When discussing executive compensation, especially within the context of SMEs, it is common to focus on absolute figures. How much the CEO earns, what the COO takes home, how many bonuses were distributed this year, etc. However, the real question is not how much<\/i>, but how<\/i> and, above all, for what purpose<\/i>. Designing a compensation system is not a mere labor issue; it should be considered a strategic matter, as it can reconfigure a company’s direction and ensure that every decision made by management adds and provides value.<\/strong><\/p>\n Owners and boards of directors seek executive compensation that drives long-term economic value creation, aligning the actions of senior management with the interests of ownership. Below are recommendations for designing executive incentive systems in SMEs, family-owned businesses, or private companies, focused on generating sustainable value.<\/p>\n In recent years, the debate surrounding the alignment between ownership and management has gained momentum. It is no longer just about attracting and retaining talent, but about ensuring that this talent moves in the same direction as the shareholders’ interests. This is where the well-known agency problem<\/b> comes into play\u2014a classic economic concept describing potential conflicts between those who own an asset (the owners) and those who manage it (the executives). Resolving this conflict is not a matter of control or distrust, but of common sense: designing incentives so that both parties benefit from value creation and suffer, to a fair extent, the consequences of its destruction.<\/p>\n One of the first starting points is distinguishing between profit growth<\/b> and value creation<\/b>. A company can increase its earnings over several years yet be eroding its future profitability if it does so at the cost of reducing investment in innovation, selling off assets at a loss, or taking on excessive risk.<\/p>\n Real value creation is measured by comparing the Return on Invested Capital (ROIC)<\/b> with the Cost of Capital (WACC)<\/b>. Only if the former exceeds the latter can we speak of Economic Value Added (EVA)<\/b>. However, this principle has direct implications for the structure of variable compensation: if only the accounting result is rewarded without considering the capital required to achieve it, short-sighted management is incentivized, prioritizing the short term over sustainability.<\/p>\n The question then is evident:<\/strong><\/p>\n Today, multiple formulas exist, some more sophisticated than others, but all must start from the same premise: compensation must be linked to the executive’s impact on the company’s value, not to the general environment, luck, or the simple passage of time.<\/p>\n In this regard, it is necessary to insist on separating the effect of context from the specific merit of the manager. To illustrate: a 10% growth in a business unit may be an achievement if the market advances at 6%, but it is mediocre if the sector is growing at 15%. Therefore, incentive design should be based not only on absolute metrics but on those relative to the competitive environment and the starting point.<\/p>\n One of the most interesting mechanisms in this field is the calculation of value attributable to the management factor<\/b>\u2014that is, the difference between what would have been achieved following an average sector strategy and what is actually achieved through the specific intervention of the manager. This approach forces a deeper analysis of decisions, their real impact, and their sustainability over time. More importantly, it allows compensation to be aligned with merit rather than sector inertia.<\/p>\n Now, for all this to work, the design of the compensation system must avoid certain biases widely documented by behavioral finance. For example, loss aversion<\/b>, which can lead executives to avoid risky projects even if they are potentially profitable. Or the so-called “house money effect,”<\/b> whereby excessive risks are taken when the committed capital is not one’s own. Numerous studies warn that these biases are not anecdotal but structural, and must be taken into account when defining bonuses, deferrals, clawback clauses<\/b>, or even co-investment schemes.<\/p>\n In SMEs, where dealings are more personal and systems less formalized, the temptation to resolve these issues in an approximate and unfounded manner is great. But it is precisely in these contexts where good design can make a more notable difference. It is not about copying models from large multinationals, but about adapting principles that work. For example, a system that combines a reasonable base salary, annual variable pay conditioned on real financial metrics, and a deferred portion over several years linked to the evolution of economic value added can be an effective solution, even without resorting to formulas like stock options or phantom share plans, which are generally only seen in large corporations.<\/p>\n Furthermore, one must not forget that value creation does not stem solely from financial statements. One can, and should, also incentivize process improvement, innovation, (orderly) expansion into new markets, or the development of more efficient, high-performance equipment. Although these dimensions are harder to measure, they are no less fundamental for the sustainable growth of the business. This is where the owner’s judgment and long-term vision play an essential role: it is not enough to reward what can be easily counted; one must have the wisdom and courage to value what will potentially sustain the company’s future.<\/p>\n Focus on Return on Capital:<\/b> To ensure management focuses on creating shareholder value, variable compensation can be linked to Economic Value Added (EVA)<\/b> or other indicators of return on invested capital.<\/p>\n EVA is calculated as Net Operating Profit After Tax (NOPAT)<\/b> minus the cost of capital on the invested money (WACC times invested capital); essentially, it measures wealth created once the return required by financiers is covered. Using EVA in incentives ensures that executives only generate significant bonuses when they obtain returns above the shareholders’ cost of capital. In fact, experts point out that the most appropriate financial way to incentivize management is through EVA, establishing EVA improvement targets for each period. Unlike traditional metrics such as ROE or ROIC alone, EVA penalizes idle capital and makes the cost of capital visible to management, encouraging investment only in projects whose profitability exceeds the WACC (aligning with owners’ interests).<\/p>\n In conclusion, executive compensation is not an issue reserved for large corporations. It is a strategic tool that can help transform an SME into a more solid company, more attractive to talent, and, above all, more oriented toward real value creation. Investing time in designing it well is not a cost, but one of the best decisions an owner who thinks beyond the next monthly reporting result can make.<\/strong><\/p>\n If you are considering designing an incentive plan aligned with value creation and your company’s strategic objectives, at Maraz Corporate Finance<\/b>, we are experts in corporate financial and strategic advisory,<\/a> and we can help you structure an incentive plan with technical rigor, a practical vision, and full adaptation to your business reality.<\/p>\nWhy can a well-designed system make the difference between sustainable growth and silent stagnation?<\/b><\/h2>\n
How to compensate based on value rather than simply on profit?<\/b><\/h2>\n
Aligning incentives with owners’ objectives<\/b><\/h3>\n
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