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Sunday, December 7, 2008

Better Carrot or Bigger Stick?

I have heard and read many people blaming executives in their pursuit for huge bonuses for the world wide financial disaster everyone faces.

One of the reasons why capitalism over communism has worked well in the last 100 years is basic human nature, a carrot works better than a stick.

And capitalism's carrot is reward (money) for doing well. These executives world wide understood the rules of the game, and pursued the carrot the fullest of their abilities. Sure, many executives probably crossed the line, and should be held accountable for breaking the laws. But the SHEER size of WORLD WIDE feasting on the financial mayhem in the last 5 years should indicate that it all can't be outright fraud.

People are calling for "sticks" executives should not have gutted companies and made them vulnerable for failure. My question is why shouldn't they? Was ANY of their reward (carrot/bonus) tied to long term viability of the company? Or was the vast majority of the reward tied to showing a great annual fiscal year, with a lump sum payoff that will last a lifetime? Once paid, the company could go bankrupt the next day (aka Bear Stearns) after the decision makers involved have been fully compensated.

The reward system is at odds with what the greater majority of people expect from companies, and that is, not only to perform well in a particular fiscal year, but a business that continues to exist for decades with hopefully some profit.

If the reward system does NOT reflect expectations of the stock holders, the government, and the general populous, the answer isn't to get sharper sticks and "shame" people to doing what people think is the right thing. History has shown people will ALWAYS (on an aggregate) do the wrong thing if the carrot lures people to do so.

Simply put, the reward system is broken. When a sports game is played by the players to the point the game is broken, the rules change to improve the quality of the game, example NJ Devils "The Trap".

What I propose is a very simple change. At the end of the fiscal year, the annual compensation is computed and awarded to the executives, with 1/5th of the total paid out.
Then, over the next 5 years, each year, if the company is meeting (within an agreed reason) expectations, 1/5 more is given to the executive, and on the 5th year, the last payment is made. This would occur even if the executive leaves the corporation. This is "fair" since as an executive, it is also their responsibility to groom the next generation of leaders for the corporation.

Once the reward is tied to continued health of companies, the executives will reset their focus to not just one fiscal year, but continued stability. Taking "short-cuts" will not give the best reward, and therefore will not be pursued.

I'm not stating this is the only solution, but an example of how changing the rules of the game, can improve the quality of the game.

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