July 21, 2022

Perspectives on incentive-based compensation

I’ve recently spent quite a bit of time with founders who are dealing with the philosophical dilemma of whether to add a performance based incentive component to executive compensation.  In case it’s helpful to others, I decided to outline some pros and cons here.

First, there are two ways to look at incentive pay.

  1. Based on performance of the company
  2. Based on performance of the individual

In either scenario, performance based incentives require a company to have goals that are deeply understood, and that are both transparent and objective.  These goals should be tied directly to financial performance and can be a good way to align incentives.  Meet the goal: get paid, everyone wins.  Exceed the goal, get paid more.  

I’ve said before (you’ll hear me say it a lot)  that a company is nothing more than the total output of its employees. As such, culture and engagement scores are the better indicator of future financial performance because they’re an indicator of employee engagement and output in real time. Financial metrics are a backward looking measure of employee output.  I am of the personal opinion that any performance based incentive compensation for executives should have an employee engagement component

Pros of moving to incentive based bonus compensation for executives

  • Public companies usually have performance based incentive comp structures to align incentives with shareholders - moving to this model helps you prepare for that in advance
  • Leveraging extra cash to incentivize employees keeps equity burn low - if you’re a later stage company with solid cash flow and a goal of minimizing ongoing equity dilution this is a good lever to pull
  • When there’s volatility, incentive pay allows you keep cash burn in check by rewarding employees based on current profits, productivity, and performance without promising that bonuses will always be paid out
  • Performance based incentives align well with a pay for performance mentality (note: I am of the personal opinion that this isn’t a great motivator for employees unless it’s large enough and in many case, it isn’t)

Cons of moving to incentive based bonus compensation for executives

  • Administrative overhead of tracking and paying performance based incentives
  • Requires sophisticated and highly predictable financial metrics (ie: revenue, EBIDTA) to be truly effective
  • Performance based incentives that are not paid out in full have the benefit of aligning incentives, but can discourage talent from staying with an organization if they can’t earn full incentive pay
  • Some argue that incentive pay encourages employees to optimize for receiving full incentive pay, vs acting in the best interest of an organization - especially at an earlier stage when you need people to take calculated risks.  Appropriate risk taking may be dampened by a focus on incentive pay attainment

A few things to note.  

Performance based incentive models work when they affect performance and behavior. It’s highly effective when a company can track progress toward related goals, and also track the corresponding bonus payout percentage. The tracking metrics should be in full view of everyone impacted so people feel immediate and obvious alignment to their performance goals.  I like this model because it aligns with objectivity.

Are you ready for Performance based incentive compensation?

There are two primary reasons to move to this compensation model. (1) you need to limit equity burn or (2) you need to increase cash compensation efficiently to attract and retain talent.

The net-net is this: 

You’ll likely move to a performance based incentive compensation model as a public company to align executive compensation with shareholder incentives, so it’s a good idea to flex that muscle prior to an IPO.   That said, I don’t think it makes sense before late Series C or D when cash flow and cash reserves are likely higher.  I also wouldn't recommend it before you have (1) strong and predictable financial metrics (ie: revenue, EBITDA), (2) sophisticated operating rhythms that provide the necessary transparency into goals, and objectivity around performance measurement and (3) the mechanics to “publicly” track and share goals and metrics with impacted folks.  

For your broader employee population, the same rules apply.  I would add that you need a strong broad based Performance Management process, otherwise you’re just creating the administrative burden of an incentive based pay structure, and paying everyone at 100% or distributing incentive pay inequitably.  A lot of companies stick to traditional salary and wait until post IPO to move to a performance based incentive model for its entire employee population.

Finally, this may seem counterintuitive, but don’t move to incentive based pay to motivate employees unless you can make it large enough and predictable enough. Before Series C-D, belief in equity upside is a far better motivator than incentive based pay and ultimately, if bonuses don’t pay out at 100%, it’s extremely demotivating to employees and may have the opposite impact.

When you’re ready to move to incentive based compensation, try dipping your toes in with a 50/50 model, with half based on individual performance and half based on company performance. The upside is the creation of shared risk - if your company underperforms, you limit cash paid out. The downside is that your lowest performers may still get 50% of their bonus if the company does well.