Institutional Investors

Here is one of my write ups on a study i did on  institutional investing looking at the case of Hermes Fund Management with respect to Total Oil. in carrying out this study research was done on various references and the outcome of the study can be read below:

A REPORT ON INSTITUTIONAL INVESTORS AND THE HERMES FUND MANAGEMENT IN REGARD  TO TOTAL AND PREMIER OIL.

INTRODUCTION AND EXECUTIVE SUMMARY

Institutional  investors   may be defined  as functional  financial   investors  such as pension funds,  insurance  companies   and mutual  funds,  preceding  a specific  objective  in  terms of acceptable  risk,  return maximization  and maturity of claims (Davis  and Steil,   2001 ). Institutional   investors  have been seen by commentators   as potential   monitors  of management  due to the engagement  of corporate  governance  activities,   in other words they play  a very vital  and effective  role in contemporary  corporate  governance.
A study carried out by the California Public Employees' Retirement  System (CALPERS)
finds a positive  stock price  reaction  when a firm takes on changes.

This  report discusses   the role  of an institutional   investor  in influencing   the strategy of a company  in which  it  invests,  using the Hermes/Total's  activities  in Burma/Myanmar relationship   as a case study.   It  is presumed  that institutional   investors  operate  an efficient  market capital  which  improves  market efficiency  (Davis and Steil, 2001 ).

Institutional Investors are a permanent  feature  of the  financial  landscape,   and their  growth would continue  at a similar  and perhaps  faster pace.  The factors that underpin   their development  are far from transitory  and in many cases have only just  started having  an impact.  Therefore  the behavioral    characteristics   of investors  would  be an increasing determinant  of domestic  and international    financial   market conditions.   The implication of financial   market stability  warrants  serious  consideration   (Bank for International Settlement Annual Report,1998).

They are a major  force in many capital   markets  due to the  large investments  made by the fund management  industry  directly  under their clients name.   Most institutional investors  are not remembered  on the basis  of the performance  of portfolio  companies, but on the basis of the volume  of assets under management.  Fund performance  is reviewed  by the  institutional   investors   because  it favors the increased  size of assets. Most companies  want institutional  investors   influence   in areas of information    supply, especially   in particular   business  development,   transparency  in accounting  and risk management  (Strum, 2009).

In order to fulfill  corporate  governance  issues whilst also  maximizing    return on investment  in Burma/Myanmar,    a recommendation   against disinvestment   has been made using  suitability,    acceptability   and feasibility   framework.   For goal  congruence,    it is important  for Hermes and Total oil  to work together towards  improving   corporate governance  issues  in  a bid  to remain in  the area.

CORPORATE   GOVERNANCE

Over the last four  decades,  a competing  prototype  of shareholders   democracy  has developed.   These days shareholders    ask increasingly   for an input  on decisions  that would  have remained   in the purview of the board's  management's  business  judgment (Watkins,   2012).   The improvement   of corporate  governance  is a popular trend throughout  the world by different  countries.   To help investors  evaluate  a firm's corporate  governance,   a number of independent    rating services  have established criteria   for good governance.   Corporations are primarily governed  by the board of directors  supervising/managing    top management  in  sync with the shareholders.

 The term corporate  governance  refers  to the relationship  among these three groups in determining  the direction  and performance  of the corporation.   Different corporations   have been anxious  that various  requirements   to enhance  corporate governance  will hold  back top company management.  Institutional   investors  are now more active  on boards in putting more pressure  on the  management  for the improvement  of corporate  performance  (Wheelen  and Hunger, 1999).

Corporate governance  has succeeded  a great number of interests   due to its  importance  for the economic  health  of corporations  and society in general. Criticism  of corporate government  is back with a vengeance  in the post-Enron  era.  Governance  reform has been a hot topic since the 1980's,   firms in America faced increased  globalization    and change,   boards were said  to be manipulated    by their  chief executives (www.studymode.com).Companies       are becoming  more involved with corporate  governance and following   more guidelines.    Corporate  governance  ensures  investors  get an appropriate   return of their  money.

CORPORATE   SOCIAL  RESPONSIBILITY

Corporations  are primarily  business  organizations  run for the benefit of shareholders having  a wide range set of responsibilities   to owned employees,   customers,   suppliers and the  communities   in which they are located  in and to the  society at large. Corporations    do not always succeed  in  achieving  the responsibilities  they support. Corporate  Social  Responsibility    (CSR)  concept  originated  in the  1950's  when the American  corporations  rapidly  increased  in  size and power.  The European commission puts two definitions   of CSR as one,  saying  "companies   deciding voluntarily  to contribute to a better society and a cleaner  environment  where  by companies   incorporate   social and environmental    concerns  in their business  operations  and their  interaction with  their stakeholders  on a voluntary  basis"  (www.mallenbaker.net). There are many approaches  by which  companies  can implement    CSR.

Implementing   community  development   projects 

Provide education  facilities
Building infrastructure  in the local  area
Make eco-friendly   products
Provide health care facilities  to the  region
Support environment   savior movements
Empower use of environment  friendly  products  in  to company

Since most of the international    standards  concerned  with  corporate  service
responsibility    issues  are implemented  on a voluntary  basis,  CSR can also be a form of self-regulating    and implementing   sustainable  and responsible  business  (Nordmann, 2012).

Former  Unilever   CEO,   Nail  Fitzgerald   expressed  his support  saying  "corporate  social responsibility   is  a hard-edged  business   decision,   not because people  are forcing  us to do it,  but because  it  is good for our business  (Riley,2012).

INFLUENCE OF INSTITUTIONAL INVESTORS

The power of the institutional  investor  cannot be challenged  due to the size of their share holdings.   Hirschmen  (1970) analyzed   the exercise  of institutional   power within an
'exit  and voice'  framework,   arguing that dissatisfaction   may be expressed  directly   to management  (voice   option) or by selling the shareholding    (exit  option).

The Cadbury  committee  (1992) saw institutional   investors  as having a definite accountability  of ensuring  recommendations being adopted  by companies, declaring that 'we look to the  institutions  in particular in order for their  influence  to be used as owners  make secure the companies  they  have invested   in  accede with  the code. The Greenbury  report  (1995) also  held  such a view  which  they said  the institutional investors should   use their  power to influence  the use of best practice as set out in the UK governance  code.The Hampel   report (1998)   also stated  how clear the role  of shareholders    in corporate  governance  concerns  the institutions. The large  and influential   institutional    investor  in the  UK,  Hermes in 2002 issued its principles, stating that companies should   seek an honest,  open and ongoing converse  with  shareholders (Mallin, 2007)  and (Useem, 1996),stated the rise of investor  capitalism in the USA  and described  how the  concentration of shares and power in  to a relatively small number of hands, has enabled  institutional investors  to challenge  management  directly on issues of concern.

Institutional investor  are seen as having a particular role  to play  in the corporate governance  of their investee  companies  and so they  are increasingly encouraged  to be more active in approaches  and should also  try to certify the 'hidden   value'  is released where  possible  (Millin,2006).    Institutional shareholders   normally monitor their  holdings by using  a screening  system based on financial  performance  such as benchmarks, problem areas and concerns  and determining   causes and effects of the problems. Though they normally do not micromanage  their  investments,  they ensure that the investee   company  is well managed  and has a very clear strategy.

Intervention   does not regularly  happen except in very rare circumstances  like  the  concerns  about strategy, operational  performance, mergers and acquisitions, inadequate succession, planning and non-compliance  with corporate  governance reform.  The institutional  investors  may by having additional  meetings with  management  express concerns  through the company's  advisors,  meet with the independent  directors,   lead directors  or the chairperson  of the board.

Others are collaborating   with other institutions  on intervening activities,   making   a public statement  in advance  of annual shareholders   meetings, requesting  an additional   meeting in order to change the company's  board,   meeting  with board committees   like the audit,   compensation, nominating/governance (Rezaee, 2008).  The institutional investors that directly  manage investments   have greater ability to act upon their  concern  regarding  human resource  management than benefit funds that outsource  the management  of investors  (Mitchell   et al,  2011 ).  In  most cases, the institutional   investor  earns its revenue as a flat percentage  of its assets under management  and it creates an incentive   favoring  rapid fund growth (OECD,   2011 ).

SCOPE OF  HERMES    FUND   MANAGEMENT

The focus funds  Hermes is involved   in,  looks  for companies   whose  performance  raises concerns  like  a falling  share price  and questionable strategic  actions.  The concerns might  come from a Hermes analyst  or from the brokerage  community. Hermes usually does not get involved   with  the worst companies  because they do not want to lose their clients  money.   Hermes tends to invest in strong companies  with boards that are open minded  enough to accept change. The companies  Hermes  picks are often very strong, but have particular  issues  that Hermes feel they can resolve (Coombes,   2004).

Hermes is the principal   manager for BT pension scheme and it manages  investment  on behalf of other pension   plans. It is  also one of the few pension funds not owned  by a bank or any large financial   institution,    Hermes believes   it offers a service  which   does not bring conflicts  like  other large financial   institutions   experience.   The only fund manager to have documented  what it requires from companies  is Hermes,  in a document  known as 'The  Hermes principles'   and this document  can be downloaded from www.hermes.co.uk/pdf/corporategovernance/HermesPrinciples.pdf.

Hermes approach  follows an observation   of business  managers  who do not influence performances  of companies. It looks  for professionals   who are active,  ensuring  the board has the  right enterprise, independence  and expertise in order to increase company's  value.

The negative side  of this  belief is that  shareholders  can create chaos,  especially   given that most companies   have thousands  of shareholders.     Even at this,  Hermes has remained  successful  in  its involvement   in  using votes to approve  board of directors   and also its  intervention   to companies failing to solve essential   problems.   In  Hermes experience,   strategic  and capital   structure failures   rarely  occurred  at companies  where the board is functioning  well,  and the presence  of solid bodies.  Truly independent   non executive  directors   focus on Hermes  involvement   with its investee  companies  on board structure.

Hermes'  intervention  in  the case of Premier   Oil was how appropriate   it was for a non• executive director   to represent the  interests of particular shareholders  (Johnson,   2005). Premier oil's  major problem  was that  it was dominated  by two major shareholders Amerada  Hess,  a US company  and PETRONAS  a Malaysian   national  oil company each of which held  25 percent  of the shares.   Premier   oil  also  had a management problem;   it was not large enough to compete  in production and downstream  work with upcoming  super major oil companies.   However,   there  were positive works too,  like building  schools,   funding  teachers  and providing  AIDS  education.

Premier's  under performance  was due to their lack  of a clear strategy which was very different from Total. Some social   groups  have raised  ethical concern  about the operation  of Premier oil  in Burma and therefore  approached  Hermes as an institutional investor in the company  to dissuade   them from further  investment.

Hermes took some actions regarding   Premier   oil by holding   regular discussions   with interested  investors,   the Burma Campaign   UK,  UK governments  and other parastatals. There was a direct   flow of communication    between the chairman   who was open to improve  the board system  by first adding new independent  NED's and discussing strategic   and ethical  concerns  of premier   oil.

The Hermes engagement  led  to a restructuring process and a tradeoff to 'swap assets for shares' which freed up cash and led to the cancellation   of the 25% shareholdings   all of which was backed  by shareholders   due to how valuable   the approach  was.

Hermes'  intervention led  to the doubling of Premier  oil  share price and their withdrawal from  Burma,  it also  resulted  in  an excess return to Hermes' clients.  In  David's  view,
'Premier   oil became  established  as a strong  independent    E&P company  with  a real
opportunity  to continue to add value   for its  shareholders.'  (Pitt-Watson   and Johnson;
2010).

SHOULD  HERMES  SEEK TO INFLUENCE  TOTAL  WITH  REGARD  TO THEIR ACTIVITIES   IN  BURMA/MYANMAR?

There are strong social and commercial  disincentives   for new investments  in weak states with a history  of political  violence  (Bannon  and Collier,   2003) as in the case of Burma/Myanmar.

Total  had a bad reputation  for corporate  responsibility   due to its previous environmental  records.  Hermes had to visit  Total's  operation  in Burma/Myanmar  as an invitation from shareholders.  Hermes did not want to go to Burma because of the controversy  and its history  of military  dictatorship.   Once conflict  breaks out it tends to make matters worse  through its effect on the structure  of the economy.

Total  had two strategies:    Operating  in troubled  regions and access to exploiting  oil and gas reserves  in mostly Organization  for Economic  Co-operation  and Development (OECD)   countries. OECD countries   help natural resource  dependent,  low-income countries  to diversify  by removing tariff and non tariff  barriers on value added goods (Bannon and Collier,  2003)  .Total  was still in Burma in regards to the poor government due to the financial   risk  in  case there was a change of regime or sanction compelled  by the UN or the  EU.

However,  its mode of business  had a good financial  performance  and underlying government power.  The project benefits   the population  as it is a significant   source of funding for the junta  in power.  To shareholders  the sole reason for starting  or investing in  a company  is to make profit. If this was what Total was doing,  then it was indeed a good business  strategy.   Founder and senior advisor  of Hermes,  David Pitt-Watson reflected  on the engagement  Hermes had with Premier Oil which he had help develop over ten years and on the positive  response  of the share price  that had been a vindication   of Hermes  approach  to fund management.

What are the possible solutions  regarding   Total?  What are Hermes'  rights and duties? Total  was convinced  that Hermes would  be impressed  due to their  dealings with corporate  social  responsibility  issues.  The issues  addressed  with premier oil were significant  governance,   strategic  and financial  issues  as well as social  responsibility and corporate  governance;   this was not the case with Total.  Total  Oil is different  from Premier Oil  in the sense that Total  was involved in a self-aggrandizing    project which formed part of an excellent   goal.

While Hermes was pressing  for some governance  improvement,   Total  alleviation  work and transparency  was not fully satisfying  despite  its operations  being  legal in its aim to contribute  to social  development   in  Burma/Myanmar.

RECOMMENDATION   AND CONCLUSION

Institutional   investors  are becoming  more important  in global  finance  contributing  to deeper and better functioning  markets.  With the growing importance  of institutional investors, regulatory   and accounting  policy changes that affect pension funds  and insurance companies can have vital implications  implemented  or completed  across the world (CGFS  papers,  2007).  The main goal for return oriented investors is to increase the value of a portfolio over the long term (Staub-Bisang,2012).   The superior  role of long-term   institutional   investors  suggest that institutional   investors  with a long-term investment   horizon  play a more valuable  governance  role  in mitigating   agency problems than  investors  with a short-term  horizon  (Attig et al,2011  ).

In  making  a recommendation   to the board,   it is  important  to consider  how:  suitable, acceptable and feasible  it is to dis-invest  from Burma/Myanmar.

Suitability:

This deals  with the overall aim and strategy of the business which  is  to increase  return on investment.  Therefore,  a balance  between  corporate  social  responsibility,   corporate governance  and return on investment   has to be reached. A decision to dis-invest  could  mean shareholders  lose out which defeats the  purpose for which  Hermes and Total  oil exists that is;  to maximize  return on investment. As a result,  it is not suitable   to dis-invest  as it does not strike the correct balance.

Acceptability:

If shareholders    lose  out they are likely   to disagree  with the decision.   Also,  CSR will  not be fulfilled  because the contribution  to social  development   in Burma/Myanmar  will be withdrawn leaving  the community  at a loss.
Moreover,  in considering   corporate  governance  issues it is important  to consider cultural differences  which  may lead to a different  approach  in Burma/Myanmar.    As a result,  Total  oil has dealt  with it by using best practice.
Based on this,  disinvestment   is unacceptable  to stakeholders  at large.

Feasibility:

Feasibility  is concerned  with the financial  viability  of the possible  decision to dis-invest based on a cost benefit analysis.   As pointed  out,  it will be very costly and time consuming  for shareholders to put pressure  on the company  especially  if it is making profit. It has also made a competitive advantage  of operating  in regions  seen to be troubled.
Therefore,  it is not feasible to dis-invest  due to possible negative financial impact.

Moreover,  in making  comparisons  with premier oil,  total  oil is  larger  and the strategy that was employed  by Hermes on premier  oil  is 8 years old which may not be implementable  in the present environment  as well as having  a smaller  shareholding presently.

Based on the issues pointed  out above;  a recommendation  will be to stay with Hermes and Total  coming together to improve corporate governance  issues. The shareholders invited  Hermes to visit total operations  in Burma/Myanmar  which  indicates  an improvement  on is needed.

A positive  reaction  is reported in a study,  when corporations  settle on governance proposals  made by the united shareholders  association,  the  author estimated  in both studies that the gains  to shareholders   exceeded  the costs (www.calpers.ca.gov).

It is important to use key stakeholders  to influence  the need for improvement  and more transparency  so as to keep them all satisfied and more socially  responsible  as a company.  This decision  could  effectively  lead  to a positive  share price reaction.

REFERENCES

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Sanon ,I;   Collier,  P .ed  (2003),:Natural     resources  and violent  conflict:  option  and actions  Washington   :World  Bank

Committee   on the global   financial    system(CGFS  papers) (2007) p31:   institutional investors,   global  savings   and asset  allocation,    report submitted   by a working  group established  by the committee  on the GCFS,   bank for international    settlements  press and communications

Coombes,0(2004):     'Any codes of governance  work.  Mckinsey quarterly.

Davis,    E.P;   Steil,   8(2001)  p12:  Institutional    Investors,    palatino '382'  Asco typesetters. Hong Kong

Johnson,   G (2005) p248:  Case teaching   notes  on premier  oil and  Hermes.    Pearson education   ltd.

Mallin,  A.C  (2007) p24:  Corporate   Governance    ,second   edition,   oxford university press.

Mirjan;  S.B   (2012):    Sustainable     investing   for  Institutional    investors, risks, regulations      and  strategies.    John Wiley  and sons.Singapore     pte,ltd

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Nordman,   C.J  (2012): Vocational   education.on  the job training  and labor market integration  of young workers  in  urban West Africa.   Background  paper for EFA global monitoring report,2012.

OECD (2011  ):  The role  of Institutional     Investors   In promoting   good  governance, OECD publishing, retrieved  28th Dec,2012

Rezaee,   Z (2008) p23:  Corporate  Governance   and  Ethics.  John Wiley and sons inc

Strum,  S(2009) P7: The influence  of institutional    investors   on corporate management   and corporate   governance  in Germany:  A multi perspective analysis diploma thesis.

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www.caliper.ca.gov      retrieved  on the 1st  Jan, 2013

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2012

Human Resource Management - Assessing Performance

Once again after going through some articles on Harvard Business Review, i came across a nice article on Assessing Performance by Patty McCord, a former Chief Talent Officer at Netflix in the January Issue through the case on "How Netflix Reinvented HR. The write up was really inspiring and goes on to show that as organizations, we need to constantly come up with innovative ways to tackle different business challenges. I am sharing this article here to inspire our thinking of the Human Resource function and a direct link to the page is : https://hbr.org/2014/01/how-netflix-reinvented-hr .The article is credited to Patty McCord and culled from the January 2014 issue on Harvard Business Review on the topic assessing performance. All words are in her own words while images are mine to make the article not appear boring to you readers. Follow the link above to view the article or you can read it below:

 Sheryl Sandberg has called it one of the most important documents ever to come out of Silicon Valley. It’s been viewed more than 5 million times on the web. But when Reed Hastings and I (along with some colleagues) wrote a PowerPoint deck explaining how we shaped the culture and motivated performance at Netflix, where Hastings is CEO and I was chief talent officer from 1998 to 2012, we had no idea it would go viral.

We realized that some of the talent management ideas we’d pioneered, such as the concept that workers should be allowed to take whatever vacation time they feel is appropriate, had been seen as a little crazy (at least until other companies started adopting them). But we were surprised that an unadorned set of 127 slides—no music, no animation—would become so influential.

People find the Netflix approach to talent and culture compelling for a few reasons. The most obvious one is that Netflix has been really successful: During 2013 alone its stock more than tripled, it won three Emmy awards, and its U.S. subscriber base grew to nearly 29 million. All that aside, the approach is compelling because it derives from common sense.

In this article I’ll go beyond the bullet points to describe five ideas that have defined the way Netflix attracts, retains, and manages talent. But first I’ll share two conversations I had with early employees, both of which helped shape our overall philosophy.

The first took place in late 2001. Netflix had been growing quickly: We’d reached about 120 employees and had been planning an IPO. But after the dot-com bubble burst and the 9/11 attacks occurred, things changed. It became clear that we needed to put the IPO on hold and lay off a third of our employees. It was brutal. Then, a bit unexpectedly, DVD players became the hot gift that Christmas. By early 2002 our DVD-by-mail subscription business was growing like crazy. Suddenly we had far more work to do, with

30% fewer employees.

One day I was talking with one of our best engineers, an employee I’ll call John. Before the layoffs, he’d managed three engineers, but now he was a one-man department working very long hours. I told John I hoped to hire some help for him soon. His response surprised me. “There’s no rush—I’m happier now,” he said. It turned out that the engineers we’d laid off weren't spectacular—they were merely adequate. John realized that he’d spent too much time riding herd on them and fixing their mistakes. “I’ve learned that I’d rather work by myself than with subpar performers,” he said. His words echo in my mind whenever I describe the most basic element of Netflix’s talent philosophy: The best thing you can do for employees—a perk better than Foosball or free sushi—is hire only “A” players to work alongside them. Excellent colleagues trump everything else.

The second conversation took place in 2002, a few months after our IPO. Laura, our bookkeeper, was bright, hardworking, and creative. She’d been very important to our early growth, having devised a system for accurately tracking movie rentals so that we could pay the correct royalties. But now, as a public company, we needed CPAs and other fully credentialed, deeply experienced accounting professionals—and Laura had only an associate’s degree from a community college. Despite her work ethic, her track record, and the fact that we all really liked her, her skills were no longer adequate. Some of us talked about jury-rigging a new role for her, but we decided that wouldn't be right.

So I sat down with Laura and explained the situation—and said that in light of her spectacular service, we would give her a spectacular severance package. I’d braced myself for tears or histrionics, but Laura reacted well: She was sad to be leaving but recognized that the generous severance would let her regroup, retrain, and find a new career path. This incident helped us create the other vital element of our talent management philosophy: If we wanted only “A” players on our team, we had to be willing to let go of people whose

skills no longer fit, no matter how valuable their contributions had once been. Out of fairness to such people—and, frankly, to help us overcome our discomfort with discharging them—we learned to offer rich severance packages.

With these two overarching principles in mind, we shaped our approach to talent using the five tenets below.

Hire, Reward, and Tolerate Only Fully Formed Adults
Over the years we learned that if we asked people to rely on logic and common sense instead of on formal policies, most of the time we would get better results, and at lower cost. If you’re careful to hire people who will put the company’s interests first, who understand and support the desire for a high-performance workplace, 97% of your employees will do the right thing. Most companies spend endless time and money writing and enforcing HR policies to deal with problems the other 3% might cause. Instead, we tried really hard to not hire those people, and we let them go if it turned out we’d made a hiring mistake.

Adult like behavior means talking openly about issues with your boss, your colleagues, and your subordinates. It means recognizing that even in companies with reams of HR policies, those policies are frequently skirted as managers and their reports work out what makes sense on a case-by-case basis.
Let me offer two examples.

When Netflix launched, we had a standard paid-time-off policy: People got 10 vacation days, 10 holidays, and a few sick days. We used an honor system—employees kept track of the days they took off and let their managers know when they’d be out. After we went public, our auditors freaked. They said Sarbanes-Oxley mandated that we account for time off.

We considered instituting a formal tracking system. But then Reed asked, “Are companies required to give time off? If not, can’t we just handle it informally and skip the accounting rigmarole?” I did some research and found that, indeed, no California law governed vacation time.

So instead of shifting to a formal system, we went in the opposite direction: Salaried employees were told to take whatever time they felt was appropriate. Bosses and employees were asked to work it out with one another. (Hourly workers in call centers and warehouses were given a more structured policy.) We did provide some guidance. If you worked in accounting or finance, you shouldn't plan to be out during the beginning or the end of a quarter, because those were busy times. If you wanted 30 days off in a row, you needed to meet with HR. Senior leaders were urged to take vacations and to let people know about them—they were role models for the policy. (Most were happy to comply.) Some people worried about whether the system would be inconsistent—whether some bosses would allow tons of time off while others would be stingy. In general, I worried more about fairness than consistency, because the reality is that in any organization, the highest-performing and most valuable employees get more leeway.

The company’s expense policy is five words long: “Act in Netflix’s best interests.”

We also departed from a formal travel and expense policy and decided to simply require adult like behavior there, too. The company’s expense policy is five words long: “Act in Netflix’s best interests.” In talking that through with employees, we said we expected them to spend company money frugally, as if it were their own. Eliminating a formal policy and forgoing expense account police shifted responsibility to frontline managers, where it belongs. It also reduced costs: Many large companies still use travel agents (and pay their fees) to book trips, as a way to enforce travel policies. They could save money by letting employees book their own trips online.

Like most Netflix managers, I had to have conversations periodically with employees who ate at lavish restaurants (meals that would have been fine for sales or recruiting, but not for eating alone or with a Netflix colleague). We kept an eye on our IT guys, who were prone to buying a lot of gadgets. But overall we found that expense accounts are another area where if you create a clear expectation of responsible behavior, most employees will comply.

Tell the Truth About Performance
Many years ago we eliminated formal reviews. We had held them for a while but came to realize they didn't make sense—they were too ritualistic and too infrequent. So we asked managers and employees to have conversations about performance as an organic part of their work. In many functions—sales, engineering, product development—it’s fairly obvious how well people are doing. (As companies develop better analytics to measure performance, this becomes even truer.) Building a bureaucracy and elaborate rituals around measuring performance usually doesn't improve it.

Traditional corporate performance reviews are driven largely by fear of litigation. The theory is that if you want to get rid of someone, you need a paper trail documenting a history of poor achievement. At many companies, low performers are placed on “Performance Improvement Plans.” I detest PIPs. I think they’re fundamentally dishonest: They never accomplish what their name implies.
One Netflix manager requested a PIP for a quality assurance engineer named Maria, who had been hired to help develop our streaming service.

The technology was new, and it was evolving very quickly. Maria’s job was to find bugs. She was fast, intuitive, and hardworking. But in time we figured out how to automate the QA tests. Maria didn't like automation and wasn't particularly good at it. Her new boss (brought in to create a world-class automation tools team) told me he wanted to start a PIP with her.
I replied, “Why bother? We know how this will play out. You’ll write up objectives and deliverables for her to achieve, which she can’t, because she lacks the skills. Every Wednesday you’ll take time away from your real work to discuss (and document) her shortcomings. You won’t sleep on Tuesday nights, because you’ll know it will be an awful meeting, and the same will be true for her. After a few weeks there will be tears. This will go on for three months. The entire team will know. And at the end you’ll fire her. None of this will make any sense to her, because for five years she’s been consistently rewarded for being great at her job—a job that basically doesn't exist anymore. Tell me again how Netflix benefits?

“Instead, let’s just tell the truth: Technology has changed, the company has changed, and Maria’s skills no longer apply. This won’t be a surprise to her: She’s been in the trenches, watching the work around her shift. Give her a great severance package—which, when she signs the documents, will dramatically reduce (if not eliminate) the chance of a lawsuit.” In my experience, people can handle anything as long as they’re told the truth—and this proved to be the case with Maria.

When we stopped doing formal performance reviews, we instituted informal 360-degree reviews. We kept them fairly simple: People were asked to identify things that colleagues should stop, start, or continue. In the beginning we used an anonymous software system, but over time we shifted to signed feedback, and many teams held their 360s face-to-face.

HR people can’t believe that a company the size of Netflix doesn’t hold annual reviews. “Are you making this up just to upset us?” they ask. I’m not. If you talk simply and honestly about performance on a regular basis, you can get good results—probably better ones than a company that grades everyone on a five-point scale.


Managers Own the Job of Creating Great Teams
Discussing the military’s performance during the Iraq War, Donald Rumsfeld, the former defense secretary, once famously said, “You go to war with the army you have, not the army you might want or wish to have at a later time.” When I talk to managers about creating great teams, I tell them to approach the process in exactly the opposite way.

In my consulting work, I ask managers to imagine a documentary about what their team is accomplishing six months from now. What specific results do they see? How is the work different from what the team is doing today? Next I ask them to think about the skills needed to make the images in the movie become reality. Nowhere in the early stages of the process do I advise them to think about the team they actually have. Only after they’ve done the work of envisioning the ideal outcome and the skill set necessary to achieve it should they analyze how well their existing team matches what they need.

If you’re in a fast-changing business environment, you’re probably looking at a lot of mismatches. In that case, you need to have honest conversations about letting some team members find a place where their skills are a better fit. You also need to recruit people with the right skills.

We faced the latter challenge at Netflix in a fairly dramatic way as we began to shift from DVDs by mail to a streaming service. We had to store massive volumes of files in the cloud and figure out how huge numbers of people could reliably access them. (By some estimates, up to a third of peak residential internet traffic in the U.S. comes from customers streaming Netflix movies.) So we needed to find people deeply experienced with cloud services who worked for companies that operate on a giant scale—companies like Amazon, eBay, Google, and Facebook, which aren’t the easiest places to hire someone away from.
Our compensation philosophy helped a lot. Most of its principles stem from ideals described earlier: Be honest, and treat people like adults. For instance, during my tenure Netflix didn’t pay performance bonuses, because we believed that

they’re unnecessary if you hire the right people. If your employees are fully formed adults who put the company first, an annual bonus won’t make them work harder or smarter. We also believed in market-based pay and would tell employees that it was smart to interview with competitors when they had the chance, in order to get a good sense of the market rate for their talent. Many HR people dislike it when employees talk to recruiters, but I always told employees to take the call, ask how much, and send me the number—it’s valuable information.

In addition, we used equity compensation much differently from the way most companies do. Instead of larding stock options on top of a competitive salary, we let employees choose how much (if any) of their compensation would be in the form of equity. If employees wanted stock options, we reduced their salaries accordingly. We believed that they were sophisticated enough to understand the trade-offs, judge their personal tolerance for risk, and decide what was best for them and their families. We distributed options every month, at a slight discount from the market price. We had no vesting period—the options could be cashed in immediately. Most tech companies have a four-year vesting schedule and try to use options as “golden handcuffs” to aid retention, but we never thought that made sense. If you see a better opportunity elsewhere, you should be allowed to take what you’ve earned and leave. If you no longer want to work with us, we don’t want to hold you hostage.

We continually told managers that building a great team was their most important task. We didn’t measure them on whether they were excellent coaches or mentors or got their paperwork done on time. Great teams accomplish great work, and recruiting the right team was the top priority.

Leaders Own the Job of Creating the Company Culture
After I left Netflix and began consulting, I visited a hot start-up in San Francisco. It had 60 employees in an open loft-style office with a foosball table, two pool tables, and a kitchen, where a chef cooked lunch for the entire staff. As the CEO showed me around, he talked about creating a fun atmosphere. At one point I asked him what the most important value for his company was. He replied, “Efficiency.”

“OK,” I said. “Imagine that I work here, and it’s 2:58 PM. I’m playing an intense game of pool, and I’m winning. I estimate that I can finish the game in five minutes. We have a meeting at 3:00. Should I stay and win the game or cut it short for the meeting?”

“You should finish the game,” he insisted. I wasn’t surprised; like many tech start-ups, this was a casual place, where employees wore hoodies and brought pets to work, and that kind of casualness often extends to punctuality. “Wait a second,” I said. “You told me that efficiency is your most important cultural value. It’s not efficient to delay a meeting and keep coworkers waiting because of a pool game. Isn’t there a mismatch between the values you’re talking up and the behaviors you’re modeling and encouraging?”

When I advise leaders about molding a corporate culture, I tend to see three issues that need attention. This type of mismatch is one. It’s a particular problem at start-ups, where there’s a premium on casualness that can run counter to the high-performance ethos leaders want to create. I often sit in on company meetings to get a sense of how people operate. I frequently see CEOs who are clearly winging it. They lack a real agenda. They’re working from slides that were obviously put together an hour before or were recycled from the previous round of VC meetings. Workers notice these things, and if they see a leader who’s not fully prepared and who relies on charm, IQ, and improvisation, it affects how they perform, too. It’s a waste of time to articulate ideas about values and culture if you don’t model and reward behavior that aligns with those goals.

The second issue has to do with making sure employees understand the levers that drive the business. I recently visited a Texas start-up whose employees were mostly engineers in their twenties. “I bet half the people in this room have never read a P&L,” I said to the CFO. He replied, “It’s true—they’re not financially savvy or business savvy, and our biggest challenge is teaching them how the business works.”

Even if you've hired people who want to perform well, you need to clearly communicate how the company makes money and what behaviors will drive its success. At Netflix, for instance, employees used to focus too heavily on subscriber growth, without much awareness that our expenses often ran ahead of it: We were spending huge amounts buying DVDs, setting up distribution centers, and ordering original programming, all before we’d collected a cent from our new subscribers. Our employees needed to learn that even though revenue was growing, managing expenses really mattered.
The third issue is something I call the split personality start-up. At tech companies this usually manifests itself as a schism between the engineers and the sales team, but it can take other forms. At Netflix, for instance, I sometimes had to remind people that there were big differences between the salaried professional staff at headquarters and the hourly workers in the call centers. At one point our finance team wanted to shift the whole company to direct-deposit paychecks, and I had to point out that some of our hourly workers didn't have bank accounts. That’s a small example, but it speaks to a larger point: As leaders build a company culture, they need to be aware of subcultures that might require different management.

Good Talent Managers Think Like Business people and Innovators First, and Like HR People Last
Throughout most of my career I've belonged to professional associations of human resources executives. Although I like the people in these groups personally, I often find myself disagreeing with them. Too many devote time to morale improvement initiatives.

At some places entire teams focus on getting their firm onto lists of “Best Places to Work” (which, when you dig into the methodologies, are really based just on perks and benefits). At a recent conference I met someone from a company that had appointed a “chief happiness officer”—a concept that makes me slightly sick.

During 30 years in business I've never seen an HR initiative that improved morale. HR departments might throw parties and hand out T-shirts, but if the stock price is falling or the company’s products aren't perceived as successful, the people at those parties will quietly complain—and they’ll use the T-shirts to wash their cars.

Instead of cheer-leading, people in my profession should think of themselves as business people. What’s good for the company? How do we communicate that to employees? How can we help every worker understand what we mean by high performance?

Here’s a simple test: If your company has a performance bonus plan, go up to a random employee and ask, “Do you know specifically what you should be doing right now to increase your bonus?” If he or she can’t answer, the HR team isn't making things as clear as they need to be.

At Netflix I worked with colleagues who were changing the way people consume filmed entertainment, which is an incredibly innovative pursuit—yet when I started there, the expectation was that I would default to mimicking other companies’ best practices (many of them antiquated), which is how almost everyone seems to approach HR. I rejected those constraints. There’s no reason the HR team can’t be innovative too.