Avoid Compensation Chaos by Building an Enduring Pay Strategy

You are about to introduce a phantom stock plan to 15 of your key people.  You have read up on this concept and decided it is a perfect fit for your business.  You are a private company and don't want to give equity away, but you do want your executive team to adopt a stewardship approach to their role in building the future business; you'd like them to think more like you as the CEO or owner.  This led you to speak with your company’s accounting firm and they agreed phantom stock would be a good plan from both a tax and cash flow perspective.  So, with all of that logic and the positive momentum you've garnered, you contacted your attorney and asked him to draft a plan agreement.  He's done so and you're about to meet with your key producers and introduce the plan to them.  STOP!! Please don't go any further.

Compensation Chaos can be avoided by building an enduring pay strategy.

Before you proceed, take a breath, step back and consider the broader implications of what you are doing.  At a minimum, there are a few questions that really should be answered before you proceed. Your response to these queries will help determine whether you're really ready to introduce the plan or not. They will help you avoid compensation chaos—a condition that occurs when there is not a cohesive philosophy, strategy and structure guiding pay plan decision making and implementation. 

  1. What is the plan's purpose? Why are you implementing it and what outcomes will indicate the plan is "working?"
  2. What part of your company's compensation philosophy does this plan support?
  3. Who is eligible for your plan? How was that list determined--what's the criteria?
  4. What is the formula for valuing shares in your plan?
  5. How many shares are you going to make available?
  6. How will the amount of shares for which someone is eligible be defined? A percentage of salary? A percentage of total shares?
  7. What percentage of owner value are you planning to share? What is that based on?
  8. How will shares be distributed and at what frequency?
  9. What are the performance requirements for earning shares? Have they been tested against any company performance standards?
  10. Have you projected the potential value of the plan relative to an increase in shareholder value?
  11. What is the level of sharing to be done under the plan based on different company performance results, such as base, target and superior?
  12. Do you have a financial model to test, measure and manage your plan?

I could go on but hopefully you get the idea.  Now consider whether you’ve asked and answered the same kinds of questions before implementing each of the pay and benefit plans you’ve initiated in recent years.  If you haven’t, there’s a very good chance you are in the midst of compensation chaos—or are about to be.

A legal document is not a pay strategy.  Before your plan is introduced to anybody, you should consider taking the following steps to ensure that a strategic context is created for its roll-out and each of the questions above is adequately answered. These will also ensure that both shareholder and employee interests are properly served.  In the end, these steps will ensure you adopt an approach to pay design that endures.

Define a Pay Philosophy

A pay philosophy is a written statement that company owners and senior strategy leaders draft to spell out a value system and construct that guides how people will be paid in the company and why.  It is written so it can be easily shared and referenced both when leadership makes decisions about specific pay strategies and when it communicates the nature of the organization’s pay system and its components to employees.  It acts as a kind of compensation constitution for those charged with envisioning, creating and sustaining the rewards strategy of the company.

Write a Purpose Statement

This step should answer the question, “Why are we doing this?” for every plan that is implemented.  It should make clear to company leadership what the plan will help the business achieve.  For example: This plan is designed to share future value of the business in a way that promotes an ownership mindset on the part of key producers.  It should build a sense of partnership between ownership and participating employees. It should improve focus on key leverage points (named specifically if possible) in our business plan and accelerate our ability to achieve our growth goal of doubling revenue in the next four years.

A purpose statement should be consistent with the company's pay standards and will be easier to articulate if leadership has developed a clear, written philosophy for compensation.

Draft a Plan Blueprint

The plan blueprint should answer the question, “What type of plan will we have and how will it be structured?”  It is basically the architectural drawing of the specific rewards program you want to initiate. It describes what type of rewards plan it will be--phantom stock, SAR, profit pool, PUP, deferred compensation, etc.--and what performance thresholds it will be based on.  At this stage, a business is determining whether the company wants to tie the reward to the business value or some other financial metric.  You are addressing whether you want to give present value away or only future value, whether the reward will be performance-based (employees must achieve a future result before they will receive shares) or have immediate value, and so forth.  The plan blueprint creates a framework in which the company's rewards strategy can be manifest.

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Develop a Financial Model

With a purpose statement completed and a blueprint in place you now need to answer a critical question,  “How much value will this plan make available and what will the reward be based on?”  Such is the role of a sound financial model.  Done right, this process projects a future value of the business under different performance assumptions--for example, base, target or budget and superior.  It attempts to anticipate the level of additional shareholder value that will be achieved under each of those scenarios so the company can determine how much of that increase can or should be shared with those primarily responsible for its creation.

This step makes clear that compensation design is an outcome-based endeavor.  You are envisioning a future result and then engaging in a kind of reverse engineering process to determine how that potential value can be communicated in "today's" terms (percentage of salary, percentage of profits, etc.).  It is a "self-financing" approach that allows the company to define appropriate thresholds of performance that must achieved before the plan will either accrue or pay out its value.  It also allows a company to envision how it might be able to pay higher percentages of value to participants if increasing levels of results are achieved.  Done right, this phase of development brings the plan to life.  To get a sense for how this modeling process works, check out the "Picture Your Future Company" tool in our new website.

Document the Plan

Once two to four iterations of the financial model have been worked through, and the metrics for creating plan value have been clearly defined, you are ready to put the final specifications on the plan and document it. This step must produce both a legal document (where applicable) that addresses all of the statutory requirements of the plan, as well as a summary plan description that explains how the plan works to its participants. The plan specifications must address all of the details of the plan--how benefits are earned, when they will be paid out, how they will be treated in the case of early termination, disability, death, and so forth. The production of these documents requires the ability to understand both the legal guidelines associated with the plan (i.e. ERISA or 409(A) issues) as well as the strategic purpose the new program will serve.

Build a Total Compensation Structure (TCS)

A TCS is a framework you build for managing and analyzing all the components of pay and benefits you are offering.  Ideally, it gives you an “all in one place” view of every employee tier, what plans they’re eligible for and at what level.  It allows you to evaluate the whole value proposition as opposed to each individual component in isolation.  Within this framework, it is easier to make decisions and adjustments in specific pay plans because you can measure each against its impact on the whole picture.

When a TCS is built properly, it allows you to have integrity in how you operate your overall compensation strategy.  By integrity I mean there is continuity and consistency between the company vision, the business model and strategy, the pay philosophy, employee roles and expectations and specific rewards for achieving results.  That structure creates the assessment symmetry needed to achieve the right balance between salaries and incentives—and every other part of your pay offering.  In the end, a Total Compensation Structure keeps your pay strategy from devolving into chaos.

Market the Plan

When a company takes a strategic approach to compensation, it doesn't just "announce" a new pay program.  Rather, it creates an opportunity to build a sense of partnership with its key people by literally marketing a future to them.  This is more than explaining how the new long-term incentive plan (or other pay program) will work.  It involves framing the compensation value proposition in a larger context that links together the vision of the company, its business model and strategy, employee roles and expectations and the rewards for fulfilling those expectations.  Although an initial meeting may be held to explain the plan and "roll it out," that communication should just be one of many that will occur as the company treats its workforce as a key constituency that needs to be consistently and effectively nurtured.

Each of these steps could be further embellished but hopefully you can begin to see how the building out of a pay strategy differs from just coming up with a plan. Further, when an organization seeks to align compensation with the business model and strategy of the company, it has an opportunity to create greater engagement and execution on the part of its key people.  It essentially makes those individuals stewards of the shareholders' vision by helping them feel a greater sense of partnership and clarity about the future of the business.

In the end, this is how you avoid infecting your compensation strategy with a large measure of chaos.

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