Yes, you read that right. Next year, you should get rid of that bonus plan you have reinvented five times in the last six years. More metrics is not the answer. A different payout schedule isn’t going to change anything. You just need to let it go. Incentive plans have become…old school. They are unappreciated, ineffective and economically indefensible. So, it’s out with the old and in with….
Value-sharing. Yes, value-sharing is different than paying incentives—very different. The intent of an incentive plan is to impact employee behavior. The intent of value-sharing is to impact productivity and profits. Incentive plans encourage employees to become manipulative and self-serving. Value-sharing plans encourage employees to become growth partners. Here’s why.
The Roles of Rewards
Your rewards strategy should support three core business objectives:
- Increase revenue.
- Increase profits.
- Increase business value.
Each of those objectives has both a short and a long-term dimension. They are also sequentially linked. As a result, employees should know the relationship between those three outcomes as well as the impact they are expected to have on each in their roles. And the way they are paid should communicate the importance of all three objectives to the organization. If your people know they can maximize their income by simply driving higher revenue, what happens to profits? Similarly, if the company is profitable but not growing revenue, how will business value improve?
Peter Drucker is quoted as saying that “the manager’s job is to keep his nose to the grindstone while lifting his eyes to the hills.” This is the point I’m trying to make here. Every business leader must balance two performance issues at the same time: producing results today while simultaneously preparing for tomorrow.
Consequently, your approach to employee performance rewards must strike the same balance. They must encourage the fulfillment of short-term targets without stifling the long-term value creation business growth relies on. So, how do you do that?
One Philosophy, Two Performance Periods
You start by developing a value-sharing philosophy. This will be easier if your organization has thought through how value creation occurs in your business—meaning the point at which you consider profits to be attributable to the contributions of your people as opposed to other factors (goodwill, owner capital assets at work, etc.). Once the value-creation standard is clear, you can decide what percentage of that added value should be shared and with whom. You can then determine how much should reward short-term versus long-term performance.
The next step is to decide on a value-sharing plan. In other posts, I’ve talked about a range of choices you have in this regard. But for our purposes in this article, let’s just talk about some general principles and a couple of examples.
1. Rewarding Short-Term Performance. The primary measure you want to emphasize in any plan that rewards results produced in 12 months or less is profit. Profit. Profit. Employees should understand that every role in the organization is responsible for improving that metric. This doesn’t mean you can’t reward team or department performance. It just means the overriding gatekeeper of short-term value-sharing is profit. If a pre-determined level is not reached (as defined in the value-sharing philosophy) then no payout is made. (Most short-term value-sharing plans have a graduated payout potential instead of “all or nothing.” Once a minimum threshold is reached, earnings from the plan can be literally unlimited if superior performance is achieved.)
2. Rewarding Long-Term Performance. The primary measure you want to use for any plan that is going to reward sustained results is increase in business value. This is because you want your people as committed to the growth of your company as you are. You want them thinking and acting like owners. This is what transforms employees into growth partners.
The most common way private companies fulfill the long-term part of their pay philosophy is by sharing some type of phantom stock. This kind of plan is based on a formula value that is determined for “phantom” shares in the company. These are like real shares of stock in that they will go up and down with the value of the business. However, no actual equity is being given. Essentially, you are providing employees a deferred compensation plan whose benefit is tied to the value of the business.
The art of effective pay design is striking the right balance between short and long-term value-sharing. Because that is different for every organization, we won’t try to resolve that issue here. What’s important to understand is that both parts are necessary. Long-term value-sharing guards against bad profits. These are profits that show up on the P&L but erode long-term business value because they were “ill-got”—they came at the cost of alienating a vendor, straining a customer relationship or otherwise letting short-term thinking impact your value-creation model. In recent years, the best example of this is Wells Fargo. Short-term gain. Long-term loss.
Short-term value sharing reinforces your company’s business model—its revenue drivers. It rewards your people’s ability to leverage the model for revenue and profit improvement. Increased revenue and profits allow the company to fuel its growth. Hence, a virtuous cycle is set in motion.
Value-sharing is the right approach because it actually holds compensation accountable—to itself. It is built on the premise that stakeholders in an organization should benefit from the wealth multiple they help create—but only once that value has been created. This approach essentially takes away the “cost” of an incentive because value-sharing is self-financing. Value is paid out of the value that is created.
So, here’s to an incentive plan-free 2019.