In a recent article for Strategy+Business, Ken Favaro offered the following perspective about organizational growth:
"Peter Drucker once wrote that the manager’s job is to keep his nose to the grindstone while lifting his eyes to the hills. He meant that every business has to operate in two modes at the same time: producing results today and preparing for tomorrow.
"But 'preparing for tomorrow' really means investing in the future, an expensive and uncertain proposition. It demands taking an incremental hit to today’s performance in exchange for an unguaranteed payoff. Meanwhile, you have to meet your previous promises of big gains to have the wherewithal to continue investing. But that wherewithal will soon be lost if meeting those promises means forgoing new investments that are essential to future results. Drucker’s dictum is not only an acrobatic feat, but a managerial one as well."
That "acrobatic feat' has implications for pay, does it not? How do you reinforce the need for your people to maintain the revenue engine of the company while simultaneously focusing on growth if your compensation strategy only rewards one or the other--or neither? The answer is you can't.
Compensation is as strategic as any other decision an organization makes. And the way you approach value sharing will have a significant impact on your ability to successfully address the Drucker dictum. As a result, it's important to understand the different roles performance and growth-oriented incentives should play in your business if your objective is to build a future company that is bigger and better than the present one.
Annual bonus plans and other short-term value-sharing arrangements should reward the year-to-year maintenance of the financial engine of the company, with an eye towards growth. They can either be based on achieving profit goals or tied to the fulfillment of well-defined key performance indicators. Sometimes, they are based on a blend of the two.
When companies tie annual value-sharing to profits, they have determined that this metric will be the paramount focus with employees. The advantage of a profit pool is that it is simple and straight forward. It allows owners to rivet the attention of employees on the production of profits. Employees gain a sensitivity to the issues that impact the income statement of the company and are rewarded for producing the thing most critical to the company’s growth.
The alternative to a profit pool is a plan that links the incentive to the achievement of specific key performance indicators. In this arrangement, there is usually a targeted benefit that is tied to a percentage of salary. An individual employee can earn the targeted payout or some amount less or more than that, depending on the metrics he achieves. Of course, the employee may also earn no bonus if minimum thresholds are not reached, which are built into the plan. Metrics in a KPI approach usually address three areas of performance: company, department and individual. The weight each is given is determined primarily by the employee's ability to impact each area based on his current role. As a result, an executive level employee may have his incentive tied 75% to company metrics, 25% to individual measures and 0% to department factors. Conversely, a middle manager's performance standards might be weighted 25% company, 50% department and 25% individual. And so on.
Growth incentives provide a method by which employees can participate in the success they help the organization achieve. When employee compensation is tied to results that are generated over an extended period of time, long-term value-sharing participants are rewarded similar to owners. As a result, they become better stewards of those long-term outcomes. They begin thinking more like owners.
Incentives tied to company growth protect good profits and prevent bad ones by ensuring that key producers remain focused on long-term value creation and not just short-term cash maximization.
Ultimately, there are about nine different types of long-term value-sharing arrangements. To choose the right plan, business leaders must examine each option in the context of the outcomes they are trying to achieve. While all of the plans are intended to reward the building of company value over time, each has a different way of creating that outcome. The choice of which plan is best is determined by the company’s pay philosophy and its comprehensive vision of what the future company will look like. For example, some owners want to share stock with those to whom the business will be transitioned one day, or because they need to extend equity to certain key people they’re trying to attract or retain. However, you might not favor diluting your equity by sharing stock but still want to tie a long-term benefit to the value increase in your business. In making a determination about which approach is best, you must examine which plan will create the alignment you seeks between pay and long-term results:
- Stock Options
- Performance Shares
- Restricted Stock
- Phantom Stock Options
- Performance Phantom Stock
- Phantom Stock
- Strategic Deferred Compensation
- Performance Unit Plan
- Profit Pool
Each option has its own advantages and disadvantages—depending on the objectives the organization wants to achieve. So, company leaders need to understand what each plan helps the business accomplish and under what circumstances it would be an appropriate approach. The ideal way to sort through the options is to employ a decision tree process. Often, it takes the assistance of an experienced advisor to help with that analysis to ensure the right approach is chosen and the desired results are achieved.
In an ideal structure, this combination of short and long-term plans keeps people focused on the current performance engine of the company while also encouraging the building of the future business at the same time. It instills a sense of trust and builds a culture of confidence because value-sharing is an inherently “fair” approach; it benefits all who create value, not just shareholders.
When engineered correctly, incentive plans are “self-financed.” This means they are funded by the future value that is generated and only paid out if that threshold has been achieved. They come out of the productivity profit of the company. This protects the short and long-term interests of both shareholders and key talent—and represents a more unified approach to growing the company.
To learn more about how your approach to pay can help hold employees accountable for both short and long-term results, tune into our webinar broadcast on January 27, entitled: "How Do I Marry Compensation and Accountability?" Register here today. Space is limited.