Everyone likes the idea of paying for performance. I don’t know any CEO or director who rejects the concept out of hand.
But it turns out that performance-based incentives are tougher to create than you expect – at least the first time around. Equity-based incentives under stock option plans have been around for decades, and some particular structural features exist in part because they address some of the issues we’ll discuss here.
There are three main issues to consider when you’re developing performance-based incentives:
- Compensation vs. retention
- All or nothing goals vs partial performance.
- Too many targets create the risk of conflicting goals at the margins.
Compensation vs. Retention
The first question is “what is your goal?” And the second is “Are you sure the employee sees it the same way?” If your employee sees an incentive as compensation, but you see it as retention, the terms aren’t going to do what you want them to. An employee will see that they’re not really getting the compensation – it may be deferred for several years – and simply not be able to afford to wait. They’ll take a better offer, and then you’ve lost out on the retention goal as well. The bottom line is that retention incentives seldom serve well as compensation.
If you’re using an equity-based structure, you should think of compensation incentives more like cash, without additional strings attached. I’ve never heard a CEO say “and if you leave, I take back all your cash bonuses.” But I can’t count the number of times I’ve heard one say “and if they leave, they forfeit all the equity.” Not have to get bought out at FMV: forfeit.
All or nothing goals vs. partial performance
Some leaders want to focus a team member on an all or nothing goal: $X of sales, or a valuation in an exit of $Y. Picking an all or nothing target definitely focuses attention. But in many of those cases, an early question someone will raise will be “but what if we hit 90% of $X or $Y? Isn’t that worth more than 0?”
And they’re probably right. If you want to pitch this stretch goal, it works best when there is already a reasonable compensation structure in place. For example, telling a sales team that has a good comp structure that there’s an extra bonus for hitting a stretch goal may get the job done. But if they are underpaid in cash and commissions only kick in at a high level, you’re going to have to guard against the fallout from that mismatch: someone who is on target will stay, and anyone falling behind will likely just leave because they’re not confident about hitting the target and they’ll feel like they’re losing money every day of the journey.
Now, I’m not saying that every incentive has to start paying out at $0 and go up. It’s absolutely sensible to consider a floor with performance above that (e.g., using a break-even sales number as the floor). Your numbers still have to work and support the business.
Too many targets
Eagerness to fine-tune incentives is the shiny gold ring for many CEOs and boards. They recognize that performance is tied to a number of different factors and want to include them all in the mix.
There are two flavors of this: one is breaking up a big package into 4 or 5 smaller packages – 25% of the bonus is based on W, 25% on X, and so on. That’s not really a problem if you’ve been able to select targets that are independent. For example, hiring new team members increases expenses, so that target conflicts with a goal of lowering SG&A.
That same problem becomes impossible when an incentive system uses multiple performance metrics at the same time. I’ve seen a company set revenue, gross income, EBITDA, and net income goals for a senior team member, all of which had to be met to meet the incentive. That’s a lot of complication for any business that isn’t mature and stable enough to know the relationship of all the different variables in the equation.
If you’re selling Tide, you can probably predict what effect a potential modest improvement in marketing effectiveness would have on sales because there are decades of data. But for a startup, it’s a lot harder to say that all of those income statement lines are going to move in sync from one quarter to the next.
But trying, today, to predict the next three years of planning and results and lock it down in ink for a CEO is a tough job for a board. And you have to be prepared to re-open the conversation when either the strategic plan changes (your strategy probably shouldn’t likely change, but it happens) or your tactical plan changes. Tax laws could change and cause a company to shift from revenue growth (implying growth in valuation because of increased future cash flows) to net income growth (implying growth in valuation because of increased cash flows from operations). If your incentive plan is written for one or the other, someone’s going to want to have a discussion.
The time-based alternative
Many equity-based incentives use time-based vesting rather than performance-based vesting to avoid having guessed wrong. In a time-based system, the board can determine each period – month, quarter, year – what the CEO’s new targets are and evaluate the CEO’s performance against the last set of targets. That’s often more practical because plans are always changing based on where you are at that point in the future, not where you think today that you will be in a year. That’s why your GPS doesn’t tell you to drive for 4 hours and only then tell you that you’re not in Boston, you’re in Lake Placid. We adjust our short-term plans, aka budgets, on a regular basis.
Here’s why this works better in most cases: tradeoffs are inevitable, so if you create too rigid a system, a mismatch is almost certain. If you’re lucky, the team member comes back and says, “Hey, this incentive system isn’t working for me any more, so either we change it or I quit.” If you’re unlucky, they just quit. If you don’t change it, they still might quit.
If you use a time-based vesting system, you gain flexibility in setting the right targets at the right time and remove the pressure of picking the right future goals today. Now, that doesn’t mean that everything is automatically great. Complications will still happen, and so you’re trading that other conversation for this one with the CEO: “Hey, we’re not happy with the company’s performance this past year. Either we change your equity incentive or we’re going to fire you.”
The difference? With a time-based model and setting current targets each period, the board is leading the conversation; the board has the initiative to choose where and when to drive the discussion, how much variation is too much, and what to propose. All of that can be prepared in advance. The other way, the CEO is in charge of the discussion and the board is forced to react.
Yes, a board should be aware of the CEO’s incentives? They could be, but the person most likely to put those numbers in front of the board *is* the CEO (or maybe the CFO), so that’s again having the CEO in charge of the conversation.
Where do I fall between those two systems of targets and uncomfortable conversations? Yes, every situation might be unique and circumstances could vary, but I start with a clear bias for action. The principle of Offensive – seize, retain, and exploit the initiative – suggests to me that the board is better off choosing how and when to raise performance issues and being able to use time on its own schedule to prepare for the discussion and negotiations to follow.
So, consider being guided by the principle of Simplicity and aim for fewer complications in your performance-based systems.
Remember, incentives work. They’re better at affecting people’s performance than we are at creating them in the first place!