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.
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
Cons of moving to incentive based bonus compensation for executives
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.