When it comes to bonus pools, don’t break the golden rule

This week’s news that the Chancellor wants the RBS bonus pool to carry the cost of any fines arising from the Libor scandal will be welcomed by many. For me, it also raised a number of interesting points on the issue of bonuses in general.

As many of you will be aware, I do like the idea of a ‘percentage of profits bonus pool model’ and I do so for a number of reasons:

(i) Firstly, it means a proportion of the cost base becomes variable rather than fixed which naturally protects the franchise. When times are good the bonus pool expands and everyone, shareholders and staff alike, get a share of the spoils. Combine this with a solid “differentiation” model to skew payments towards the people who are making a key difference and a bonus pool can act as a great incentive. Vitally, it also means that staff are incentivised to think in terms of margin and profitability, rather than driving revenues at the expense of profits.

(ii) Second, when times are bad the opposite happens and costs shrink with profits. In short, if there are no profits, there are no bonuses. If the bonus pool accounts for 20% to 30% of total compensation at the height of a boom, then the natural shrinkage of the pool on the downside of the cycle means that compensation related costs can shrink by that same 20% to 30%. This effect can be especially powerful in software companies* where a large proportion of overall costs fall under either salary or commission and allow the company to quickly pull-back into a defensive “rainy day” stance.

Of course, the second scenario motivates people to compete and get things rocking again in an effort to return to the good old days as soon as possible.

The underlying principle of the above is that if times are good everybody is a winner, including staff; but if times are bad everyone takes a haircut and more importantly, the franchise is protected in the long term. The golden rule of any private business must be to “protect the franchise” as it is the source of shareholder wealth and employment in the long term (and for that matter, it’s also the source of those much sought after bonuses).

Any observer of the compensation debates over the last few years will quickly appreciate that many management teams take a decidedly different view when it comes to bonuses during a downturn. Namely that there should be big bonuses when times are good to ensure everyone is a winner and equally big bonuses when times are bad because, quite frankly, they feel they are entitled to make a mint whether the wider franchise can support it or not.

The problem with this view is that it violates the aforementioned golden rule and to this I say, roll on the ‘shareholder spring’!

– Danny

*Same applies for any business where compensation makes the lions’ share of total costs e.g. many investment banks, consulting firms, law firms etc.