The Managerial Theories - Essay Example

The ‘Managerial’ Theories Contents Contents 1 Introduction 1 Incentives tools available 2 Wage and bonus increases 2 Group incentives 3 Stock Options 5 Stock Options for Early-Stage and Entrepreneurial Companies 5 Non-Monetary Rewards 7 Who are the Owners, and Who is Running the Company? 9 Conclusion 10 Bibliography 11 Introduction The standard economic theory would indicate that the more managers are offered to work in a firm, the greater their motivation to work, and the more attractive employment in the firm is to those searching for a new position. The microeconomic theory also predicts that the more one is paid for one's work, the more hours one will work—but with a declining willingness to add hours as the relative value of leisure time climbs in relation to the rewards for work (Devine 1974)). This paper covers the inherent conflict between providing costly incentives to motivate managers to perform well, against the overall profit motive of the firm. In analysing this conundrum, the author will call on the different kinds of motivational tools available to the Managing Director and the Board of Directors of a firm, and how those tools are regarded both by the managers whose incentives are affected, and the shareholders of the firm, who are presumably trying to maximise their gain (Griffith 2000). Incentives tools available Wage and bonus increases As income taxes have risen over the past historical era, the outright impact of salary or bonus increases has been moderated somewhat. The incremental tax on income in the UK and the US is at about 50%, when all local and national income taxes are taken into account. Thus the standard supply and demand relationship demonstrates a curve, as shown below. Since taxes climb with income, the curve’s change in slope is more pronounced: Figure 1: Relationship of supply and demand for labour (Universite de Geneve 2007) As compared to the turn of the last century, when income taxes were less than 10%, the total impact of increases in wages has therefore moderated. The second influence on this moderation has been the increase on the value of leisure time (Kokoski 1987). As the value of leisure hours has increased, the amount which needs to be paid to offset the value of leisure time has also increased, all else being equal. Group incentives Group incentives can take the form of income increases (salary and bonus) or non-monetary rewards, such as additional vacation days. From a microeconomics standpoint, there is no difference between group pay incentives and individual pay incentives. There are psychological differences which can be substantial, however, depending on the type of performance being rewarded. An extreme example of the point above is an individual whose personal rewards far exceed those of the group, and in achieving his goals may actually be a detriment to the shareholders. An example of this might be Robert Eaton, who was the Chairman of the Chrysler Corporation at the time that his company was approached by Daimler-Benz. Eaton agreed to a plan whereby Daimler-Benz would merge with Chrysler, and he sold the Board of Directors and employees' unions on the plan. What he didn't reveal was that he stood to gain over $100 million personally if the deal went through. The resulting hue and cry were that Eaton "sold out" Chrysler, which was borne out by subsequent events. Chrysler's largest shareholder at the time, the Tracinda Corporation1, sued Daimler-Chrysler for over $8 billion for erasing nearly $38 billion of market capitalization due to the transaction (CNN 2000). Figure 2: Reduction in share price since merger (CNN 2000) Thus a personal incentive (for Eaton) was in direct opposition to the interests of the shareholders. Stock Options Stock options have the advantage of better alignment with shareholder expectations. The theory is that managers are incentivized to take actions which benefit the longer-term performance of the stock. While stock options are clearly a reward for early-stage and/or fast-growing companies, they may be less of an incentive which aligns with shareholders' interests on two fronts: If the shareholders are relatively short-term orientated, then a longer-term investment strategy may not be in their interest. In recent years, the activities of "takeover artists," LBO specialists and hedge funds has resulted in significant shifts to shorter-term value realization, even at the cost of longer-term performance. On the other hand, how the Board and management tailor the incentives can have a significant impact on short-term stock performance while hurting the longer-term welfare of the shareholders (Garvey 2003). This "short-termism" focuses top management on meeting agreed-upon stock targets, which may result in actions deleterious to longer-term investment; a company which cuts back on customer service, R&D and/or sales activities may realize shorter-term profit benefits while hurting longer-term growth and stability. Stock Options for Early-Stage and Entrepreneurial Companies Stock options are treated differently for tax purposes in small and start-up companies. In general, such early-stage companies may receive either venture funding or “family and friends” funding. In either case, the relative valuation of the share options granted at the time of formation is very low or nominal. Executives make the rational choice to take a high risk (of failure of the business) and low salary in order to receive “outsized” returns in the appreciation of their stock. Thus the early-stage goals of the shareholder (such as a venture capitalist or individual investor) are better-aligned with the managers of the firm than at larger companies. Economic theory would suggest that the entrepreneur makes an informed "decision tree" to assess the probabilities of success or failure, the rewards or penalties attached to each, and the opportunity cost of his/her time. In an environment where failure is not penalized, where other entrepreneurial positions are easier to obtain, and where there are many start-up companies, such a decision is eased by reducing the downside costs and, perhaps, increasing the upside rewards (as there are more opportunities for a profitable liquidity event). Thus the entrepreneur may find a better “personal reward/risk calculation” in Silicon Valley or London than in Leipzig or Detroit, as the upsides are better and the downsides are not as deep. There are at least two potential mismatches between the entrepreneur and the venture capital investor. The first is that the entrepreneur may have a vested interest in selling early, rather than taking further dilution in further Preferred Stock rounds. The venture capitalist, while he/she may receive a higher IRR (internal rate of return) by selling early, may realise two benefits from waiting until a liquidity event: (1) the total cash return may be higher, even if the IRR is lower, and (2) the VC may have the opportunity to take additional preference share advantages, such as 1X or 2X liquidity preferences, higher stock percentages, or other advantages if he/she puts in more money. In many cases, the Venture Capitalist, seeking to assure continued management focus on the longer term, may include terms in the venture investment, such as vesting (typically 4-year vesting with a 1-year ‘cliff’), stock bonuses based on milestone achievement, or additional stock incentives if certain financial targets are met. There is a pernicious influence of venture capitalists which can be demotivating to the management team: most venture capitalists have little time to devote to each of their portfolio companies. They, therefore, have an incentive to put in "proxies" managers, such as CEO's (too early), CFO's and others whose function is largely administrative, and whose loyalty is more tied to the VC than to the management team. Thus, there is an inherent disincentive to management to work with venture capitalists. Non-Monetary Rewards There is broad agreement in Industrial Economics that the “intangibles” of corporate performance depend to a large degree on the effectiveness of management: … internalization theory neglects relationships among the intangible assets within the firm. … the successful firm must manage key processes and information - such as those developed through R&D - better than its competitors, and must also consider other cultural variables, such as the personal responsibility of the "individual technocratic entrepreneurs (Mishra 1998). Although these "intangible" managerial talents are open to capture in a free market for labor, the rewards for technical entrepreneurship and creative teamwork move beyond mere monetary rewards (Murphy 1990). Rewards for team achievement include recognition within the company and the industry, additional benefits on one’s resume, and the satisfaction of a job well-done. The converse is also true: the larger the company, the more anonymous the employee, and the more likely that the employee is less likely to want to contribute to overall performance. Studies performed in the 1970’s illustrated that employees in larger (and by inference more anonymous) companies tend to suffer strikes more often due to the lower amount of non-monetary rewards (Shorey 1975). On the other extreme, start-ups and small, fast-growing companies have a lot of non-monetary rewards. The freedom to create, the feeling that one makes a difference, and the ability to see one’s handiwork appeals to those employees who want to demonstrate that they are productive and creative. Although work on entrepreneurship and rewards is still in its early stages, it is clear that the non-monetary rewards are a key factor in the start-up of new businesses (Leitch 2005). These non-monetary rewards can include: The drive to want to work on one's own, to realize one's product or service free of a corporate hierarchy. The wish to employ those with talent, regardless of seniority or climbing up the corporate ladder. The wish to demonstrate to one’s family, friends and community that one can create a successful business. The wish to direct one’s own career, rather than be dependent on others for one’s financial well-being. The inability or unwillingness to work within a larger corporation’s more political structure, and the concomitant notion of developing one’s own corporate culture. Who are the Owners, and Who is Running the Company? As companies get larger, older and more set in their ways, there is a temptation on the part of management to tend more to their own "nests," and pay less attention to shareholders. In a time of little shareholder power or activism, such complacency can result in diminished capital appreciation or even capital destruction. In such cases, the interests of incumbent management in preserving the status quo are at odds with the shareholders, who will attempt to write down the value of their stock. If, on the other hand, the laws and customs of the country are more friendly to intervention by shareholders, then managers' risk of corporate takeover or management replacement is higher. It is easy to see the difference between the UK and Germany up to the last few years: in the UK, non-performing incumbent management has been replaced since the Thatcher years. In Germany, the "autocracy" and comfortable cross-shareholdings have made for a cozy nest for non-performing management. Recent changes in bank ownership and cross-shareholdings have awakened shareholder activism, and management teams at Siemens, Telekom, Daimler-Benz and many other top companies have been affected by newly-empowered shareholders. Thus the incentives between shareholders and managers are better-aligned. Conclusion It is no contradiction for beneficial shareholders to encourage the granting of shares, monetary and non-monetary rewards to managers who perform. The more transparent the managers’ compensation, and the greater the power of shareholders, the more likely that incentives will be paid, and all will benefit. The converse is also true: lack of transparency in compensation, poor links between performance and compensation, and/or low shareholder power all support poor performance. Bibliography CNN. "Kerkorian sues Daimler." CNN Money, November 28, 2000: n.p. Devine, P. J., Lee, N., Jones, R.M. and Tyson, W. J. An Introduction to Industrial Economics. London: George Allen & Unwin, 1974). Garvey, G. T., Grant, S. and King, S. P. "Myopic Corporate Behaviour with Optimal Management Incentives." Journal of Industrial Economics, 2003: 231-250. Griffith, A. and Wall, S. Intermediate Macroeconomics, 2nd Rev. Ed. London: Pearson, 2000. Kokoski, M. F. 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