The Right Way to Pay

After decades of paying employees in the same old way, cutting-edge CEOs are solving their worst compensation problems by adding one critical factor: risk.

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The Clinic

Over the past few years a growing number of entrepreneurs have forged a quiet revolution in compensation plans, jettisoning traditional salary structures and carving out bold new incentive programs for their entire organizations. What they're discovering is that the right pay strategy can transform a company. What's more, the right compensation system is pivotal in determining how effective you are at leading your company, how productive your staff is, and ultimately whether your company succeeds or fails.

The key to the shift in motivational leadership is a concept known as "pay for performance." The notion -- which at its most extreme makes every employee's compensation variable and dependent on his or her productivity and the success of the company -- is certainly not a new idea. But recently, more CEOs have been discovering its transformative power. Done right, variable comp helps business owners keep fixed costs low and prod employees toward greater productivity.

In the past 18 months, many privately held companies have put an increasing portion of their employees' compensation "at risk," says Karen Jorgensen, a Los Angeles-based human-resources consultant and author of Pay for Results: a Practical Guide to Effective Employee Compensation. The shift means that more of an employee's compensation comes from bonuses, commissions, profit sharing, or stock options, and less from salaries. What's more, the variable-pay concept is filtering through the entire organization, says Jorgensen. Five or ten years ago, it was predominantly salespeople and executives who received incentive pay.

The misbehaving economy is largely behind the switch. CEOs are caught between penny-pinching customers demanding value for less money and employees wanting more pay for less work. "The only way to make that [squeeze] work is by incentivizing the employee to help the organization drive revenues and profits," says Jorgensen.

Also driving the trend is a collective cultural disgust with "obscene comp programs -- the Monopoly money, the pay schemes that screw the little investor" -- that have been proffered in recent years, says Charles A. (Chuck) Coonradt, author of The Game of Work and CEO of a consulting company by the same name in Park City, Utah. "The societal conclusion seems to be that people ought to make money the old-fashioned way, by earning it."

But for owners who find themselves with bloated payrolls, instituting a sane, effective comp system is not as simple as cutting staff, slicing pay scales, and starting fresh with new employees. Although it may seem as if the staffing shortage of the late 1990s is long gone, today's looser labor market is just a minor blip in what will likely be a continuing labor crunch. "Businesses continue to rely more on knowledge workers, and fewer such workers are entering the marketplace," says Jorgensen. "With birth rates down, employers are going to have a hard time finding the knowledge workers they need."

The good news is that now is probably the best time to rethink your compensation strategy and put a plan in place that will make your company more competitive than ever. That said, how do you start? Take a few lessons from CEOs who've tried it.

"Every year my payroll increases, but I have nothing to show for it. How do I break the cycle?"

One surprising answer to that question: It's time to ditch the merit raise, at least according to Coonradt. "Merit is the most abused, prostituted, and misunderstood word in the whole world of compensation," he says. "There's no common definition. It can mean anything from attendance to real measured contribution." Typically, Coonradt says, employees accrue higher salaries without necessarily adding any organizational value. "So after 10 years of 4% raises, their comp is now 48% higher, but you haven't done a single thing to tie it to performance or productivity."

Paul Clayton never liked the idea of merit raises. Well, actually, it wasn't the idea that bothered him. It was the execution. Throughout his career, including his 16-year tenure as president of Burger King, Clayton found himself embroiled in annual debates over merit raises. Do they really reflect performance, or are they just an entitlement? In the end the answer was obvious: "Every year it comes down to doling out whatever the finance department says we have available, which is usually 4% to 5%," he says.

In 2000, Clayton became CEO of the San Francisco-based Jamba Juice, which now has 350 fresh-juice stores and revenues of $120 million. The company had recently acquired a large competitor and had launched into a number of new geographic markets. Sales had climbed sharply, but Jamba Juice had yet to do more than break even in any year since it was founded, in 1990. Clayton decided to halt growth in new markets and turn his attention to building an infrastructure that would support future growth -- profitably.

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