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.

His plans meant overhauling the way Jamba Juice pays its professional and administrative staff -- 100 people in the marketing, real estate, research-and-development, and IT departments who are critical players in growing the 4,500-person company. For those 100 people, Clayton has done away with merit raises and will adjust salaries only "when people are promoted or there's an inequity in the marketplace," he says. "We're moving to a culture where the best performers get the best rewards." Clayton believes that dramatically restructuring the way Jamba Juice pays its staff will help him double the size of the company by the end of 2005, both in revenues and in the number of stores.

"People said that they never thought the options were going to be worth anything anyway. I just scratched my head."

--Richard Rhodes

Instead of merit increases, employees now receive bonuses, provided the company meets its targets for net income and annual sales growth. Many employees became eligible for 10% bonuses, a far cry from the typical 4% merit raise. And their bonuses increase the more the company exceeds its net-income goal -- a figure that Jamba Juice makes public and encourages employees to track monthly. "We wanted to reward employees for those times when the company really beats the pants off the plan," says Bob Andrews, director of human resources.

Jamba Juice, which ended its first year with the new bonus system in September, not only met its net-income goal but quadrupled it. "In fairness, when you're talking about numbers as small as our plan number was, it's not as impressive," says Clayton. "But considering that the best Jamba had ever done was break even, it's pretty significant."

"Our sales are off. Way off. Maybe every one of my employees should be selling?"

When revenues are down, some CEOs feel that everybody should bring in sales, from the accounting clerk to the receptionist. If that is the case, then why not put everybody on commission? That's exactly what smart growing companies are doing, says Jorgensen. "It used to be that only the salespeople were incentivized on sales. Now we're seeing it with customer service, purchasing, collections -- because it's all tied to the customer."

Jennifer Gilbert loves that idea. Gilbert is the CEO of Save the Date, a $22-million event-planning company in New York City. The company's sales soured along with the economy in early 2001 and worsened further after September 11. As Gilbert watched sales decrease, she decided she'd better shrink her payroll expenses. "We had some very high-salaried people, and normally they'd be worth every penny," she says. "But now I can't afford them unless they're bringing in sales."

In the fall of 2001, Gilbert cut everyone's salary to a lower base with increased bonus potential. Her employees are divided into teams that include a salesperson, production people, and administrative staff. She sets quarterly sales goals for each team, and if they hit their goals, everybody on the team makes money. She also sets individual sales goals for her on-site event staffers and pays them commissions when they sell clients additional services, such as entertainment, decor, transportation, or registration assistance.

The new system has helped Gilbert achieve four things. First, she decreased her fixed salary costs. Second, employees work faster. "Everybody is more aggressive, getting things done and moving on to the next thing," she says. Third, unproductive employees departed. Four staffers left the company because they either couldn't -- or wouldn't -- sell. "But my attitude is, If you're not helping to grow the business right now, then we don't need you," she says. (The company has 8 employees, down from a high of 15.) Finally, her employees are so much more productive that Gilbert is convinced that her new comp system is the reason the business has survived. "Many companies like ours have gone under," she says. "Our sales are flat, but we're doing it with 40% less staff, so no matter what, I'm ahead."

"We're moving to a culture where the best performers get the best rewards."

--Paul Clayton, CEO of Jamba Juice

Of course, many companies would find it difficult to follow Gilbert's example. It might be easier to mimic what Marion McGovern has done. McGovern is the CEO of M Squared Consulting, a San Francisco-based service that brokers engagements for independent consultants. Rather than placing all her employees on commission, McGovern is offering incentives to employees who support her salespeople.

In August 2000, when McGovern was drafting M Squared's 2001 compensation plan, things were looking pretty rosy. Despite a slowdown in Internet-related business, "it was still a heady, go-go time," she says. In 2000 the company made $23 million in revenues. McGovern expected M Squared to grow 9% the following year, to $25 million, and she made bonuses contingent on reaching that figure. But by the end of the first quarter, clients started pulling back on their consulting requests. Then came the April 2001 Internet-stock meltdown. "We went from having 150 to 200 consultants placed at clients to 100 in one fell swoop," McGovern says. Sales for 2001 came in at just $12 million.

McGovern laid off 22 employees. Not surprisingly, morale dropped like a stone, and her comp system just added to the misery. "Our system was such that in up times, everyone made money, but in down times only some salespeople made money and the rest of the staff didn't," she says. McGovern wanted a new system that encouraged people to work hard in slow times, when the company really needed it.

Early this year McGovern froze base salaries. Then, with team spirit in mind, she created a commission-like incentive structure for client-services employees, who partner with outside salespeople. The idea: if client-services staffers receive incentives for sales, they'll be more likely to help the salespeople close deals. Under the new system, client-services specialists receive incentives of 0.5% to about 1.5% on the sales that their partner salespeople close. She also tied the new plan to the company's revenue goals. For example, if the company makes 150% of its target, the percentages double. Today about 50% of M Squared's employees receive a sales-based incentive, up from 25%.

After two quarters under the new system, McGovern is optimistic. The 2002 plan has the company bringing in $13 million, a 10% increase over 2001, and McGovern says M Squared should hit its target. Plus her employees are more enthusiastic, although the new pay plan may not deserve all the credit. "Some of our teams are red-hot right now," she says. "But it's hard to say how much of it is because of the new compensation structure. Part of it is just that business is picking up. That's very invigorating."

"Employees don't understand that bonus means something extra. How do I get them to earn their bonuses?"

When you pay more, you should get more. But most bonus plans are based on company-performance measures like revenue growth and net income, and individual employees typically don't understand how they contribute to companies' goals. (It's hardly surprising: most employers can't objectively measure their employees' contributions either.)

Says Coonradt, "For a long time we've had this concept that if everybody gets a share of all of the team's results, we will have some magical bonding and team effectiveness." By and large, that magic doesn't happen, he says. Now he sees a new trend emerging. "We're seeing a lot more companies tying compensation to the performance of the individual or the department manager," he says.

That's not to say that owners should throw out the notion of rewarding employees for the company's overall performance. Bill Palmer believes that a combination of companywide goals and individual incentives works best. Palmer, CEO of Commercial Casework, an $11-million cabinetmaking businesses in Fremont, Calif., ties his company's annual bonus plan to revenues and gross margin targets, then gives his employees shares in the plan based on the value of their position to the company. All 100 of Palmer's employees -- from administrative staff and managers to cabinetmakers and carpenters -- participate in the program. "Our salaries already reflect the differential in responsibility," says Palmer. "But we wanted to have the bonus reflect that, too. It's not a huge range, but we give a little more to say we value leadership."

Palmer's employees can earn more shares by completing classes ranging from advanced carpentry to financial education to English as a second language. The bonus plan pays out quarterly, but Palmer posts weekly updates telling everyone the cumulative value of the bonus and the value per share. That means employees not only can watch the share price rise and fall but can alter their own performance in response. "When you have piece of the action, that motivates you to make the bonus bigger," says Palmer. "It's a great educational tool."

Of course, Palmer has created individual goals that are easy to measure -- an employee completes a class and earns a bonus. It's tougher to measure individual and departmental contributions to a company's overall health. Just ask Brad Borne, CEO of IDEAS Inc., a $2.4-million product-development company in Uniontown, Ohio. Late last year IDEAS was growing at a pace of about 100% annually, but profits weren't growing commensurately. So early this year, seizing an opportunity created by the softening labor market, Borne decided to try to increase profits by dramatically decreasing pay raises and tying bonuses to improved productivity. "We've got a lot more [leverage] as an employer right now, and we're taking advantage of it," he says.

Borne turned his attention first to his manufacturing department, which makes up about a third of the company's 18 employees. "We thought that was the area where we could increase the bottom line the most," he says. "We weren't operating as lean as we possibly could." Each quarter Borne sets a target gross-profit percentage for his manufacturing staffers. Then he tells them how they can achieve that goal. "The quarterly costs for that group are fixed, because we own the machines and equipment, and there's no penalty for using it more," he says. "We wanted to see them do more with their own time, utilizing our resources more and using outside resources less."

CEO Brad Borne dramatically decreased pay raises. "We've got a lot more leverage as an employer right now, and we're taking advantage of it."

After two quarters, Borne says, the new system has elicited about 95% of the effort he was hoping to see from his staff. "I would like to have seen that extra 5%," he says. "Maybe we'll tweak the system and make it a curve instead of a straight line, to give them more incentive to make the goal." During the next year, Borne also wants to experiment with giving employees individual goals, in an effort to tailor the motivational process to a particular person's career path. "The problem is, it's such a difficult process to monitor," he says. "You wind up creating a half-time job just to keep track."

"Annual bonuses don't work. At least, I don't think they do. Do they?"

They don't. Or so say compensation experts, who advise employers to make more-frequent payments -- and, more important, offer more-regular feedback that comes with those bonus payments.

In late 2001, Brad Borne began paying bonuses quarterly rather than annually. "When you break it into smaller pieces, it's easier for people to see the impact of their effort," he says. "It puts the onus on individuals to perform and at the same time lets them reap the rewards from the effort that they put forth." Borne tries to put himself in his employees' shoes. "When I got only an annual bonus, did it really affect my performance in June?" he asks. The shorter time frame also gives Borne a chance to change a compensation system that continues to evolve.

Of course, there is a potential hazard to a quarterly bonus payout. If the company does well early in the year but tanks later on, inflated payouts from early quarters can put the company at financial risk at year-end. Bill Palmer protects his company against that possibility. He has installed an annual bonus system that has quarterly payouts, but each quarter the company holds back 50% of the bonus amount in a reserve account. He can then draw against that money if the company starts doing worse than expected. Of course, the backup system kicks in only when the company is actually able to pay bonuses, which hasn't happened this year. "We're just not hitting the numbers, for the first time in five years," Palmer says.

"After all the bad press about stock options, why should I even consider sharing equity?"

Probably no aspect of compensation has received more attention lately than stock options. In the late 1990s, options were the embodiment of dot-com wealth. But interest in options has waned recently, from the perspectives of both employees and employers. "The collapse of the dot-coms and the general crisis in faith in corporate America have jaundiced the value of stock options," says Coonradt.

But offering ownership opportunities is still a great way to lure and motivate top-notch employees. One alternative to stock options that's on the rise of late: the venerable ESOP, or employee stock ownership plan. "It's surprising, because ESOPs generally swoon with the economy," says Corey Rosen, executive director of the National Center for Employee Ownership, in Oakland, Calif. "It's probably because ESOPs are considered safer than stock options. They typically have additional and diversified retirement plans [beyond the ESOP itself], so employees are somewhat protected against disasters."

Richard Rhodes learned the usefulness of sharing equity when he started his company, in 1998. Rhodes is CEO of Seattle-based Rhodes Ragen Smith, a $10-million, 32-person company that recovers and sells handcrafted stone building products. Rhodes and his start-up team had plenty of experience in masonry and construction, but they lacked expertise in overseas business development, which would be critical for the new business in recovering architectural elements from abroad. "We needed someone with deep relationships in China who knew how to manage the export/import logistics," Rhodes says. Rhodes had some start-up capital but not enough to offer the kind of salaries the people he needed would be looking for. So he offered a share of the company to two potential hires -- and got the necessary know-how in return for 20% of the company.

Luring potential partners with equity is a tried-and-true way to start a business, but Rhodes decided to take the ownership concept companywide by installing an ESOP at the beginning of this year. He set aside 24% of the company's equity in the program but dropped the percentage to 17% recently when he took on outside investors. Employees receive options based on their level of responsibility. The shares have no street value until the company is acquired or goes public, but at any time employees can use their options to purchase a portion of the company, which would make any future liquidity event a lot more meaningful.

Rhodes had initially hoped that the ESOP might transform his employees into business owners. "We wanted to have an entrepreneurial culture," he says. "I also hoped we would attract new-economy workers in an industry that pretty much defines old school. We're literally bricks and mortar. The stone industry is pretty stagnant, and we're looking for tools to make it sexy."

But after a year's experience, Rhodes feels that lower-level employees either don't understand the idea of ownership or simply don't care. "It's a great democratic principle that everybody gets stock at our company," he says. "But I would have thought it would have inhibited more people from moving to new jobs." Rhodes recently lost some key employees who had significant amounts vested in their stock-purchase plans but left without exercising their options. "In exit interviews they said that they never really thought the options were going to be worth anything anyway," he says. "They didn't even ask what it would cost -- they just abandoned them. I just scratched my head."

Still, Rhodes is convinced that the ESOP makes a huge difference to his four management-level employees. "We have people on our executive team who took major pay cuts to come here, because they feel they're really participating in the future of the company," he says. "It has allowed us to bring in a higher caliber of execs when we can't really afford to pay the going rate." Rhodes thinks the discrepancy in the ESOP's impact on the two groups may be due to the fact that his managers are more invested in the business and have greater responsibility, but it may also have to do with education. "[The managers] typically have more business training, and they may also have aspirations to someday have companies of their own," he says. "Ownership feels like a stepping-stone."

Rhodes says he could also be the victim of a cultural shift in attitudes about ownership. "When we were putting this program together, we were riding on the coattails of Microsoft," he says. "Options really meant something in Seattle, and we were trying to tag along with some of that goodwill." But gone are the days of the overnight Microsoft millionaire, as are the days when the average worker placed much personal stock in stock. "Options are much more interesting when they hold the promise of infinite growth -- as an abstract article of hope -- than as a 30-page document of nitty-gritty details," he says.

Bonuses, profit sharing, equity. What it all comes down to is risk -- and finding opportunities for employees to share not only that risk but also the upside. Finding the right comp program -- one that perfectly balances risk and reward -- can be tricky. But not even trying could be the biggest risk of all.

Christopher Caggiano is a senior associate editor at Inc.

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