How to Optimize Your Compensation Plan
Your compensation plan has the ability to unleash your employees’ capabilities in a way few other managerial levers can. Yet incentives can be a touchy subject and even the best-intentioned approaches have the potential to motivate employees to produce less, take a different job, or worse, take actions that harm the company. Compensation plans are notoriously difficult for this reason. They are an effective fulcrum for either productivity or ruin.
Charlie Munger, longtime partner of Warren Buffett, famously said, “Show me the incentives and I’ll show you the outcome.” Your team is made up of human beings and humans are naturally inclined toward self-preservation and to seek their own prosperity. A good incentive plan harnesses this innate energy for the benefit of your organization in a way that both parties prosper. You want to illustrate to your employees that the company’s success directly ties to their own.
We’d like to say that we have been great on incentives from the get-go, but it’s only time on the front lines and trial and error that have taught us a few things that work (and others that don’t). This essay is an attempt to lay them out in such a way that makes the basic principles easy to apply to your organization in order to better engage your team.
The Incentive Toolbox
When building a compensation plan, there is no limit on your creativity. You know your business best and, barring some (mostly local) regulatory restrictions, you are free to construct incentives in a way that fits your unique situation. Before we talk about specific strategies, it’s helpful to lay out how we think about available tools.
Salary/Hourly Wages
Salary, hourly wages, or more simply “base pay,” is most effective when it covers the basic lifestyle of an employee. If your team is constantly worrying about housing, food, transportation or even “wants” they’ve grown accustomed to, you’ll receive less focus from them in the workplace. Pay a fair wage that covers the essentials.
Notable exceptions to this rule tend to be in the area of sales. If an employee’s sole job is as an individual contributor in sales, we have seen successful compensation structures where salary is replaced in part or in full by a draw on future commissions. This bridges a potential gap in compensation timing without diminishing the motivation to provide for the organization.
Bonuses
Bonuses are useful when tied to specific “stretch” objectives or the accomplishment of a big milestone with clear utility for the organization. Some examples are the completion of a project, the closing of a deal, hitting a target metric, or landing a new customer. Commissions are, in our opinion, a type of bonus as they reward a specific measurable accomplishment at or around the same time that it is accomplished.
Annual or Holiday bonuses can feel nice at the end of a good year, but if the amount is based on subjective decisions made by company management, employees can feel short changed or worse, they may overextend themselves in expectation that their bonus will be the same as last year (see: National Lampoon’s Christmas Vacation). What’s more, because these types of bonuses are paid at a fairly arbitrary period in time, employees may not benefit from them at the same time that their work is having its impact, leading to disconnect between effort and outcome. There are better ways to do incentive compensation, but if an annual bonus works best for you at least communicate in advance what criteria you will use to make your bonus decision and what the range of outcomes will be. We’ll touch on this more in later sections.
One exception to advanced notice is when an employee goes above-and-beyond in a rare, extraordinary way. A “thank you” check can be a fantastic way to show appreciation and encouragement, in addition to whatever normal incentive compensation the person would have received.
Benefits
While we use this term for a very broad category of items, there is a ton of creative potential in this area that you can use to differentiate yourself with current and prospective employees.
Broadly speaking, benefits are compensation where the company pays money for a good or service that it then passes on to the employee. Using this as a lens, your benefits package should focus on things that are a) lower cost - measured in either time or money - for the company to provide due to its bargaining power or b) high utility for employees. If a benefit you’re considering doesn’t meet either of these criteria, it may be better to simply pay your employees more.
If you’re struggling to determine what set of benefits is correct for your organization, we highly recommend asking employees. Benefits are for encouraging them to come work for you and to stay and they will be able to clearly articulate whether they’d prefer a 401k match or pet insurance. One caveat to asking is opportunity cost. If the person doesn’t perceive any tradeoff, the answer will always be yes, and often with minimal marginal utility.
Equity
Compensating with equity or equity-like incentives is the ultimate in aligning employee interests with those of the company. However, it must be constructed in such a way that the employee can clearly understand the link between ownership and their personal financial situation. For example, employee stock ownership programs that only provide for liquidity if the company is sold or acquired creates several layers of abstraction between owning the stock and an actual financial outcome, except if that’s the goal everyone is striving towards.
This gap can be bridged by paying dividends or distributions to shareholders based on company profitability, or equity can be replaced altogether with a profit-sharing arrangement, giving employees the major benefit of shareholding without the tax consequences and potential control issues of making them actual owners.
How to Use Incentives
Incentives Should Be Tailored
It is rare when the same incentive plan will work for all employees across all levels and functions of the organization. There are certain compensation mechanisms that can be broadly applied (like ESOPs, stock grants, or profit sharing), but the details of how these incentives get unlocked are more powerful when they are tailored to the various functions of the organization.
A general rule of thumb here is: the higher you are in the organization, the lower on the income sheet to measure your performance. Senior management has agency over demand generation, overhead, and everything in between. As such, their compensation should be closely tied to the profitability of the organization. In contrast, the sales team has agency over converting leads, but very little over CAPEX, support teams, or rent, therefore their incentives should rest on metrics higher on the income statement like net sales, or gross margin. We’ll get into this more in our section on making your incentive plan “controllable.”
Incentives Should Be Clear
The biggest disappointments happen over incentive plans that are unclear. There are several ways you can introduce ambiguity:
Targets Are Subjective
“Managerial discretion” often finds its way into compensation plans, especially when it comes to bonuses. The main problem here is that there is no definition around what the manager classifies as success. As a result, the main behavior this structure tends to drive is brown-nosing. Employees will reason, “If my manager likes me, that bonus is locked in!” This also puts unfair pressure on managers to make judgment calls on who is deserving with little to no objective criteria.
The best solution here is to make targets as objective and measurable as possible. Yes, this takes more work up-front, but will also prevent most arguments about what incentives are deserved when the time comes to pay them out. If there’s a number to be hit and we hit it, reward is unlocked.
“Managerial discretion” is often a fallback when we’re unsure of what a reasonable target is because the project or initiative we’re trying to incentivize is new, or the input behavior desired is difficult to quantify. Situations like these can be solved by chopping up an incentive target into time-bound pieces where outcomes are more visible. You may not know what an outcome should look like a year from now, but how about next quarter? Feedback on behavior is more helpful if discussed with specifics and close to the time of action. Chop an annual bonus up into pieces and agree with employees that you’ll set targets quarter by quarter until you all have better visibility on the initiative.
Targets Have Multiple Definitions
Stating that a bonus or similar incentive will be released when a project is “done” leaves the door open to interpretation. Project-based bonuses should have a very clear definition of what you mean by “done.” Is it done when the new warehouse is built or when it’s permitted for occupancy? Is it done when the new feature is code-complete, or when it’s in the hands of users? It takes a bit of extra time to spell these things out, but in doing so you are saving yourself from potential headaches and conflict.
Rewards Are Subjective
It is very tempting to tell an employee, especially one who is tenured and trusted, “get this done for us and we’ll take care of you.” This immediately creates an expectation in the employee’s mind of what the potential reward might be. That expectation will be front and center in their thinking each time they work on the project you’ve asked them to tackle. As you know from your own experience, expectations can easily become untethered to reality.
Sometimes you’ll get lucky and the reward will exceed their expectations. Many times it will not, and the relational damage done when there’s a negative mismatch can be difficult to heal. Save everyone the trouble and be clear. If your employee feels like the compensation on offer is too little, that conversation will have far less emotional energy than when it’s conducted after they’ve already put in the work.
Incentives Should Be Controllable
The most demotivating incentives make an employee feel like nothing they do will have an impact on the outcome. For example, a metric that can be easily moved by interest rates or other outside factors is likely to cause someone to throw up their hands in frustration. Likewise a metric that is heavily dependent on the cooperation or effort of a completely different department can be demotivating for an individual contributor (but could be a great incentive for a manager to build a better relationship with other managers).
The employees you’re incentivizing have to feel like they have agency over the outcome or the incentive loses its motivation. Every member of your team should be able to succinctly describe how their actions can lead to attaining the target goal. Too many levels of abstraction and they’ll check out.
Incentives Should Be Achievable
Even when goals are within your team’s locus of control, they also must feel achievable. Setting big, audacious goals can be motivating for certain situations, but if they feel outlandish they will lose their ability to motivate, and likely demotivate.
If you believe a goal is attainable and employees disagree, it’s easy to blame their lack of imagination. But assuming the target is reasonable, cultivating belief in the achievability of a goal is the leader’s job. Illustrate plausible paths toward achievement. Demonstrate your own commitment to the goal by dedicating resources to training, additional headcount, or technology in order to increase the team’s chances of success. If your team feels the goal is disconnected from reality, it may as well not exist.
Incentives Should Be Rewarding
While it seems obvious, we’ve seen plenty of incentive systems where the potential payouts were so small that they were completely ineffective. But what does an incentive look like that’s “big enough?” Here’s one way to think about it: The rewards that come from a well-constructed incentive system will be impactful enough that employees’ imaginations connect it to something tangible. Upon hearing the potential payout, your team should think, “With that, I could _____” If your reward evokes something they can connect to their lives outside of work, it will be effective.
Incentives Should Be Challenging
Setting goals over which your team feels high agency and are achievable is different from setting goals that are a slam dunk. In an effective compensation system, periods where all incentive metrics are achieved should be rare. If we’re thinking about a normal distribution bell curve, “all metrics hit” should be at least a 1 if not 2 standard deviation event.
Credit: https://analystprep.com/cfa-level-1-exam/quantitative-methods/key-properties-normal-distribution/
Without goals that feel like a stretch, incentive compensation is relegated to the same psychological position as base comp and it won’t drive your team to push themselves to better performance.
Incentives Should Be Balanced
In his seminal book High Output Management, former Intel CEO Andy Grove introduced the idea of measuring in pairs, where one metric is meant to control for potential negative outcomes flowing from the other. Within these pairs, he recommends having one metric be volume-based and the other rate-based.
An example is helpful. Let’s say you’d like to incentivize your sales team based on, well, sales. Using Grove’s pairs model, your first metric might be the amount of gross sales dollars and the second might be refund rate. You could construct an incentive plan that pays out a certain amount based on dollars sold so long as the refund rate stays below a certain level. The reason for this is obvious, but worth stating -- if the team is purely incented based on sales with no regard for customer satisfaction, it’s not difficult to imagine a slew of unintended consequences.
It’s better yet to combine the metrics and base incentives on a net number. So instead of gross sales and refund rate, you could simplify and pay out on net sales. If your sales team is selling a catalog that contains products with highly variable margins, it might make more sense to base incentives on gross margin dollars rather than gross sales and a margin rate.
Incentives Should Be Stress-Tested
The best way to determine the right balances for your incentive metrics is to try to break them. Your team is likely constructed of ethical people you trust, but we have to remember that incentives are powerful and can unintentionally create bad behavior.
There are two helpful ways to stress-test your metrics. The first is to brainstorm with your leadership team how your performance metrics might be gamed. Ask yourself “If I wanted to max out my personal payment from this program, consequences be damned, what would I do?” Your answers should spell out for you what tweaks you might need to make to create a less gameable system.
The second is to run a simple backtest on your compensation system. Assuming you have your last 3-5 years of financials, calculate what your team would have earned in prior years under your system. If you have a forecast, run the model forwards as well. Model out a year where the company is unprofitable. Does your incentive system still allow for large payouts to employees? Putting your model through the motions will help you improve it prior to launch. Remember, the goal of a new incentive program is to create more flourishing and have everyone share in that flourishing. It’s not to burden the company with additional overhead for the same performance.
Incentives Should Be Aligned
Perhaps the most critical part of any incentive compensation plan is that it is aligned. Alignment with the goals of the organization is clearly key - ensuring that each individual’s incentive, if met, will produce an outcome desired by the company.
More challenging is ensuring that incentives in different departments of the company, while aligned with the overall company, are not in conflict with one another. As an example, it makes sense to incentivize a Sales team on sales and a Customer Success team on renewal rate. But these metrics can actually be in conflict. Sales is incentivized to convert any lead possible, regardless of their long-term potential. Customer Success would rather throttle incoming sales to make sure only the highest qualified prospects are converted.
These types of situations are where you as the leader will need to get creative. Maybe sales should get 75% of their commission up-front and 25% when the customer renews for the first time. Or perhaps sales should receive a slightly lower commission on first sale, but also receive a royalty for each renewal that customer has. There are many ways to solve situations like these, and it will take your deep knowledge of your company and its culture to create a system that is internally aligned and optimized for output.
Incentives Should Be Benchmarked
Your business faces daily competition from firms offering similar products or services. If you’re lucky, this set of competitors is small and you have done your research on how to differentiate yourself to customers. When you are seeking to bring on new talent, your competitive set grows exponentially. Most prospective employees are not bound to the same niche your company is and therefore have many options in where to ply their trade. Further complicating matters, your existing employees have a similar wealth of choices.
Competition is fierce in the market for talent. If your incentive structure is misaligned with what others in the market are offering, your ability to attract and retain good people will be severely limited. Just as you have rigorously worked to understand your business’s competition and set your prices accordingly, you must ensure that the compensation plan you’re offering is compelling for new and current employees in the market of job offers.
Websites like Payscale, Glassdoor, and even the Bureau of Labor Statistics can help with some preliminary research, and if you’re doing a good bit of hiring, it may be worth paying for a data source to help your benchmarking. As with most things, “national averages” of compensation are only helpful if the market in which you’re hiring is representative of the national average, so be sure to adjust your ranges based on regional differences. If you’re hiring for roles that are becoming full-time remote as the norm, remember that you’re now competing with national firms who may not even have an office nearby.
Now that you know what you’re competing against, you can decide how you want to compete. For example, a mission-driven organization with an incredible corporate culture seeking to hire like-minded people is going to have more success offering below-market compensation than will a grind-it-out cold-call sales shop seeking mercenaries. Where you position yourself on the sliding scale between 100% incentives-driven and 100% culture-driven hiring depends a great deal on your organization’s personality and the type of person you’re seeking to hire.
However your compensation is structured, be prepared to patiently walk prospective hires through the details and sell them on why your total incentive package is better. Offer letters are sales letters for your way of doing things and should be persuasive about why your organization is the best next step for a prospect. If your incentives are appropriately structured, you will begin to attract aligned people who will help you succeed.
Conclusion
The ideal compensation structure prospers employees when the business is successful. It aligns the innate desires of employees to drive desired outcomes. Your employees want an incentive plan that is tailored to their role and has clear goals that feel achievable and controllable; one that will reward them when they deliver for the organization. Your business needs an incentive plan that challenges employees in a healthy way to pursue goals that are balanced against unproductive behavior, tested to ensure they will produce desired outcomes, aligned with the company’s aims, and are competitive enough to attract and retain great talent.
Getting this balance right takes work, and if you’re like us you’ll make plenty of mistakes along the way. The outcome will be worth the effort and can lead to an engaged team of people who benefit from moving your business forward for many years to come.
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