Why You Need the Right Balance between Short and Long-Term Incentives

The right balance between short and long-term incentives helps both maintain and leverage your business model.

In his Strategy+Business online column, Ken Favaro said this:

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.

The dilemma posed here plays itself out in every dimension of the business, including compensation planning. When it comes to pay, business leaders face the same balance issue: What blend of short and long-term incentives will support the growth we're seeking without sacrificing current performance? The ability to answer that question is critical to any company wishing to align compensation with the organization's vision, business model and business strategy. Here are a few principles to consider.

  1. Incentives are most effective when defined and executed as value sharing plans. This means the company figures out what value creation means in financial, ROI terms and what portion is attributable to non-human capital at work in the business versus that which is considered "productivity profit." When this approach is taken, incentives become "self-financing." Value is only paid out when, if and as it is created.
  2. Value sharing plans should ultimately be split 50/50 between short (12 months or less) and long-term (12 months plus) performance. Short-term plans such as annual bonuses should reward the maintenance of key financial drivers in the business model. Long-term plans should reward sustained results based on growth targets. Value sharing plans tied to sustained success are designed to prevent "bad profits"--those that erode shareholder value--by tempering decisions that maximize short-term compensation at the expense of customers, margins, innovation, etc. Good profits come from sustained, value creation execution and outcomes.
  3. Both short and long-term plans should reward the right combination of company, department and individual performance. These factors will vary by employee "tier." For example, senior level management might have incentives that are based 75% on company performance, 0% on department performance and 25% on individual performance. A middle management employee, on the other hand, could have his value sharing based on 25% company performance, 50% department and 25% individual results. And so on.
  4. Incentives (both short and long-term) should reinforce the business model. An organization's financial engine drives revenue for the business. As a result, short-term value sharing should reward the maintenance of the virtuous cycles of your model. On the other hand, long-term plans reward leverage; they should share value with those who help accelerate or expand what the revenue engine is able ot produce. This is part of what keeps an employee's "nose to the grindstone while lifting his eyes to the hills" as Drucker suggested.

Thinking about compensation in these terms will dovetail effectively with what Favaro describes as the "strategic five" questions that should be answered in developing an organization's strategic anchors for growth:

  • What businesses should we be in?
  • How do we add value to our businesses?
  • Who are our target customers?
  • What is our value proposition to those customers?
  • What capabilities make us best at how we add value to our individual businesses and how each business delivers its value proposition?

Compensation needs to align itself with these anchors if it is going to be a strategic tool that helps fuel growth instead of becoming a distraction and drain that diminishes it. Striking the right balance between short and long-term incentivesis an essential means of accomplishing that. 

To learn more about how these principles can help shape your compensation strategy, attend our upcoming webinar, "I'm Paying My Top 4 People $1 million...What am I getting for It?"




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