Compensation Programs that Make Sense

Oct 18, 1999

As hard as it may seem to believe, 1999 is already wrapping up. We’re into the last quarter of the year now. Over the next couple of months, many A/E/P and environmental firms will be struggling with how to distribute this year’s profit dollars to their employees and owners. They’ll also be taking a look at setting staff salaries for the new year. It’s high time that most companies examine the way they are doing things compensation-wise. The accepted practice of paying everyone with the same education and internal job status pretty much the same salary, and then differentiating bonuses based on individual job performance may be a flawed concept. Think about it. Who takes the risk of whether or not the company does well? If the firm doesn’t make any money, there probably won’t be a bonus pool. That means that the lowest performers got theirs (since they are low performers, they won’t get much from the bonus plan, right?), and the highest performers did not get what they deserved. Is that what you are trying to do with your “incentive” plan? It doesn’t make a lot of sense. A lot of firms cook up elaborate schemes for doling out the bonus dollars. Most companies allocate some percentage of either cash or accrual profits to the bonus pool. Occasionally, there is a profit threshold that has to be met first— whatever it is that the firm has determined it needs to shore up the balance sheet through retained earnings or to buy back stock from departing shareholders. I have no problem with any of this thinking. It’s all sound. What I do have a problem with, however, is how some companies go about determining who gets how much of that bonus pool. What is often called a formula-driven bonus distribution program is nothing more than a subjective system masquerading as a quantitative one. The qualitative data on the individual’s performance (work ethic, teamwork, company spirit, creativity, quality consciousness, or whatever) is converted into some sort of numerical score. That score is then entered into a formula that, in turn, spits out a dollar amount of bonus. Some of these formulas are incredibly complex and have 20 or more variables. I like a simple formula based on a percentage of overall company profits that uses the percentage of total payroll each employee represents to determine his or her individual cut. No time is wasted in this process either! Adding in the element of stock ownership may further complicate these formulas. Because the majority of companies are organized as C-corporations instead of S-corporations or partnerships, the profits cannot be paid out in accordance with percentage of stock ownership. They can’t, that is, unless the firm is willing to pay taxes on those dividend distributions. By paying out profits to shareholders through an obscure and complex bonus plan, the corporation can deduct all of that money as salary expenses. Here’s the problem: how much incentive is there for anyone to buy more stock if they already have the minimum amount required to get into the “club” for the big bonus pay-out? None! This can really screw up the ownership transition plan! There are some companies out there that would be better off to take their lumps and convert from C to S status or to simply pay out some of their profits as non-deductible dividends. There has to be some direct and obvious link between the percentage of stock owned and the share of the profits received. The rub comes for firms with big shareholders who have retired on the job. Those firms need to buy their stock back instead of avoiding the problem. And as far as salaries are concerned, every day that goes by helps convince me that the more frequently n employee can get his pay adjusted, the better and more motivated he will feel. Four times a year is not too much. You don’t need to exceed your overall budget for increases either, if you dole out the raises sparingly and to the best people, instead of leveling out the field for your best and your worst. Why is it that all of your associates with 15 years of experience and professional registration make within $4,000 of each other? Are they are all worth about the same? If you say yes, I don’t believe you! It would be a much better situation if your best performers earned twice what the worst did in terms of base salary. Then, if you had the type of bonus program I describe, the best would also get twice the bonus. Plus, you could allow the best to buy stock (giving them the profit distributions and equity appreciation of ownership) and deny that opportunity to your worst performers. And if the best people have the highest salaries, they’ll be more resistant to recruitment. That’s good, too. So think about these things before you go down the old cow path of doing business as usual. A novel compensation plan that is simple to administer may be the cornerstone of a new direction for your firm— one that makes you even more prosperous in the future than you are today. Originally published 10/18/1999

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