On a trip to the US several years ago, the aircraft I was on pulled away from the gate on time. However, within a minute, the engines suddenly powered down. We waited almost three hours on the tarmac, in the sweltering heat, without air conditioning, until the flight finally took off.

The gentleman seated next to me explained what had just occurred: the airline staff’s bonus was based on the aircraft pulling away from the gate on time. They were not going to forego their bonus just because there was no available slot for taking off on the runway. With the best of intentions, the airline had actually created an incentive system which made passengers suffer. My point is that great care must be taken when designing a bonus system, so as to avoid the seemingly perverse effects that may actually destroy company value. A well-designed bonus system, one that creates genuine motivation for staff, is therefore a necessity for creating corporate value.

In different organizations, it is different combinations of the board, CEO, and senior officers who create the incentive system for all staff of the company. Creating the right incentive system is one of the most important functions each group fulfills. The following three considerations must be taken into account when designing any incentive system:

1. It must be motivating. There is no use in trying to motivate staff with equity if staff members have a short-term perspective, or are at a phase in life where they need cash to start a family or buy a first home. As the saying goes, “happiness is getting what you want, and wanting what you get.” It is therefore crucial for anyone designing a bonus plan to know the people involved quite well, to know what will really motivate them. Very often it can be non-monetary factors such as recognition or a title. In such cases, throwing money at trying to motivate people can actually be a complete waste. Very often, there is a conflict between designing a system that is tailored to everyone’s individual needs, versus a “one-size-fits-all” type of bonus system that has the advantage of being consistent, but may not take into account the preferences of a few individuals who are outliers.

2. Create the appropriate alignment of interests, particularly between senior management and shareholders. Generally speaking, equity, an option to obtain equity, or profit share may create the right kind of alignment. However, it is extremely important to factor in the appropriate level of risk that may be taken by management – witness the undue risks taken by bank certain bank CEOs leading up to the financial crisis. Another example: if you reward someone with a percentage of revenues, don’t be surprised if there is suddenly pressure on margins. Are there checks and balances in the system? Is the CEO allowed to make unfettered decisions about risk? Is the person on a revenue-share bonus allowed to make decisions about margins? If not, there is less of a problem.

3. Reward the types of behaviors you wish to encourage. Is it top-line growth you wish to encourage? Or is it frugality in terms of expenditure? Is it the taking or avoidance of risks that you wish to encourage? Is it team work or individual performance? Make sure that your bonus scheme truly does create the desired behaviors, and that you are not creating undesired side effects (like cut-throat competition amongst your own staff) or inadvertently neglecting to encourage other behaviors that are equally important for the success of your firm (e.g. rewarding sales alone is unlikely to achieve the desired effects of quality, customer satisfaction, etc.)

A bonus system makes a statement about the values of a firm. If you try to sell your firm or raise capital for your firm, investors will inevitably ask about what kind of incentive systems your firm has in place, and how well they are working. Ultimately, you need a motivated team to build corporate value. But there is no magic bullet, no ideal bonus system that works for all organizations. The devil is, as so often, in the details.

My previous column (Part I of this series) dealt with risks in the valuation of companies, stressing in particular that the higher the risk associated with a company, the lower the value of that company. This is not static: investors' perceptions of risks constantly evolve as they assess a company and the valuation process is consequently also evolving in tandem. In the context of privately-owned companies, few things are more crucial than the due diligence process, when an investor reviews - in detail - all of a company's title documents, financial records, contracts, etc. Because of this, it is in the interests of all owners to identify and manage risks well in advance of engaging in serious discussions with investors.

So what types of risks are we talking about? There is always the risk of a surprise, but here are just some of the types of risks about which investors are usually cautious:

• Client risks: Is a company's client list well diversified, or does one client represent a disproportionate volume of revenues or profitability? What are the chances of losing the most profitable client(s)?

• Technological or industry risks: What are the chances of a company being left behind by technological change? What other industry-related risks are there (eg. changes in the business model in the industry?)

• Competitive risks: What is the probability of competition intensifying, whether through the entry of significant new players, or renewed efforts from existing players?

• Financial risks: How high is the leverage of the company and what are the chances of default? If a company is listed on a stock exchange, what are the chances of a hostile takeover? What are the possible effects of currency exchange rate fluctuations on the company's profitability? In the event of a change of control, what rights do the company's banks or financiers have? What is the risk that there may be a mis-statement in the financial statements or tax returns?

• Human resources risks: What are the chances of losing key staff? How difficult would they be to replace? Is there an ample supply of blue collar labor? What are the chances of staff costs escalating rapidly? Does the company have one or more unions covering its labor pool? What risks might this entail? Does the company have unfunded pension obligations? Do staff members have stock options that might have an acceleration clause regarding certain events such as a change of control? Will there be any extraordinary severance payments in the event of a change of control? Has the company regularly paid its social security and payroll taxes? If management receives a big payout under a liquidity event, will their motivation be diminished?

• Supply risks: Does the company have an ample supply of raw materials and other inputs it needs to carry on business? What are the chances of disruption?

• Regulatory risks: Are any relevant laws or regulations changing in a way that could have an adverse effect? Are there any ambiguities in laws or regulations that could be construed by government authorities or third parties against the company?

• Environmental risks: Has there been any water, air, or land pollution associated with the product or the property used or owned by the company? An increasing number of legal jurisdictions have strict liability provisions which don't ask questions about how the pollution was caused: if the pollution is on your land, you may be liable to remove it, even if you did not cause it.

• Product liability risks: What are the chances of products being recalled, repaired or replaced? Similarly, if it is an advisory business, could there have been any errors or omissions that come back to haunt the company?

• Intellectual property risks: Does your company have strong and valid rights to its intellectual property? Does it own patents or trademarks, for example? When do these expire?

In Part III of this series (which will appear shortly), I will deal with the issue of how to deal with some of these risks, once they are identified.