Answers to the following three questions can help owners determine whether their compensation programs translate their business priorities into employee decisions and behaviors to carry them out:
- What employee behaviors and results does our compensation strategy reward?
- How does compensation encourage key employees to consider long-term business value?
- How would our compensation programs affect key employees during an ownership transition?
What employee behaviors and results does our compensation strategy reward?
Consider the business that wants profitable growth but pays sales incentives based only on revenue. A salesperson deciding between two opportunities has a clear financial reason to pursue the larger sale, even if it offers a lower margin, requires costly customization or creates collection risk.
What an organization measures, rewards and celebrates can influence those decisions. In this case, the plan has prioritized revenue, regardless of what the strategy dictates.
That does not mean every strategic objective belongs in an incentive plan. Too many measures can make a plan difficult to understand and administer. A useful exercise is to identify the few results that matter most to the company’s next stage and determine which employees can influence them.
If profitable growth is the objective, a sales plan might account for margin or customer retention alongside revenue. If the business needs stronger cash flow, the plan could give appropriate weight to collections or working capital. The right measures will depend on the organization, the roles covered by the plan and the decisions those employees can reasonably affect.
Owners should also examine how the measures work together. A well-designed plan gives employees a clear view of the results they can influence without encouraging one objective at the expense of another.
How do our compensation programs shape key employees’ long-term decisions?
Owners may invest in capabilities, customer relationships or new markets knowing the return may take years to materialize. Many compensation programs, however, evaluate employees’ performance one year at a time.
Annual incentives do serve important purposes of recognizing progress, reinforcing near-term priorities and helping maintain financial discipline. But when most or all an employee’s incentives depend on current-year results, long-term investments may receive less attention, particularly when they reduce short-term performance.
Employees do not need to assume the same risks as ownership. They do need a reason to consider how today’s decisions may affect the business beyond the current year.
A multiyear incentive can provide that reason without involving actual equity. Phantom stock is one example of a long-term incentive approach. A cash-based plan can also tie compensation to specific business goals. For example, a company focused on profitable growth and customer retention could make part of an executive’s cash award payable after three years, based on sustained margin and retention performance. That structure would tie part of the executive’s compensation to outcomes that take time to develop.
The appropriate structure and time horizon will depend on the company’s objectives, the employee’s role and the results that person can influence. Employees also need to understand how the business creates value, which decisions they are expected to affect and how performance will be evaluated.
How would our compensation programs affect key employees during an ownership transition?
A business is better prepared for a change in ownership when the people responsible for its performance have a reason to remain engaged. Compensation is one part of that preparation.
Consider an executive who trusts the owner to reward their contribution to the company’s success, even though no written arrangement defines how or when that reward would be paid. The executive may receive competitive base pay and discretionary annual bonuses, but their expectation of future rewards rests largely on a personal relationship with the owner.
If the executive does not know how an ownership change would affect their compensation or role, they may begin to question whether remaining with the company serves their interests. The uncertainty can emerge at the same time as the business needs continuity from its leadership team.
Written compensation arrangements can clarify what key employees may receive if they remain with the business and meet defined expectations. Depending on the company’s objectives, an arrangement might provide a retention payment after a specified period or address how an existing long-term award will be treated if ownership changes.
Those provisions require planning before a transition is underway. The design should reflect the company’s circumstances and consider the related tax, legal, accounting and administrative implications. The objective is to replace assumptions tied to one owner with arrangements that key employees and future ownership can understand.
Design compensation for the business you are building
Individual compensation arrangements may continue to serve the purposes for which they were created. Even so, the system they form may no longer reflect the company’s priorities, stage of growth or plans for an ownership transition.
Examining the system as a whole may uncover arrangements that support the company’s direction, as well as those that send a different signal or depend too heavily on informal expectations.
Before adding another exception or incentive, owners can gain a clearer view of whether the compensation system supports the business they are trying to build by considering how the pieces work together. That perspective can provide a stronger basis for deciding which arrangements to retain, revise or replace.
