What's Wrong with the Current System? Compensation without Long-Term Value Creation

Feb 6, 2004

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Getting Bigger by Growing Smaller: A New Growth Model for Corporate America

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Whatever Goes Up...

Bad compensation mechanisms cannot be blamed for all of our stock market and economic woes. But bad compensation mechanisms were certainly a big part of this mess. Compensation mechanisms were tied in with the greed that gripped our markets. Individuals had economic incentive to behave in a manner that might not contribute to the long-run wealth creation of the organization. Another factor was that when our capital market systems gather momentum, there is little that can slow them down. Rising stock markets create new wealth, which enables companies to use inflated stock as currency to buy other companies. New infusions of risk capital then enter the market, providing funding for additional investments. With rising equity levels, companies can borrow additional bank debt, driving leverage and risk to new heights. This may result in yet another round or cycle of appreciating stock, harvests, and new investments. Reality may not set in until much later when it becomes too late to reverse a large transaction.

Once the first ripple of quarterly reports indicates that the high-profile companies missed their financial projections, things begin to unwind. This is bad news with markets adjusting quickly. Over recent years, the investment cycle of (1) invest, (2) harvest, (3) invest again, can also move rapidly in reverse. However, in the opposite direction it appears as (1) sell, (2) sell lower, or (3) liquidate the assets. The stock market crash of 2000–2003 was just this type of reversal of fortune.

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