I'm Spending $1 Million on My Top 5 People - What Am I Getting For It?
What Results Are You Paying For?
When Jack Welch left GE, he received, and continues to enjoy, a retirement benefit valued at approximately $9 million per year plus perks. At the time of his retirement, his package received a lot of press attention and created no small controversy. The reality is that Welch's package amounted to less than 3/100s of 1% of the shareholder value that was created during his tenure (0.03% of $396 billion). His total compensation during his entire period of service was less than 2/10ths of 1% of the value created.
This example illustrates a fundamental premise in examining the value of compensation. As you juxtaposition Jack Welch's compensation arrangement with GE's results during his tenure, it hardly seems exorbitant. The reason is because compensation is being evaluated in the context of results that have been achieved - not strictly within an expense framework for which no commensurate value has been reconciled.
Although the numbers in your business may vary widely from those illustrated here, the premise and principles applied should not. Compensation should drive and be tied to results that are quantifiable, measurable and that can be impacted by the person being rewarded for their achievement.
Growth Implies Different Results
What are you getting right now for what you are paying in compensation? You are getting the current result, whatever that might be - right? If the results you achieved this year are not measurably different than you got last year, what will you do next year to drive a different performance level? And how will pay differ as a result of those changes?
Growth implies that a different result will be achieved in the future than is being achieved right now. By extension, the strategies that have been used to get the current result can't be the same in the future if a different outcome is desired or expected. Because compensation is one of the strategic tools in a business' arsenal to affect change, companies wishing to develop a different performance result in the future can't expect to fully achieve that if its rewards programs don't correlate. For example, if a company decides its target is to grow net income over the next three years by 20% per year, it should ask itself certain key questions. What part of our compensation plan communicates that goal to employees? If we achieve or exceed that number, what are we willing to share? Who should participate in that growth if we meet our financial targets? To what extent will key employees' participation in that growth be the fuel that brings it to realization? In other words, what comes first - growth or employees that are motivated by incentives to create growth?
If an employer is asking what he is getting for the amount of compensation he is paying - whether that is $1 million, $10 million or $100 million - he has not yet forged a strategic link between rewards and the financial performance of the business.
Start With Well Defined Financial Outcomes
The starting point for becoming more strategic in rewards design is in drawing relationships between different components of compensation and financial outcomes the company wants to derive. This begins with the development of effective financial models.
This financial framework is essential to both defining and projecting the outcomes one wishes to achieve as well as creating a template within which a correlation can be made between compensation and company performance. Effective models will make assumptions about the financial targets the business wants to fulfill having determined what their achievement will mean to ownership.
For example, assume a company currently generates $20 million in revenue and $2 million in profit. What would it mean financially to shareholders if it could grow that profit number to $6 million in the next five years? What would have to happen within the organization for such an achievement to be realized? What would ownership be willing to pay to achieve that result? (Think of the Jack Welch example mentioned earlier.)
Models are built to create a financial picture of what such numbers would mean to owners if those results are achieved. Assumptions are made about any fixed or financial variables one wishes to assume within that revenue structure, accounting for increases in manpower, expenses and so forth. Fixed and variable costs are assumed and targeted.
This financial framework becomes a tool for measuring and testing various incentive arrangements that might flow from the financial results targeted. For example, a company may decide that if a $6 million profit target is achieved over the next five years, a company would be willing to share 10% of that number in incentives for key people (or 5% or 20% or 15%). The percentage to be distributed in the form of incentives become a function of what that profit figure means in real additional equity value to shareholders, how much of that value seems economically viable to share and what needs to be paid to "unleash" the performance level required to bring about that result.
Ideally, the modeling process helps you visualize both the financial structure that will support the projected growth and the thresholds that need to be attained if growth goals are to be achieved. With the financial picture vividly embedded, the company can then shift its attention to the behavioral components that will lead to those results.
Behavior Targets Follow Financial Targets
Once company ownership has determined the financial targets it wishes to achieve, and knows what they will mean in terms of increased equity value, it must then identify and manage the factors that will lead to those outcomes. For growth to occur, sustained performance needs to be achieved. Those results are largely a function of key people, executing key performance indicators that have grown out of a visionary business plan.
Execution is the key component in this process. What needs to be executed is defined in an effective business strategy. Who needs to execute those things is matter of role definition. Setting clear expectations defines the execution that needs to occur within those roles. The latter also assumes the business has the right people in place to carry out that execution and achieve those results.
In this context, compensation becomes a tool ownership uses to accomplish any or all of the following:
- Define specific areas of performance expectations
- Unleash passion towards the fulfillment of those expectations
- Increase focus on key result areas
- Reinforce the vision and strategic plan of the business
- Create an effective blend between individual, team and company effort
- Project a unified financial vision for growing the business
- Encourage achievement within the context of company values
- Engender an "ownership mentality"
- Nurture a culture of confidence through the achievement of sustained results
- Define what needs to be executed and how one will be rewarded for doing so
When a business has developed the ability to clearly envision its financial future, constructing a culture that will lead to its fulfillment becomes a natural and cascading exercise. Vision leads to strategy development. Strategy leads to the identification of key performance indicators. Performance indicators require execution. Execution is attached to roles and expectations. Finally, rewards become the glue holding all of these elements together. They provide a system for vision and strategy fulfillment with the intent to link company financial fulfillment with the personal financial fulfillment of its workforce - especially its key talent.
Components of Pay
Once a company has determined the behavior it needs to elicit for the achievement of its vision and strategy, it must then determine the right mix of compensation elements that will best under gird that performance standard. Essentially, these components will be drawn from the following categories:
- Core Benefits
- Executive Benefits
- Qualified Retirement Plans
- Supplemental Retirement Plans
- Short-term Incentives
- Long-term Incentives (cash)
- Long-term Incentives (equity or phantom equity)
Typically, we can place components into two categories: fixed commitments and variable commitments. Each also addresses a different purpose in fulfilling the Total Rewards requirements of employees. Some address sustainable cash flow needs, while others meet security or wealth accumulation objectives.
Ultimately, given the intent described in this summary, a company should be able to identify the following for each form of pay:
- Purpose - what corporate and employee needs are we serving through this mechanism?
- Standard - how will this form of pay be defined in terms an employee can relate to?
- Investment - what is the total potential investment to be paid out of this plan?
- ROI - what (financial) results will have been generated if (or before) that payout is to (or can) occur?
This exercise forces a business to better evaluate the relationship between their financial targets and how they are paying people. It is an execution oriented philosophy that gives shape, form and meaning to the roles and expectations of key people in the organization. It speaks to the interdependence of personal and corporate vision and goals so that a more unified financial approach for growing the business can be achieved.
Rewards to Results
Ultimately, the "rubber meets the road" when a rewards plan generates a different performance level from employees. Companies that succeed at this learn to create the linkage outlined in the earlier part of this article. They also understand what comes next - and that is to ensure that rewards lead to the results that are being sought.
If rewards are going to be effective, they must create greater focus on the part of participating employees. Focus comes because employees feel compelled by the company vision, they feel encouraged by the positive work environment in which they work, they are drawn to the path they can follow for personal and professional development, and they are motivated by the financial rewards they will receive by achieving their targets.
This framework describes a culture of confidence - one that breeds and perpetuates success through sustained performance. Employees are focused because the company has developed a rewards structure that unlocks a passion sufficient enough to create focus on the roles and expectations it has for its people. That focus leads to execution and creates a culture that is not "copyable." Execution and confidence lead to results. And sustained results yield a competitive advantage.
For compensation to do its part in changing results within an organization, the following must occur:
- Both the model and the compensation plan must be understood
- Both the model and the compensation plan must be valued
- The results must be believable (achievable)
- Employees must be committed (ownership)
- Results must be measurable (concrete)
- Results must be communicated (regularly)
If these things occur, you will not only know what you are paying your key people, you will know what you are getting for it.