December 15, 2022

Harmony: 6 Elements for Fair, Equitable, and Consistent Compensation

In our first three articles in this series on harmonized Management, Measurement, and Compensation systems, we posited the following: Lesson 1: Successful organizations have rational, documented systems which are purposefully managed to work in harmony. Less successful and ‘dysfunctional’ organizations often have the elements but have not focused on ensuring they reinforce each other to deliver desired behaviors. Lesson 2: Management Systems define Why are we here, where are we going, how do we get there — with a passion for repeatable, definable processes. Lesson 3: Management and Measurement systems are partners that shine when done well, just like our favorite duos in film. Owen Wilson and Ben Stiller in Meet the Parents and Zoolander, or Paul Newman and Robert Redford in The Sting. Remember, to be a winner you need to keep score. We are going to explore the key elements for complementary compensation systems in this article. The six key elements are listed below:
  • Measurable Goals consistent with the Vision, Mission, and Annual Plan are essential
  • Does the measurable activity create value?
  • Do you want to pay for the activity?
  • How do you want to pay for success: base compensation, variable or success compensation component, and potentials stock options?
  • What can you afford? How does your compensation plan compare to competition?
  • Make sure your compensation plan emphasizes retaining key players: Who are they, and how critical to mission success?
By now, our hypothetical company, Success Inc., has a winning Management Systems with a clear North Start (Goals) and has translated that into this year’s annual plan. The annual plan includes deliverables by line of business and department that align with the North Star, and measurement metrics have defined using our Measurement System best practices. Now we will integrate the Compensation System to reinforce and encourage the achievement of the measurement metrics – while avoiding dysfunctional behaviors. We are strong proponents of healthy performance planning and counseling (PP&C) systems. Yes, they may seem as if they belong solely in the management systems, however we view them as foundational connective tissue for management, measurement, and compensation systems. PP&&C systems provide management the ability to focus and delegate responsibilities to their teams. Annual performance plans should also capture the Measurement metrics for each team member, thereby aiming everyone toward this year’s objectives to reach the North Star. And, when an individual has received a fair and informed annual appraisal that is directly connected to the determination of the annual bonus, variable compensation award, and granting new stock options – we’ve achieved the essence of a harmonized system that will deliver consistent, excellent results for Customers and Investors. For those who want to dive deeper into performance management best practices, we recommend the following reads: We will spend most of this article focused on the variable and equity ‘success-based’ or goal compensation components. Before we get there, we will briefly discuss base compensation which also includes benefits. Employees have a sense of what is a competitive base salary for the position and job title they currently hold. Attempts to pay under a competitive level will likely result in a longer-term staffing dynamic resulting in lower skilled and quality employees. In tighter job markets with low general unemployment, this will also lead to higher attrition. Unwanted attrition adversely affects the organization as institutional knowledge is walking out the door. The individual going to a higher paying job at another company was trained on your time, with information potentially about your customers, proprietary intellectual property, and who they think are the best candidates in company to join them at their new employer. Conclusion, there is little long-term value in underpaying solid or superior performing employees. How do you know if your compensation is competitive? There are advisory firms who will benchmark your employee compensation by position and level. Your employees will be placed in relative competitive pay scales by quartile. You can decide what your compensation strategy should be and move employees over time to the desired position versus competition that is affordable. Using the annual appraisal system with the competitive benchmarking allows you to differentiate annual increases based each employee’s performance and their relative position in the pay scales. Higher performing employees who are lower in the competitive pay scale for their position should logically receive higher annual increases compared to lower performing, more highly paid peers. If your organization can’t afford the outside advisory firm, you can still get a lot of information looking at job sites such as Indeed and others to see what firms are offering for some of your key positions. The objective is for employees to feel that they are paid fairly and equitably compared to other organizations and peers within your organization. I know this sounds theoretical, but in at least half of the turnarounds/transformations in my career have required restructuring the Compensation system. Another important consideration should address the need to retain key or strategic employees within your organization. Over-paying these individuals with higher base compensation probably is not the best approach, as this will tend to distort your competitive pay gameplan and does not link their performance to the company’s success. That’s why variable compensation and equity-sharing programs come into play. The key employee should be responsible for an activity or portfolio of activities that demonstrably add-value to the enterprise both this year as well as three to five years in the future. You can quantify the value of the activity, and consequently what is a fair bonus, commission, for similar approach as an added compensation element to their base compensation. Using this approach, your monthly base competition remains fair for all employees, and the employees with variable compensation receive incremental compensation based on affordable programs tied to actual company success. The use of equity variable compensation relieves the company of cash outlays today and more closely aligns the employee’s view and performance to that of the investors – in theory. What are sure-fire ways to undermine employees’ faith and trust in variable compensation schemes – I’ve seen many. Smaller, owner/operator firms may face a cash crunch, and proceed to arbitrarily and capriciously change the rules of the game. I’ve seen this too frequently with sales commission payments versus the original compensation program. Deferring cash payments due to ‘cash crunch’ is another approach – usually with the owner/operator continuing to pay themselves as if there is no crunch. There is nothing more visually jarring than to leave a meeting with the owner when your variable pay has been reduced below expectation and watch the owner drive off in a new, foreign car. Let’s take a closer look at equity compensation plans. In theory, these are excellent retention and reward programs. Since most stock option or other virtual programs require the employee to remain at your company to have the equity ‘vest’ so they become more under the control of the employee to convert into current cash. And, as the company only pays cash in the future after vesting, they preserve cash today to fund operations and growth. What can go wrong? Here are a few I’ve experienced:
  1. The company’s future looked excellent when the stock options were granted, however in 2-3 years it underperforms, and the stock options do not grow in value.
  2. Further, the employee is a minority shareholder and has no ‘control’ over the company. The owners arrange a cash transaction that benefits them (they have a special class of stock) but is not available to the employee stock option holders.
  3. The company goes bankrupt,
  4. The company is acquired by a competitor, who only purchase the owner’s shares (see #2) and starts a new employee stock option plan.
If you can’t tell, I view stock option plans in most privately-held companies as providing zero compensation benefit. Something like winning the lottery. According to data from the Bureau of Labor Statistics, approximately 20% of new businesses fail during the first two years of being open, 45% during the first five years, and 65% during the first ten years. Only 25% of new businesses make it to 15 years or more. Basically, the odds are against your stock options. I know that sounds pessimistic and flying in the face of conventional wisdom – particularly for the high-tech sector. Just a cautionary tale, and one Cuba Gooding clearly grasped in Jerry Maguire when he told Tom Cruise, “Show me the money!” Moving back into a more positive tone to close-out our Compensation system article, the Compensation system needs to be fair and equitable, supported by fair employee evaluations, and connected closely to Management systems annual plan and North Star. Employees should be able to monitor forward progress against the compensation metrics with regular, transparent Measurement System metric performance reviews. If the statements about the Management System and Measurement system are true, fair and equitable Compensation systems support our goal—Harmonized Performance for Customers and Shareholders. And just maybe, Success Inc. will be in the 25% of companies that survive their first 15 years. Lesson 4: Compensation systems must be closely linked to Management system goals and objectives, be reinforced with regular, transparent Measurement system reporting, and employees must believe the Compensation system is fair, equitable and not subject to owner self-interested manipulations. In privately-held firms, be very careful to avoid ‘over valuing’ stock incentive programs in lieu of cash compensation.
In this article:
Connects the compensation to the Management & Measurements systems; and discusses core elements for effective compensation systems.
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