Scaling Up Compensation

1. Compensation is a strategic tool, not just an expense

Think of people's salary not as a cost but as an investment.

Strategic advantage: Compensation is one of your largest expenses and thus one of your most important strategic decisions. It can give you a significant advantage over the competition, support or hinder the culture of the business, and drive (or not) the behaviors you need to scale your organization.

Good Jobs Strategy: When executed well, compensating people extremely well can put a powerful flywheel in motion that leads to operational excellence, loyal customers, and increasing revenue and profits. This virtuous circle, called the Good Jobs Strategy by MIT professor Zeynep Ton, means paying significantly higher salaries than your competitors, yet enjoying lower labor costs per unit and higher profits because your employees are more productive.

Examples:

• Costco pays 30-40% higher salaries than Sam's Club, yet is more profitable and grows faster
• Mercadona, a Spanish supermarket chain, pays double the minimum salary and 50% above competitors, resulting in 46% higher sales per employee than the average US supermarket

2. Align pay with culture and strategy to differentiate your company

Strategy is about being perceived as different versus your competition. Ideally, all your People practices (recruiting, leadership, compensation) reinforce these differences.

Be Different: The first principle of compensation design is to Be Different. Your compensation system should be unique and tailored to your specific context, culture, and strategy. Copying another company's compensation approach, no matter how successful, is likely to backfire.

Examples of strategic alignment:

• Lincoln Electric's piece-rate regime aligns with its quality-focused strategy and culture of psychological ownership
• The Container Store's "1 Great Person = 3 Good People" philosophy allows them to pay twice the industry average
• Egon Zehnder's profit-sharing based on tenure supports its long-term relationship-focused strategy

Stakeholder expectations: Start with the end in mind and work backward. What do your various stakeholders (customers, employees, shareholders, community) expect your firm to deliver? How do you plan on delivering, in a differentiated way, on those expectations? Your compensation system should incentivize behaviors in your employees that your customers appreciate and make them reach for their wallets.

3. Create fairness, not sameness, in your pay structure

The main goal of such a system is to create Fairness, not Sameness – the second design principle you want to keep in mind when going about this work.

Pay structure: As companies grow, they need to implement a formal pay structure with job categories, salary levels, and pay bands. This creates coherence but should also accommodate for large differences in performance. The key is to design a transparent and equitable system that allows for meaningful differences in pay between low, average, and top performers.

Performance distribution: Performance in most knowledge-based jobs is not normally distributed, and the difference in impact between two employees in the same job category can be huge. For skilled jobs, the productivity difference between the best and worst performers can be up to 15x or higher for highly creative jobs.

Design considerations:

• Create separate career paths for managers (Leaders) and individual contributors (Makers)
• Build broad pay grades with spreads of 100% or more to accommodate outliers
• Allow significant overlap between grades to retain key talent
• Consider using criteria like education, experience, training, time horizon of tasks, and scope of work to determine pay levels

4. Use individual incentives sparingly and strategically

Go Easy on the Carrots. It is very difficult to obtain people's discretionary efforts for longer periods by dangling "carrots" in front of their faces.

Limitations of incentives: Financial incentives are designed to influence employee behaviors through selection, information, and motivation effects. However, they often fail to produce the desired results and can lead to unintended consequences.

Conditions for effective incentives:

1. The role is repetitive and focuses on doing just one thing
2. The goals are unambiguous and one-dimensional
3. It is easy to measure both the quantity and quality of results
4. The employee has complete end-to-end control of process and outcome
5. Cheating or gaming the results are practically impossible
6. The role is very independent, i.e., there is little or no need for teamwork or collaboration
7. The employee is not expected to help or support others
8. The employee considers the incentive as meaningful, and the payout happens frequently

Sales compensation: Sales is often the only area where individual incentives work well. Consider tailoring your sales compensation plan to the psychological profiles of your stars, core performers, and laggards. For example, stars need unlimited upside potential, while core performers benefit from multi-tier targets with increasing payouts.

5. Gamify gains to drive critical numbers and behaviors

Gain-sharing plans use the information effect of incentives. By making goals specific and tangible, and tying a reward to them, gain-sharing plans tell people what is important.

Gain-sharing schemes: These plans involve teams or the entire company committing to move the needle on a critical number (e.g., productivity, spending, quality, customer service) tied to a bonus. Gamifying these schemes can make them even more effective, as people engage and change their behavior purely to have fun.

Examples:

• MiniMovers' breakage bonus: 3% of revenue is set aside for a team bonus, distributed if nothing is broken during moves
• Hilcorp's DoubleDrive campaign: $100,000 bonus for all employees if the company doubled production and reserves in 5 years
• Continental Airlines' punctuality bonus: $65/month for all employees if the airline ranked in the top 5 for on-time performance

Design considerations:

• Focus on one or a few critical numbers that align with your strategy
• Keep the plan simple and easy to understand
• Consider using irregular, ad hoc rewards for greater impact
• Implement non-monetary rewards like experiences or altruistic bonuses

6. Share profits to foster an ownership mentality

A profit-sharing scheme is a gesture of fairness and a way for owners to reward those who generated the profit in the first place.

Benefits of profit-sharing:

• Aligns interests of shareholders and employees
• Helps attract and retain talent
• Fosters an ownership mentality and better decision-making

Implementation tips:

• Include all employees in the plan
• Set a minimum threshold before profit-sharing begins
• Determine a profit goal and share percentage
• Consider different distribution methods (equal amount, proportional to salary, or tiered by job level)
• Implement quarterly or annual payouts
• Combine with open-book management and financial education

Example: Access Fixtures distributes 20% of annual pre-tax profit among employees, representing 15-20% of their total compensation. This has led to employees making more owner-like decisions, such as turning down unnecessary expenses and considering the impact of new hires on profitability.

7. Consider value-sharing options to attract and retain talent

Value-sharing programs and growth are mutually reinforcing. As Freeman's research shows, value-sharing programs increase a company's value, which in turn creates the currency needed to fuel these programs.

Value-sharing instruments:

• Stock grants or options
• Restricted stock units (RSUs)
• Stock appreciation rights (SARs)
• Phantom stock
• Employee Stock Ownership Plans (ESOPs)

Benefits:

• Strong selection effect for attracting talent
• Retention effect due to long payout and vesting periods
• Reinforces employees' role as stewards of the company's interests
• Can create significant wealth for employees

Examples:

• Outback Steakhouse's manager investment program increased manager retention from 6 months to 5-10 years
• Google grants stock awards to all employees based on individual performance
• Chobani granted 10% of its shares to employees before its IPO, potentially creating many millionaires

Considerations:

• Decide between granting full ownership rights or economic rights only
• Determine whether to allow participation in full value or only appreciation
• Consider going public to create liquidity for employee shares
• Evaluate tax implications for both the company and employees

8. Pay a living wage, not just minimum wage

Most leaders agree that inequality is a huge problem in the world. But few see that the way they design their compensation systems is at the root of that problem.

Living wage definition: A wage that covers the basic needs of an employee and sometimes their family, including food, housing, healthcare, education, and transportation, as well as some discretionary income.

Impact of living wages:

• Reduces financial stress and anxiety for employees
• Improves productivity and reduces turnover
• Contributes to overall societal well-being

Implementation strategies:

• Use MIT's Living Wage Calculator to determine appropriate wages
• Conduct pay equity audits to identify and address disparities
• Consider redistributing benefits to support lower-income employees (e.g., Heath Ceramics' 401(k) restructuring)
• Implement more frequent pay periods (weekly or bi-weekly) to help with cash flow
• Offer financial literacy education to help employees manage their money effectively

9. Evolve compensation as your company grows

Compensation systems tend to develop organically with the growth of the organization. New elements get added over time as needs arise, but without much concern for internal coherence or structure.

Growth stages:

1. Startup: Individual negotiations, focus on equity
2. Early growth: Implement basic structure and job levels
3. Rapid growth: Formalize compensation philosophy and policies
4. Maturity: Refine and optimize systems, consider broader value-sharing

Evolution example: Tinuiti (formerly EliteSEM) evolved its compensation system from an almost all-variable, uncapped model to attract talent in its early years, to a more balanced approach with fixed salaries and commissions as the company grew and established its reputation.

Key considerations:

• Regularly review and adjust your compensation strategy
• Balance short-term incentives with long-term value creation
• Adapt to changing market conditions and talent needs
• Maintain flexibility while creating structure
• Communicate changes clearly to employees

10. Implement non-monetary rewards for greater impact

Research indicates that non-monetary rewards have a more substantial impact on performance than monetary rewards of equivalent value.

Types of non-monetary rewards:

• Extra vacation days or sabbaticals
• Special projects or assignments
• Training or educational events
• Travel privileges (e.g., business class flights, luxury accommodations)
• Recognition programs
• Flexible work arrangements
• Wellness programs

Benefits:

• Evoke emotions and create lasting memories
• Can be more cost-effective than monetary rewards
• Appeal to intrinsic motivation
• Contribute to a positive company culture

Examples:

• Starbucks offers full tuition coverage for bachelor's degrees at Arizona State University's online program
• Hilcorp gives $2,500 to new employees to donate to a non-profit of their choice
• Verne Harnish's practice of giving employees $2,000 annually to donate to charities of their choice

Implementation tips:

• Tailor rewards to individual preferences and needs
• Use a mix of monetary and non-monetary rewards
• Consider implementing "altruistic" bonuses that employees spend on others
• Create opportunities for unique experiences and personal growth

Last updated: August 14, 2024