusually strong effect on the lowest-paid employees. Last year, the bonus averaged $2/hour. Our starting wage is $8/hour and the average is $10, so $2 is a big number."

With this type of direct incentive system, you won't be surprised to hear that during the three hours I spent at the company, half of it spent walking around the plant, I didn't see a single employee taking a break.

Stock vs. stock options
Just because I favor cash bonus systems doesn't mean I object to companies' efforts to make employees shareholders, such that they not only think and feel like owners, but are owners. In my opinion, however, showering employees with options is the wrong way to do this, for the reasons noted above. Far preferable are systems in which the company buys stock in the open market, expensing this cost as compensation, and awards it to employees -- or, even better, sets up programs through which employees can purchase the stock on their own, perhaps at a slight discount to market value.

AAON, for example, matches the first 3% of employees' contributions to their 401(k) plans with stock purchased on the open market, so shareholders suffer no dilution. In addition, over the past three years, AAON has contributed an average of $3,000 each year of company stock (vesting over five years) to all employees' accounts, even if they made no contributions of their own. (Like the cash bonuses, the amount is the same for every employee). With the stock doing so well over the past few years, this $9,000 stock grant is now worth approximately $20,000. That's the better part of a year's salary for the average employee!

Markel's loan program
I discovered another innovative program to encourage stock ownership at Markel Corp. (NYSE: MKL). First, some background: According to Vice Chairman Steve Markel, the company does not issue stock options, yet nearly all employees are shareholders. As he put it, "A lot of our employees have a lot of skin in the game. [Consequently,] our employees read the annual report, think about it, and correlate our value statement to their work at the company. When we talk about our results, they care and they listen. It feeds on itself."

To build share ownership among employees, Markel, like many companies, matches employees' 401(k) contributions partly with company stock, also allowing employees to purchase stock at a modest discount via a payroll deduction program. What is unusual is a loan program Markel set up with a local bank that allows employees to borrow money to buy stock at a company-subsidized interest rate of only 3%. More than 70% of Markel's North American employees participate in this program, and they have borrowed more than $10 million through it.

Conclusion
I wouldn't advise anyone to have a material fraction of their net worth in their employer's stock: I can't tell you how many sad stories I heard from Lucent (NYSE: LU) employees who had not only lost their jobs but also seen their savings, which were often mostly in Lucent stock, wiped out. But as a current or prospective shareholder of a business, I like to see broad, deep stock ownership throughout the company.

Next week, I will continue my discussion of corporate culture and compensation with some tips on how to identify which companies have strong cultures and sensible compensation programs.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of AAON and Berkshire Hathaway at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.