Thursday, January 31, 2013

Compensation components and other terminology

The way I think of financial interactions between an enterprise and an employee is relatively simple. It has six components, which come together for a total package, if we put other benefits, like pensions, insurance, tuition, and similar aside for now. But before defining them, let me define three time horizons for the purpose of this discussion:

  • short-term - time comparable with the enterprise's financial planning period. From a quarter to couple years.
  • mid-term - time comparable with an average employment duration at the enterprise. From two to a dozen years.
  • long-term - Anything beyond mid-term. Often tied to expected company longevity or major shareholders' interest span.

The resulting thought I want to leave behind is that different compensation tools have specific purposes. I will also try to show how dangerous are attempts to achieve multiple effects with a single instrument, seemingly tuned for wider application. Finally it should show the importance of clear communication of compensation terms and intents behind them.


A guaranteed income for a defined set of functions with clear performance and quality expectations. The purpose of the salary is to foster a sense of stability and balance the urgency of "need it done tomorrow" with "will have to deal with my outcomes later". Undersized salary creates a negative attitude, hostile interactions between individuals and enterprise. What I have seen is that oversized salaries drove anxiety up, encouraged political posturing and other bad things. Yearly salary changes wider than 5% without changes in underlying expectations destroy the sense of stability and put people in the "underpaid" or "overpaid" buckets, with detrimental effects mentioned above. This is the only compensation component I know of which may and should send the stability message.


A portion of revenue promised to an individual or a group based on their specific and ongoing performance regardless of the enterprise bottom line. My experience in commission-driven sales teams brings the observation that commission drives very short-term-minded behaviors, usually tied to the reporting period, with planning horizon no further than 2-4 such periods. An interesting thing to observe in such teams is how different their definitions of time horizons. Something farther than four sales compensation cycles is beyond their view of long-term and does not worth more than a lounge chit-chat mention.


A non-guaranteed, non-recurring achievement recognition. A tool to drive or encourage a short-term behavior. To be effective, bonus either can be a surprise "thank you" payment, or tied to an extremely thoroughly defined set of objectives. Things I observed as problematic when using bonuses: (a) creating an expectation of a bonus; (b) having vague bonus criteria; (c) for whatever reason refusing to pay bonus if criteria met; (d) announcing a bonus pool / making one person's bonus in reverse relation to another person or a group.

Specifically on each point:

  1. When bonus becomes routine, there is a conflict of expectations. An enterprise still believes it can freely change the bonus amount to drive short-term behaviors. An affiliate then sees bonus as a part of the salary and stability message. When enterprise actually fluctuates the bonus, then employees experience negative effects similar to salary fluctuation.
  2. A poorly defined bonus criteria drives manipulative behaviors, especially for hard to achieve tasks. People do "just enough" to be able to argue for the criteria met, or come up with reasons why effort should be compensated as well as the result would have. Often vaguely defined criteria is a sign of a lazy or incompetent management, one which feels they will not be held accountable, or one which is not motivated to even care about company's mid-term success.
  3. Companies and departments operate in dynamic contexts. Available funds may grow or shrink. It is totally wrong to expose that uncertainty to people at the bonus level. As a tool to drive a specific objective it deteriorates very fast if promises are broken. Employees start to see it as a carrot on a stick tied to their head. They will not run faster next time management wants them to. Because of that I think it is a very good idea to put promised bonus money aside in accounting procedures, almost in an escrow account.
  4. It so obviously creates inner tension in an enterprise, which takes forms of inner politics, manipulation, and sabotage, that it is mind-boggling how companies refer to it as "constructive inner competition". I have only seen it hurt companies in mid-term and beyond.

Profit sharing

A portion of an enterprise or a division profit promised to an individual on an ongoing basis. It is good to use as a mid-term priorities driver. To be effective for the mid-term horizon it needs to be relatively stable and well defined. It addresses people who are expected to see and impact a bigger picture both horizontally (multiple lines of business) as well as vertically (both top and bottom lines, or income and expenses).

Given that: profit sharing can not exceed a certain portion of a balance sheet; need to be relatively stable to have the desired mid-term impact; and should accommodate profit-sharing flexibility of future employees - it is important to avoid over-allocation of it, or to build in time-guards and absolute caps. Profit sharing is one type of compensation, which at least in one case I heard of it linearly declining in percentage over a course of 10 years down to a third of the original formula, with a review possibility.

In terms of what can be done wrong: revenue sharing does not belong to lower-impact levels in the organization. Without material ability to impact mid-term balance sheet most people I saw considered it as a part of salary, quite often as an insignificant corporate gimmick.

A frequently (yearly or similar) changing formula of profit sharing (which includes shifting percentages between departments), creates two problems.

  1. First, it's impact becomes short-term. The benefit itself plays an effective role of a bonus - and people start to treat it as such.
  2. Second, profit sharing is by it's nature is a piece of a pie in a very damaging way. So it becomes a bonus where one person's income is in reverse proportion to another person income. The company with such an arrangement will quickly find on it's hands the bonus problem (d) - and the culture will be destroyed in no time.

I have seen companies trying to combine bonus and profit sharing programs. In the specific case I am thinking about, quarterly bonus was tied to some very vague objectives and depended on a shared profit formula. This is close to an ultimate wrong - achieving none of the benefits, yet bringing all the damages.

Equity (affiliates)

I can think of two objectives when giving up equity to people working at the enterprise.

One is to motivate a long-term positive impacts from people, who are in a position for such impacts. It often takes form of option grants to leverage the motivation impact of the equity share. The pitfalls have to do with sizing and pricing the grants, as well as assessing cultural impact on the enterprise when the information becomes public - if the public's perception matters.

Another objective is to motivate early contributors in a situation when there is not enough money to immediately compensate them otherwise. What they really get is a recognition of their time and effort investment (or other resources) in a form of a portion of the company future value. By the nature of startup effort it is a high risk venture for those involved already. Adding uncertainty to the mix greatly reduces the perceived value of the reward. Reducing the uncertainty increases the perceived value.

Two major components of the uncertainty are being able to control a liquidity event and a pricing formula. Even though specific time or price are not known upfront, the clear definition of who and when can "press the button" is a must in all situations I have seen. For all I have heard for startups, equity vests after the first year - on average about when business viability becomes clear. Pricing formula is often not addressed for this early equity allocation for companies which drive towards a capital event - with a common expectation of a cash out to pay for the invested time and effort. I have seen startups which do not plan a capital event in a foreseeable time to spell out reasonable repurchase conditions, may be in a multiplier of rolling revenue or similar.

The biggest problem in both scenarios (start up and long-term motivation) I saw was when the status of equity at the time of separation was not clear - and there is no public market for that equity. When company leaves itself an option to buy or not to buy the equity out, then people stay longer than they should without much interest in their work. They hope that something will get clear "soon" - and rumor mill always finds something to feed the anxiety in that regard. All in all it is more beneficial to have a well defined separation process - and a valuation as soon as possible. That helps to move out of the way those who non-productive faster before the atmosphere becomes toxic.

The second issue creeps up is when shares are diluted faster then they appreciate absolute value. Equity owners obviously do not like to see the asset value to go down. Especially when they see it happening not because of market forces, but because they think management needs to please other people by issuing extra shares.

Equity (third parties)

As this write up talks about relationships between an enterprise and an employee, then the third parties with equity are most likely are past employees or heirs of past employees. Depending on equity transfer rules equity may also be gifted, split at a time of divorce, etc. For publicly traded company this likely is not an issue. However, for private equity company this may become an issue. So the units transferability should not be a part of the equity benefit, except for survivorship, inheritance, and where required by law.

I do not see any benefit or legitimate use for a company to encourage equity transfer away from current or past employees. I do see benefits of better focus when such equity is routinely bought out and kept to an unavoidable minimum.

The effects of mixing things

As I have mentioned at the very beginning, I saw much damage done when tools with different expected impact horizons - and purposes - stirred together. There is a reason the options are presented above in the order they are. A common management pattern is to use a concept made to benefit a farther horizon, but to modify it, so that it effectively plays role of a closer-horizon tool. Above I mentioned bonuses becoming part of a salary, profit sharing treated as a bonus. In many trading companies people talk about bonuses - when really those are commission arrangements. Even equity may be arranged in an operating agreement in a way to mimic profit sharing features.

A valid question is: why does it matter? Supposedly we can address the bad scenarios mentioned above, watch out for new problems and not to worry about intricacies of compensation terminology.

It needs to be addressed because quality of used terms affects the quality of communication. In a good case it causes people spend extra time to get on the same page with each new person involved. In a bad case it causes lasting misunderstanding and wrong business and personal choices. In a worst case it enables someone to use the ambiguity tor manipulation, create an arbitrage on different understandings of used concepts. There is no positive outcome to ignore the terminology.

I see three reasons for discrepancy between the intent and description to happen - besides an low-functioning plot to confuse employees.

The one reason I am on board with is potential tax benefits. If it is good for one or both of the sides, everyone clearly understands intentions and how they are arranged in compensation package, and everything is legal - nothing to worry about, the discrepancy is worth the nuisance.

Another observed reason for such discrepancy is when the compensation structure is created with very clear intentions and proper verbiage initial. However, it later shifts to accommodate new scale, tax, or legal realities. Sometimes in this process the original intentions are lost and new concepts serve current perceptions of the intentions, or new intentions altogether. This is not a good scenario, as it goes hand-in-hand with poor communication to employees. Really, if the management can not maintain continuity of intentions, what would it communicate to employees?

Finally, it is possible that the management acting with best intentions, however does not clearly map those intentions into compensation simply because of the lack of expertise or perceived priority. This is theoretically easier to fix than the previous case. It will take time and effort which are unavoidable. If not done carefully it may also leave a cultural scar behind. This is the scenario, which is easier to avoid than to fix.

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