Design by Zuza Hicks; elements from Shutterstock

Design by Zuza Hicks; elements from Shutterstock

The Art of the Long View

What if an executive’s pay was dependent on the performance of his successors?

Back Longreads Jun 23, 2015 By Jeff Wilser

Two-point-four billion dollars. It’s an abstract number. It’s tough to get your head around. For context, $2.4 billion is enough to pay the annual salary of about 66,000 school teachers. It’s enough to pay Lebron James’ salary every year for a century. And according to a study from the National Bureau of Economic Research, $2.4 billion is the 2001 through 2008 total compensation of 10 executives from Lehman Brothers and Bear Stearns. The banks went under. The economy buckled. And the executives were free to buy more Champagne.

It’s an extreme example of what economists refer to as the agency problem, wherein the incentives of executives are misaligned with the incentives of the company. “The divergence between how the top executives and their shareholders fared implies that … the executives’ pay arrangements provided them with excessive risk- taking incentives,” conclude the authors of the bureau study. If you have stock options that vest in five months, who cares what happens in five years?

But one company is doing things differently. The Wine Group, which owns beverage brands Almaden, Cupcake, Franzia and flipflop, has a radical compensation model for its top brass. Using a 7-year-moving average for its valuation, it issues shares that can take 20 years to fully monetize and keeps a focus on the company’s future growth, not present value.

The results? In 2002, revenue was roughly $200 million. Today, it’s a billion.

The Framework

Short-term incentives can cause long-term problems. Exhibit A: research and development. “Many executives have little incentive for making longer-term investments in the firm,” says Steven Currall, former dean of the Graduate School of Management at UC Davis and now the chancellor’s senior advisor for strategic projects and initiatives. “One way this shows up is declining investments in R&D. This is a pattern that emerged in the 1980s and continues today. The financial returns of R&D don’t pay off in one quarter or two quarters or three quarters.”

Exhibit B: acquisitions. It can take time to develop a new product, new idea or new technology, and if a CEO doesn’t have that time — or, more to the point, isn’t compensated for that time — it’s tempting to seek a short-term fix. “Many companies use a strategy of acquisitions to import innovation into the firm,” Currall says. “Those acquisitions can bolster short-term financial metrics, and the CEO can be rewarded on the basis of this acquisition strategy. This has troubling implications because it’s diminishing our country’s leadership and innovation.”

The Wine Group wants to buck that trend. Headquartered in Livermore, it’s the second largest wine distributor in the country, shipping just under 60 million cases annually, according to outgoing CFO Richard Mahoney. The company is private and has roughly 1,000 employees. Its current incarnation was founded in 1981 by Arthur “Art” Ciocca, who served as CEO for the next 20 years and is generally credited with the firm’s core values and long-term growth. In the decade from 2001 to 2011— right through the recession — earnings grew by more than 12 percent annually, according to Chairman Bill Jesse in a Harvard Business Review article he co-wrote with Currall.

Here’s the framework: Every year, TWG hires an external auditor to calculate the company’s valuation and fold that into a 7-year rolling average. Then, the company issues new “units,” which are like stock options. These units are owned by the top echelon of management. New offerings are called C units and can be converted into either A units that pay out over 5 years or, for the highest level of management, B units that come with voting rights and, unlike most stock options, have a long, long time frame before they can be fully monetized.

“For someone who is just issued B units, it can take 20 years to monetize,” Mahoney says. In many cases, the real payday doesn’t come until after the executive has retired.

This is more than just a compensation model. It’s a way to motivate the troops, recruit top talent and, most importantly, enforce what the company calls its “recitals,” or core values:

  • We will not sell ourselves. We will be an independent, managed-to-own company that is private.
  • We will remain in healthy financial condition with a view toward long-term value creation.
  • We will motivate our owners to work on behalf of future owners. We want to leave the company in better shape than we found it.

The model gives the recitals teeth. The 7-year valuation forces senior management to view a long-term horizon. “We’re not sure that seven years is the optimal number,” Mahoney says. “But we are sure that managing performance based on one rotation of the earth around the sun isn’t necessarily how most business cycles work. And you can’t game the system over a long period of time.”

That’s especially important in the wine industry. Grapes take time. Unlike a tech company that can launch a new widget and dazzle Wall Street, a vineyard needs many quarters, sometimes many years, before owners know the return on investment. Wine makes even farming look fast.

“It’s not like you’re growing soybeans or corn. You’re not planting grapes today and hoping to sell them in the fall. Sometimes it takes five years,” Mahoney says. Decisions on how to invest capital, therefore, take time before they can be judged. So it’s no surprise that there are so few publicly traded wine companies. “The cyclical ups and downs have made it difficult for public companies to thrive over the long-term in the wine business. When you’re private, you’re better able to do so.”

Performance, Not Politics

Robert Smelick is the CEO of Headland Ventures, a Sausalito-based venture capital firm. He guest-lectures at schools like Harvard and the University of Virginia. Over the years he has sat on many boards, including The Wine Group’s. And he often cites Ciocca as an example of a great leader.  

“Art had a saying, ‘When politics is up, performance is down,’” he says. Smelick recalls one batch of vermouth that, while satisfactory, was not quite up to snuff. The head of operations approached Ciocca to tell him someone had accidentally included a new herb. The batch, which was “not our best,” was still good enough for market.  

Art thought for a minute. He then said, “Dump it.”

“You dump a bunch of cases of vermouth, and if you’re a small company … well, that gets people’s attention,” Smelick says. “That’s not what people who manage earnings do. This takes discipline and great leadership.” TWG always embraced the long-term view.

“Maybe we’re going to face three or four really tough years, but we can tighten our belt and respond to the fact that Mother Nature is dealing cards that aren’t favorable,” Smelick says. If TWG notices that competitors are, say, planting 4,000 acres of grapes, they might forecast an over-supply in the market and decide to liquidate inventory, creating a short-term hit but longer-term health. That’s a bitter pill to swallow if Wall Street expects you to nail a quarterly target.

Just as TWG can dump a batch of bad vermouth, it can also stick with a new acquisition even if the short-term looks shaky. “We’ve done acquisitions that, in the first year or the next 18 to 24 months, didn’t add value. But over time they did,” Mahoney says. He declined to specify which ones, but the company has pulled in Corbett Canyon (’88), Glen Ellen Winery and Concannon Vineyard (’02), Golden State Vintners and Fish Eye Wines (’04), Big House Wine Co. (’06) and Almaden (’08).

And then there’s the ultimate planning for the long-term: Succession. “We spend a tremendous amount of time on succession,” says Mahoney, who retired as CFO at the end of 2014, but, tellingly, still uses the word “we” when referring to the company. “I wanted to make sure that the guy replacing me (John Sutton) is a better CFO than me. And he’s already better than I ever was,” he says, laughing. “Part of it is a cultural thing, and part of it is that I’m counting on them keeping the wheels on so I can monetize my economics.”

This is a polite way of saying he has oodles of B units, and his fortune is still pegged to the firm. The chips are still on the table. “We refer to ourselves as stewards, not owners. We’re stewards of the company. It’s our obligation to take care of it and leave it in better shape than we found it.”   

Could It Work for You?

A few key caveats: While it’s true that TWG uses a long-term compensation model and has enjoyed years of steady growth, it’s overly-simplistic to assume that a long-term compensation model causes steady growth. It’s a contributing factor, not a panacea. “I don’t think a comp model can ever be a substitute for sound leadership and good decision making,” Ciocca says.  

Smelick, who hammers home the importance of leadership in his college lectures, echoes the point. “The TWG compensation plan is terrific, and the results speak for themselves. But keep in mind, the results are very much a function of the people. If you select the wrong people, the compensation system isn’t going to bail you out.”  

This framework isn’t a good fit for everyone. “We’ve had a lot of candidates who’ve said, ‘This isn’t for me,’” Mahoney admits. Then again, that, too, has merit: It’s a useful filtering system. “The model is self-selecting. If someone wants to become famous in their industry, this isn’t the place for you. The probability of success here, so far, has been 100 percent for our owners. But it takes time. It’s not fast. You put your head down and you grind for a decade or 15 years, and you’ll do very, very well.”

It’s also not for every firm — especially if you need to raise funds. You need to have the right cash flow to make this work.

“We’re not accessing the public markets for capital, and we’re not going to. We’re not going to sell ourselves to the public,” Mahoney says. The company’s insistence on staying private is so strong, in fact, it’s written a clever clause into the model: If the company is ever sold, all proceeds go to charity.

So could something like this work for a publicly traded company? Alex Edmans, a professor of finance at The Wharton School of Business, has proposed a creative solution: the dynamic incentive account. “Each year, the manager’s annual pay is escrowed in a portfolio to which he has no immediate access … As time passes and the firm’s value changes, this portfolio is rebalanced monthly so that 60 percent of the account remains invested in stock at all times,” he suggests in policy blog voxeu.org.

Channeling the spirit of The Wine Group, he adds that short-term vesting periods can trigger risky behavior, so, “Even when the manager leaves, he does not receive the entire value of the incentive account immediately. Instead, it continues to vest gradually; full vesting will occur only after several years.”

So why don’t companies do this type of thing? “Inertia. Habit,” suggests Currall. “It’s not a minor change to policy, routines and organizational culture. It’s a big change.” One reason the model works at The Wine Group is that it folds so neatly into the company recitals. But many firms simply don’t have those kinds of values. If a company wants to implement this compensation model, therefore, Currall says the first thing they need to do is develop that framework. “It’s not a model that you can just drop in; it needs to be embedded in a broader value-set.” Easier said than done.

Let’s think back to Bear Stearns and Lehman Bros. If those CEOs knew their personal fortunes were linked to the value of the banks in 2012, would they have leveraged their assets so aggressively? Would they have been so blasé about risk? Would the economy have tanked? We’ll never know. But the thought has absolutely crossed Mahoney’s mind.

“In 2008, if you’re about to take a terrible risk and put your company in harm’s way, what if you had to wait six months or two years to cash in?” he asks. “You’re more thoughtful about the decisions you make.”

True, hindsight’s 20/20, but that’s exactly the point of the model: to capture seven years of hindsight. And there’s at least 2.4 billion reasons to give it some thought.

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