June 26, 2012
The purpose of incentive plans is to do exactly what the name implies – incentivise the people in your company (both executives and employees) to contribute more than they normally would. In other words, you want them to work harder, move faster, take on more ownership, and generally make as great a contribution to the overall success of the company as possible.
Usually the incentive is to share in the company’s upside in some way. A common mechanic for that is a stock option plan that coordinates payout directly. There are a variety of options though, including bonus schemes, commissions on sales, and so forth. More recently, there has also been an emphasis (rightly so) on non-financial incentives, such as work conditions, opportunity for professional advancement, and so forth. But, in general, a major component of the incentive model for startups remains dollars. This is especially the case for mid to senior level employees where upside is a significant portion of their overall compensation.
How you structure your incentive plan depends a little bit on your corporate culture but the fundamental challenge is always the same: How to translate the reward of real dollars into better performance of your team. For that to happen, your incentive plan needs to achieve Proportionality, Transparency, Appropriateness, and Certainty.
Proportionality. There should be a pretty tight correlation between the company’s success and personal payout for the employees. You want to have a system that can’t be gamed easily, and that really rewards meaningful advancements with meaningful payout. So if somebody does more, they should get more. If the company is more successful, employees should get more, and so on.
Transparency. Employees need to understand and see the dynamics of the incentive plan. While nobody can predict the final payout in advance, employees should see that they get more if they do a bit more work on something. Incentive plans should not only be transparent enough that the employees can see the impact on their own behavior, but also be able to see the impact on other employees. They don’t necessarily need to know who owns how much of the company, but they should have some general sense of what it will translate into if they get promoted, and, based on their peers, what their reward will be if they do some certain extra. If employees don’t understand these dynamics, the incentive plan is less likely to influence their behaviour in the desired way.
Appropriateness. Appropriateness is a bit more of a judgement call. On one hand, you want employees to have a large enough stake in the company that the payout has a meaningful impact on their life, and, therefore, creates a true incentive. On the other hand, you clearly don’t want to create a social collective with employees who own the entire company, because (presumably) you have to leave some room for investors and other major stakeholders. In North America, that usually means you end up with an incentive pool for employees somewhere in the range of 10-30%, usually hovering at about 15%-20% unless you have significant elements for founders in the pool.
Certainty. More recently, certainty has become increasingly important. When you make an incentive plan, you are making a promise. You are telling people that when they work for less pay, or work harder for normal pay, they will be considered when it comes time to divvy up the company’s benefits. Employees’ certainty that you will keep that promise is critical, because their belief in the outcome has to be very high in order for an incentive to exist. Everyone will understand that the company might fail, but everything fails if there are scenarios when the company succeeds and employee payout evaporates despite the promised incentive.
In my opinion this is the hardest problem to solve in an organization because certainty is the only factor that does not depend entirely on the company itself. If you are in a market or demographic where employees have been routinely screwed in incentive plans (read my post on ethics and employee equity for example), it lowers employees certainty in that entire industry or region. The best way to counteract this industry effect is a mixture of ensuring the personal integrity of the leadership team, and, most importantly, going to the effort of putting in place a solid legal structure for your incentive plan to ensure that arbitrary last minute changes are less likely, or unable, to claw back employees promised reward.
Ultimately, Transparency is the foundation for any employee incentive plan: if your employees don’t understand how the benefit mechanism works, they won’t have the motivation or understanding to make that extra contribution you are looking for. Proportionality and Appropriateness need to be taken into account to ensure that you are incentivizing the right people, for the right reasons, in a way that won’t compromise the company’s health. But no incentive plan will give you the desired results if employees’ trust and certainty that they will actually receive their benefit is compromised.