Stock Incentives for Professional Managers: Pain and Punishment

“In the West, rules and frames build trust between family businesses and professional managers. But for China’s first generation private entrepreneurs, the trust is placed with shares in managers. But, does this make enterprises more family-like and private? Are managers owning shares of the company more trustworthy?” A lady with a German face and a classical Chinese name raised this question in a CEIBS Kaifeng CFH seminar, CEIBS, on Mar. 28th. This provoked a heated discussion among the first and second generation entrepreneurs present.

The German lady, Su Mingyue, is President of Voith Turbo Power Transmission (Shanghai) Co., Ltd. She is a professional manager for this hundred-year-old German company and in charge a joint venture of which Voith holds 70% of the shares. Voith Group is one of the biggest and most historic family enterprises in Europe. Founded in 1867, it has lasted for 5 generations. Like major German family enterprises Bosch and Henkel, Voith is an unlisted, 100% family-owned enterprise. After 1971, all Voith family members left management and only stayed on as “guards” for the enterprise. But professional managers were never given shares. This is common in European family enterprises and has allowed companies to last a century or longer.

European family enterprises seldom give shares of stock to professional managers. The system of management and trust and the maturity of professional managers maturity have let these companies carry on over the years in their respective countries. But in China’s case, the social context, system of trust and interests all differ, so the problems faced become more difficult.

Departing Professional Managers

The second generation owner of Fuanna shared with a well-known case concerning its senior managers. Founded in 1994, Fuanna is the leading company in household textiles and listed on the SME board. Prior to listing, Fuanna restructured the company and offered 7 million shares. Some of the initial offerings were given to its 109 employees. Before listing, 26 of these employees left office or switched jobs in succession. Fuanna took them to court for breach of promise, and petitioned the return of their initial stock gains. The company ultimately won the case and received more than 10 million in compensation. This is a classic example of “pain and punishment” with stock incentives. “The complex social context nowadays is challenging the capacities, ethics, trust and loyalty of our management,” said the owner.

A second generation entrepreneur said that when his/her company was listed, it offered no shares to professional managers. This led to a number of managers departing. “Before listing, our staff all believed that after all these years of hard work under the Chairman they should have some shares of the company. We offered to buy homes and provide transportation for employees serving longer terms, but didn’t give out shares. This really disappointed them. So, after listing, some lost their drive and left the office en masse.”

Many private enterprises have listed in recent years, and many professional managers wanted stock options in return for their years of service. Yet China’s listed companies have been troubled by wave after wave of senior departures. Statistics show that Jan. 2014 alone saw 214 senior management resignation announcements in nearly 200 companies in Shanghai and Shenzhen. As of the end of March, listed companies in both places altogether had issued 300 more senior management resignations. One important reason for this was the desire to “cash in” their shares at a later date, as the lock-up period was set to expire or the stock price had been overvalued.

Wang Jianlin, Chairman of the Board of Dalian Wanda Group Co., Ltd., was asked, “As a large shareholder of Wanda, what do you think of the allotment of shares?” He answered: “Having a modern enterprise system doesn’t equate to having shares. For now, there still isn’t agreement on whether a group of bigger shareholders or a complete system of professional managers does a better job. Professional managers have advantages and also disadvantages. They don’t care long-term interests. Actually, shareholders and professional managers are both applicable. But only the one wearing the shoes knows how well they fit.”

If they don’t receive shares, managers leave immediately; if they do receive shares, they may still leave in the future. The debate remains open and views still differ. But this provides private entrepreneurs and second generation entrepreneurs with an impetus to address the problem. As Mr. Wang said, “Only the one wearing the shoes knows how well they fit”. Facing the decision of whether to give shares or not, and when to allot them if so, different entrepreneurs must look to the methods that fit their businesses’ needs and developmental situation.

Opinion 1: Different stages of development require different incentives

Chen Zhifeng, member of CEIBS Pando Tree Association and Chairman of the Board of Shanghai Miyuan Group Co., Ltd., thought that different stages of enterprise development require different handling of shares. “China’s business environment is extremely bad. The government is immature and policies are changing. Employees and bosses need to grow. And the second generation that is just taking over the business is still learning. At the start-up stage, allotting shares can be good. But if you can’t make money, disputes begin to appear; and if you have made money, the disputes are even bigger.”

Besides, the portion of shares allotted is related to the degree of development. Yang Yihua, Chairman of the Board of Wuhan Sevalo Construction Machinery Group Co., Ltd. and member of CEIBS Pando Tree Association believed that “as the enterprise grows, when a high salary alone is not enough to motivate managers, we need to turn to stock incentives. We need to enter the capital market, where the shares have the chance to increase in value. After all, the shares real value depends on the capital market. In addition, some managers know the stocks’ true value and how many times over it has increased in value, but some don’t. So the incentives are limited to ones who are aware of them.”

Opinion 2: Leapfrog to success

Lai Yun, Chairman of the Board of Nanjing Lehui Light Industry Equipment Co., Ltd. said, “One would think stock incentives easy to manage, unless he runs the business himself. In China’s current business environment, wealth is built over the long term. So we work to leapfrog over the competition to succeed. This sometimes calls for a reconciliation between the two options: given shares, managers cash them in and leave, so you have conflicts; but without shares, they will cause you trouble, and you can’t leapfrog over competitors. It is a stage that we all have to go though.”

Opinion 3: Stock incentives are good – when used carefully

One guest considered stock incentives important and cited his company as an example. “Share allotment serves two purposes: payback and motivation. The key for share allotment is that both duty separation and profit sharing have to be reasonable and done the right way. In the Chinese context, we’re still dealing with human nature – there’s no way you can stop shareholders from abandoning your company. But what you can do is to leverage their strong points for the biggest gains.”

The guest’s company was founded with 5 shareholders. Later, for control purposes, a new company spun off, leaving two co-founders in the company (the founder and one shareholder). The founder gave this shareholder 15% of the company’s shares and assigned in the articles of incorporation the shareholder’s duty to raw material purchase, excluding him from sales. The company then set up an important joint venture company dealing raw material, of which the shareholder was given 49% of the shares. The joint venture had annual sales of ¥100 million. So, although he owned a small part of the Group, he still held a lot of shares in his division. This arrangement helped the Group to grow. “You need to be the biggest shareholder to extend enough influence over the company. Small shareholders can’t challenge you, because the founder controls the sales and small shareholders can’t get to the clients.”

Opinion 4: Find complementary partners, and stress profits rather than shares

One entrepreneur stressed the importance of profits over owning stock: “China’s business environment is bad and it’s hard to find business partners. But partners are a must. You can’t be jack of all trades, so you’ll have to find others that complement your strengths.” As a start-up, you need to find partners at the core of your business, and decide whether to give them shares. If you can’t make money without them, give them a portion, but not a big one. Keep the company under your control. You can drop some investments from partners, or offer bigger dividends or your gains, but never the shares. Offering shares will bring you trouble down the road. When the stock price rises, your partners won’t sell them, but if hard time hits, they cash them in. So every time we made money, I paid dividends, putting it all on the table.”

Opinion 5: Conditional withdrawal

Another guest considered stock incentives positive: “During listing, companies are faced with many problems. But at this stage of development, stock incentives for professional managers are positive. There are problems but also benefits. What we need is to set rules and restrictions on shares’ selling price or proposed withdrawal before listing to reduce the negatives. For a listing company, profit sharing is critical. You need to share profits with your staff, especially with management. By doing this, the biggest shareholder shows employees that he is generous and willing to share. This will build the brand and win hearts and minds. That’s why Fuanna, even after its manager departure, still enjoys public praise—they basically did a successful PR campaign for ¥10 million.”

Opinion 6: Pay the bill and face reality

One entrepreneur who once worked in New Oriental Education & Technology Group Inc. used his company as an example. As in the film American Dreams in China, the company’s founder, Yu Minhong, has a western management philosophy and is concerned with the public’s well being. His goal has been to build a long-lived enterprise, and in 1998, New Oriental starts to allot shares. For his internal employees, however, this “is a way to retain talent. But the shares go to people who shouldn’t get them. Some are just instructors without true talent. Without shares, they are satisfied with modest earnings; with shares they leave or turn into troublemakers. This was a painful lesson for Mr. Yu. He aimed to leverage the shares to expand business, but ended up creating either overly ambitious staff or enemies. But ultimately you have to face the music. You have to stay clearheaded even though it can be more painful than a divorce—and when the pain fades, it’s important to keep your compassion and faith in others. You can always start again, work hard and make more money.”

Opinion 7: Separate money and controlling rights

Prof. Oliver Meng Rui, Co-Director of CEIBS Kaifeng CFH, believed that there is always friction between entrepreneurs and professional managers. “In economics, this is the called a ‘principal-agent problem’, in which the ‘master’ and the ‘servant’ ask for different things. One way to turn servant into master is to give him shares. But for now, this isn’t the best option. In China, many professional managers take the shares, cash them in, and then leave. China still hasn’t established a business culture that values contracts, law, and professional managerial ethics. So when allotting shares, it is important to exercise caution. You can separate the rights to the cash flow and the control of it. The cash flow belongs to shareholders—all the money made goes to them. But shareholders may not control the cash flow: control of it can be transferred through certain mechanisms to the person who can generate the most profits with it.”