This article is the ninth in a series on what causes a firm’s value to increase
When compensation gets thrown into the discussion at companies people always pay attention.
I first started consulting in 1985 in the strategy subsidiary of the Hay Group, one of the leading compensation consulting firms in the world. When they performed their annual Employee Satisfaction Survey for clients, the best score any company could muster for positive satisfaction with base compensation was 50%. The global average score for positive satisfaction with base compensation was only 25%!!! What do these data suggest? Most people are not satisfied with their pay and want more money. Duh.
Why are we discussing compensation? It is because a sound approach to compensation can be a huge contributor to growing the value of your firm.
Compensation plans can be divided into Base Pay and a wide variety of what were called Incentive Plans and now referred to as Pay-for-Performance plans. Best practice views that Base pay is for Effort and Pay-for-Performance plans are for Results. Base pay is paid when people and managers perform their job accountabilities at some acceptable level of achievement. As long as they achieve this they can count on being paid, of course as long as the firm is solvent. Pay-for-Performance is for achieving measurable results above a key trigger or threshold within some specified time period. If the trigger or threshold is not achieved, there is no incentive pay. It is all or nothing for this component of compensation.
The commonly used threshold that will trigger incentive payouts is a measure called Economic Value Added (EVA). In simple terms this is net operating profit over and above what investors require as their minimum return.
Al Rappaport’s landmark 1986 book, Creating Shareholder Value: The New Standard for Business Performance, demonstrated that many firms’ approaches to incentive compensation were totally wrong. For example, not once in thirty years did Bethlehem Steel earn more than its trigger. Even with this reality the firm’s executives developed a country club atmosphere with extraordinarily lavish perks and a tight-knit culture disinterested in hard-nosed thinking about emergent competition (foreign competition and mini-mills), new technologies or the lack of a viable approach to the unions. This wrong-headed view of incentive compensation and perks was a huge contributor to Bethlehem’s eventual bankruptcy.
So how can your firm proceed with a sound view of base and pay-for-performance compensation? While thinking has shifted back and forth over the last twenty five years, the prevailing view is that valued key contributors need to be rewarded as individuals, not teams.
Study after study shows that the people who consider themselves key contributors in their organizations want to be assessed as individuals and rewarded as valued individuals. They recognize the importance of team work, but at the end of the day want to be recognized and rewarded for individual achievement and performance.
So based on current findings and thinking, here is the prevailing approach for assessing your organization’s total compensation approach:
Decision 1: Should your base pay be at market, below market or over market?
Decision 2: Should your organization offer some kind of pay-for-performance plan? The answer is yes if you want to motivate and incent growth in revenue, profits, and firm value beyond their average historical rates of growth.
Decision 3: What should the relationship be between your base pay decision and your pay-for-performance decision?
Many firms will actually lower base pay when they install some kind of pay-for-performance plan. But they provide the opportunity for much higher total compensation if the trigger is exceeded in the pay-for-performance approach, and there is no cap on that kind of pay. Other firms do not lower base compensation, but cap the pay-for-performance amount.
Decision 4: Who should be in the group in the pay-for-performance pool?
Best practice suggests this group should be kept to only those individuals who can directly influence EVA. These are managers and executives who directly influence sales growth rate, operating profit margin, working and fixed capital investment into as long into the future as is possible.
This part of the compensation approach can be contentious. There is many times a desire to include long term loyal people, even if they do not directly influence EVA. The stance should be this is what base pay is for until a time where these persons desire to have the visibility and accountability for growing EVA and then they should be included in the pay-for-performance plan and incentive pool. Those who opt though to be part of the pay-for-performance plan do not have just the upside. If there are no EVA results, there is a downside as well.
A sound approach to base and pay-for-performance compensation is fair and just to all and also provides an extra amount for those with the stomach for visible accountability for results.
Next Up: Strategy, Firm Valuation, and Boards of Directors
Bill Bigler is Director of MBA Programs and associate professor of strategy at LSU Shreveport. He spent twenty five years in the strategy consulting industry before returning to academia full time at LSUS. He is the incoming president of the board of directors of the Association for Strategic Planning, one of the leading professional associations in the field of strategy. He can be reached at bbigler@lsus.edu