Executive dilemma: Approve the cloud, get a pay cut

The common EBITDA metric that financial analysts follow -- and which affects executive pay -- is biased against operational expenses such as cloud services

Executive dilemma: Approve the cloud, get a pay cut

EBITDA is defined as a company’s earnings before interest, taxes, depreciation, and amortization. Although you likely have heard the term before, few people outside the executive suite (other than accountants) really know what it means. It's widely used as a measurement of a company’s current operating profitability.

But as a company moves to the cloud, your EBITDA numbers could look worse. That's because EBITDA isn't adjusted for operating expenses like cloud services -- but is adjusted for the depreciation of capital expenses, which decreases under the use of the cloud.

The cloud's effect on EBITDA will matter greatly to publicly traded companies, where senior executives' bonuses and stock grants are determined by EBITDA performance. In some cases, 50 to 75 percent of their total compensation is affected.

By moving many workloads to the cloud, your company avoids hardware and software purchases, saving money, but the EBITDA doesn't credit you for those savings. Instead, it penalizes you because it comes from an era where capital-expense depreciation was a common method to boost perceived profitability.

Because of the mismatch in what EBITDA incentivizes and what is good for the company (moving to the cloud), some senior executives will face a reduction in their income to do the right thing for the company. Some will choose their income over company benefits.

A company shouldn't put itself in a position where executives are disincentivized to do the right thing.

If you’re a private company, all you have to do is change your metrics to incentivize saving money -- that is, moving to cloud -- rather than pick a standard like EBITDA that favors capital expenses.

But if you’re a public company, it's not so easy. After all, EBITDA is a common metric, even if it's not well understood outside of accountants and financial investors. The good news is that financial accounting standards bodies are considering a change in metrics to value the savings from operational expenses like the cloud, so as to reduce the capital-expenses bias in EBITDA today.

However, for now EBIDTA is the standard, and public companies will be measured against it. Until the standards change, top management will need to push against the EBITDA win, repeatedly telling shareholders that the cloud is the best move for the company's true efficiency and the hit to EBITDA is a necessary price -- and not a real price after all. Top management will need to back that up with changes to the internal incentives now based on EBITDA.

If you're in IT, this may sound like one of those odd preoccupations of senior management, but it's a real barrier to significant, sustained cloud migration. If you sense executive resistance to the cloud -- likely in the form of second thoughts as the personal implications get realized --the EBITDA bias may be the reason why.