Quid Pro Quo: Thoughts on Pay for Performance
Over the past few months, it would have been difficult to tune in to any major news source without hearing the Latin phrase “Quid Pro Quo.”…
Over the past few months, it would have been difficult to tune in to any major news source without hearing the Latin phrase “Quid Pro Quo.” In political discourse, it has a negative connotation implying that one has engaged in bribery (offering a reward) or extortion (threatening a punishment) to achieve a desired outcome.
Notwithstanding this present negative connotation, “quid pro quo” is commonplace in modern American business, particularly in sales-driven organizations. Here, quid pro quo takes the form of incentive compensation plans, often referred to as “pay for performance” plans.
Incentive compensation is an accepted feature of the compensation system at most companies today, particularly those with a sales-driven revenue model. The conventional wisdom holds that these plans drive better business outcomes. The employees most frequently participating in these plans are members of the Revenue organization and the Leadership Team. These incentive cash payments are bonuses or commissions with the payout based on the level of achievement against certain financial or operating targets.
Why are incentive compensation plans fairly common? There are several reasons.
First, it stems from largely unquestioned theory, made famous by Harvard psychology professor B F Skinner, that humans respond positively to incentives, in the form of physical rewards. This theory was extended to the business world in the 1970s with the belief that incentive compensation would improve corporate performance. The argument was that people value money. So the opportunity to earn more money should be highly valuable. And thus rewarding certain behavior with something employees value, money, would reinforce that behavior and encourage more of it.
Second is the desire to align interests between the employees and the owners of businesses. The natural state of affairs, per the principal-agent theory originated by Professors Jensen and Meckling states that agents (management and employees) know a lot more about a business than the principal (shareholder or owner). And that agents will leverage this asymmetry of information in a manner that benefits them at the expense of the principal. Hence the need to create compensation policies that align interests. What began as aligning the economic interests of top managers with shareholders, through the issuance of restricted stock and options, now includes a lot of pay for performance cash compensation which impacts a much wider set of employees. In the founder-led start-up world, where founders and co-founders often own as large an equity stake in the business as any single venture investor, founder/CEOs realize their primary economic interest is to act as a shareholder rather than as a non-founding executive or regular employee. Hence, they often push for implementing pay for performance broadly across the company.
Third is a specific desire to mitigate risk around hiring, given the fact that a sizable percentage of new hires don’t work out for the employer. With the existence of pay for performance plans, employers feel less exposed to the risk of a “bad hire”. If the new hire does not perform up to expectations, they won’t receive their commission or bonus. A related belief is that anyone working for contingent compensation must really believe in the business and therefore is a “better fit” for the company. This sounds great in theory. In reality, the asymmetry of information is substantial, so the candidate knows a lot less than the employer about whether they are likely to succeed in their new role (i.e. the employer knows a lot more regarding the quality of the training program, the value of the product to customers, the competitive environment, the strength of their teammates, the quality of their manager, etc.).
Fourth, I have seen situations where CEOs prefer offering incentive compensation broadly as they believe this keeps “guaranteed base salaries” lower. They believe they get the best of both worlds — being able to hire top notch talent with the offer of a high total compensation package and the downside protection of paying out less if things for the business don’t go well.
Contrary to conventional wisdom, my strongly-held belief is that offering incentive compensation rather than an equivalent higher base salary rarely leads to improved corporate performance. Daniel Pink’s research, published in the book Drive, on what motivates humans resonates deeply with me — a superb ten minute animated video explanation of his research can be found here. I agree with Daniel Pink that most people working in complex roles in the information economy today are motivated more by intrinsic factors (i.e. overall satisfaction gained from the work, the learning and growth, or the contribution to helping others be they colleagues or customers) than by extrinsic factors (whether monetary rewards or punishments).
With this research being widely known for the past ten years (YouTube says the video link above has over 17 million plays), I am surprised that the effectiveness of incentive compensation in improving corporate performance is rarely questioned. If anything, incentive compensation plans are even more common today than they were a decade ago. And, when there are criticisms of an incentive compensation plan not working well, the critiques are aimed at plan design — including, incorrect target metrics or payout formulas that can be gamed.
So, knowing that incentive compensation will continue to exist, and that the CFO is a core stakeholder in designing, approving, and implementing these plans, here are some recommendations to corporate leadership on the broad topic of incentive compensation.
Cash Compensation must be Fair: Employer should pay people fairly (a market rate) for their role given their expertise. Even when employers can offer a talented person a below market wage because they don’t know their worth or are desperate, I recommend against this approach. At some point, every talented person will likely figure out their fair market value and either leave or be bitter and have lower motivation to contribute to the business. Fairness matters greatly to most humans, and with regard to pay, research by PayScale shows that employees rate fairness in pay as more important than actually receiving additional pay.
Management Matters: When talking with team leads about incentive compensation plans, managers often ask how to design a plan to encourage or discourage a particular behavior. I tell them every time: “incentive compensation plans are not a substitute for management and oversight.” Managers need to be willing to teach, mentor, motivate, set explicit expectations, and have difficult conversations when performance is below these expectations.
Limit Incentive Compensation to a Select Number of Roles: These should be roles where performance is easily measurable, target incentive compensation is sizable (20%+ of total compensation), and most other companies in the market pay in a similar manner. These roles include select positions in the Revenue organization and select senior Leadership Team members (CEO, COO, and CFO). The latter three Leadership positions merit incentive compensation because these individuals are responsible for overall company performance and not a single department (whereas other Leadership Team members focus primarily on the success of a single department or function).
Incentive Compensation should not be Risk Management for Hiring: Often companies have a lower hiring budget for a position that the candidate they really want to hire is seeking as salary. Employers sometimes offer the difference in pay as incentive compensation. This change in compensation from base salary to a bonus does not de-risk the hire. The best people know what they are worth and will go elsewhere if they believe the cash compensation is not fair (see #1 above). And the cost of a poor hire to the business is much greater than the savings from not paying out the incentive compensation component of their total pay package.
Great Incentive Compensation Plans Are:
Simple — Easy to understand payout calculations for the recipient and the finance team. Ideally, calculable simply in excel without need to complex commission software. In my experience, complexity opens up more opportunities for “gaming the system”.
Aligned — The success of each individual should be linked to both overall company success and to the buyer (customer) getting value from their purchase. Areas for alignment include ensuring that: (i)commission or bonus payout is linked to the customer paying; (ii) discounts to rate card over some limited level (I suggest 15%) are approved by the COO or CFO (and not simply the sales leadership); and, (iii) in a subscription business, extra payouts for a multi-year agreement and some holdback until the renewal of a single year deal.
Measurable — The financial and operating targets on which incentive compensation is to be paid must be clearly defined, easily calculable and transparently shared with the employee receiving incentive pay..
(Appropriately) Controllable — Payout metrics should be related to behaviors undertaken by the individual having incentive compensation. Individual contributors should have the most direct control over outcomes (knowing that no one totally independently controls an outcome). And there will be less direct control over outcomes for more for managers (who are compensated on team performance) and even less direct control for senior Leadership (who are compensated on company performance).
Long-Term — Customers and capital providers (in the private company universe) hope for long-term relationships with companies. Incentive compensation plans should be designed to reward behavior that creates consistent long-term value. Even though incentive compensation plans may require monthly or quarterly payouts, I recommend those are restricted to only the target payout. My strong preference is to pay accelerators (for achievement over target) only at the end of a full calendar year, when performance can be measured over a longer period of time.
Transparent — All people at the same level and in the same role should be paid using the same plan. I strongly believe in employees knowing that “there are no special deals” (again principle #1 above in action). Revenue leaders and some people operations leaders don’t like this as they feel is takes away a degree of freedom they might have in recruiting.
Compensation, including incentive compensation, can be a heated emotional topic and lead to heated discussions. My advice to leaders is to remember that three important things: (1) Most of life is a series of repeated interactions; (2) You will not always be in the one with more power and status; and, (3) Reputations take a long time to build and are easy to lose. Those three principles lead me to suggest a few guidelines for compensation: (1) Strive for fairness; (2) Give more in the short term, particularly if you believe in the person — you should get back a multiple of that in the longer term; (3) Seek out win-win outcomes, even if you could have found another outcome more favorable to you; (4) Find way to recognize and reward people in ways beyond compensation.