Scaling Up Compensation by Verne Harnish and Sebastian Ross

The Big Idea: Compensation is one of your largest expenses and, therefore, one of your most important strategic decisions.

Overview: 5 Principles for Effective Compensation Design

Principle #1 – Be Different: Aligning Compensation with Culture and Strategy

The first principle of compensation design is to Be Different. Strategy is about being perceived as different versus your competition. Ideally, all your People practices (recruiting, leadership, compensation) reinforce these differences. They must incentivize behaviors in your employees that your customers appreciate.

A Good Jobs Strategy means paying significantly higher salaries than your competitors, nevertheless, enjoying lower labor costs per unit and higher profits because your employees are more productive.

You might feel tempted to copy the compensation systems of these outstanding firms. But that would be a big mistake. Your system will only be effective if it is tailored to your unique context. Make compensation a critical part of your strategy, make it your own, and make it different.

Principle #2 – Fairness Not Sameness: Creating a Coherent and Flexible Base Pay Structure

Scaleups need to go to the drawing board and design a compensation system that deserves the name.

The key is to design a transparent and equitable system that allows for meaningful differences in base pay between low, average, and top performers. Performance is not normally distributed, and thus base pay shouldn’t be either.

Principle #3 – Easy on the Carrots: Using Incentives Effectively

Zehnder decides to be deliberately old-fashioned. The firm could do what everybody else in the industry does and pay its people juicy commissions. Yet this would be unwise, given the firm’s culture and strategy.

Financial incentives influence employee behaviors in three ways. They help people decide if they want to work at your firm (selection effect), they tell employees what is important (information effect), and they can motivate people to try harder (motivation effect).

Most bonus plans fail to drive performance. Instead, they become entitlements and cause undesired behaviors. We argue that individual financial incentives only work for simple, routine, measurable, and independent jobs and that your sales roles are likely the only candidates where such carrots will be effective.

Principle #4 – Gamify Gains: Driving Critical Numbers Through Pay/Play

In gain-sharing plans, teams or even an entire company commit to moving the needle (often in a gamified manner) on a metric that points to a specific challenge of the business (productivity, spending, quality). This number is then tied to a bonus and paid out to employees when the goal is achieved.

The power of gain-sharing schemes lies in their information effect. By making goals specific and tangible, and tying a reward to them, gain-sharing plans inform people what is important.

Principle #5 – Sharing Is Caring: Getting Employees to Think Like Owners

While stock and stock options grants are standard practice among Silicon Valley-style tech companies, we find these tools underutilized in the vast majority of mid-market firms.

Compensation is Not Logical, It’s Psychological

In this book, we focus on the monetary elements of your compensation system. However, when discussing monetary compensation, you always need to consider the total reward package as the different reward elements complement each other. Small and midsize companies have great opportunities to offset less competitive salaries and benefits with relational rewards.

Ch 1. Be Different: Aligning Compensation with Strategy

Being different is key to any effective strategy – and that includes designing a “strange” compensation plan that incentivizes the behaviors your customers and other stakeholder expect.

But make sure your comp plan aligns with your culture / core values or risk it being rejected. This is why it is dangerous to just copy someone else’s compensation plan.

Don’t look at people as a cost; they are an investment.

The first principle of compensation design is to Be Different. Strategy is about being perceived as different versus your competition.

The role of the compensation plan is to incentivize behaviors in your employees that your customers appreciate and make them reach for their wallest. Only then do your HR policies create true value for the firm and make you stand out in the marketplace.

Your People systems should be outright strange.

One of the Container Store’s core values is “1 Great Person = 3 Good People.” Therefore, they are willing to pay them up to twice as much as competitors.

The Container Store wants excellence and has the firm belief that performance differences among people are huge and that outstanding people deserve to be lavishly rewarded.

Incentives are powerful shapers of culture.

Your design choices should reflect your culture’s position about people and money. If you trust that team will always work hard, you will pay them a high fixed salary. If you don’t, you pay them variably. If you believe that competition among colleagues improves performance, you will pay individual bonuses. If you think cooperation produces better results, you will reward team bonuses.

Culture (and strategy) influences a company’s choice about compensation and vice versa. You need to start with a well-defined culture. Do you have three to five core values that describe the basic behavioral norms everybody in your organization has to follow?

Don’t just copy another company’s comp plan. Make it a critical part of your strategy.

The Good Jobs Strategy (coined by author Zeynep Ton) directs companies to pay people extremely well to put a powerful flywheel in motion that leads to operational excellence, loyal customers, and increased revenue and profits.

Mercadona, a follower of the Good Jobs Strategy, invests $5k per new employee in a four-week boot camp, offers intensive tutoring, gives regular salary increases, generous bonuses, 30 vacation days, and family-friendly schedules. It is Spain’s largest and most profitable supermarket chain and beats Walmart by a factor of 3x.

Worry about what people do, not what they cost. (From Jeffrey Pfeffer’s classic HBR article Six Dangerous Myths About Pay).

Costco pays 30-40% higher than Sam’s Club.

Netflix says: one outstanding employee gets more done and costs less than two adequate employees.

Hire fewer but far more productive people.

To be clear, the higher worker productivity at these Good Jobs Strategy firms is not the result of paying people higher salaries to work harder and smarter. The higher worker productivity is the result of getting the best talent and retaining them.

A compensation philosophy is a written statement that outlines how people in your organization are paid and why.

PwC pays low salaries but develops its people to land big jobs elsewhere.

KKR believes every employee of its portfolio companies should be an owner.

Unilever offers great management training with guaranteed promotions if goals are met.

Startups and scaleups can’t offer great salaries but can offer long-term wealth creation and dynamic work environments.

Ch 2. Fairness Not Sameness: Creating a Coherent and Flexible Base Pay Structure

Base compensation is rarely motivational – and raises are short-term in their impact. Base pay is considered a hygiene factor. As a company scales, it’s important to establish clear pay grades. Performance is not normally distributed, and thus pay shouldn’t be either.

The 3 drivers of base pay: competencies, sustained performance, relative labor market value

Read Pay People Right! by Zingheim and Schuster.

Base pay does not motivate. People won’t work harder because you increase their base pay. Base pay drives attracting and retaining talent.

However, paying people below what they consider fair is highly detrimental to motivation and performance.

Extrinsic fairness means your people are paid fairly relative to the market.

Intrinsic fairness means your people are paid fairly relative to their co-workers.

Perception of fairness is not logical. People’s assessment of fairness depends on how they feel about their boss.

Read 12 Elements of Great Managing by James Harter

Read First Break All The Rules by James Harter

Humans are not rational when it comes to pay. Receiving $1,000 less per year than the colleague next door can easily be perceived as a massive personal insult.

Although compensation is not rational, a well-thought-out pay structure can go a long way to reduce anxiety, social envy, and drama.

As your company grows, you must introduce pay structures, with standardized salaries and pay bands for jobs.

You might need to create two separate pay structures and career paths for Leaders (managers) and Makers (individual contributors). This allows individual contributors to advance in their career without having to become a manager.

Set up a pay structure early in your company’s life. Don’t wait.

Pay for high performance. For skilled jobs, high performers are 10x+ more productive.

When employees ask for a career path, this is often a coded way of asking “How can I make more money?” The solution: wider pay bands in your pay structure.

If competition and ambition are important values in your firm, a large pay band might make sense. If you want to foster values like solidarity and generosity instead, then you might want to limit the salary spread and pay people more equally.

Read Are You Paid What You’re Worth? by Michael O’Malley for help with pay structures.

Read The Leadership Pipeline by Ram Charan about leadership development.

Base salaries should be reviewed once per year for everyone, at the same time. Don’t be forced to a schedule based on employee start dates.

Don’t mix performance reviews and compensation reviews. Learning from performance feedback is difficult when money is on the table.

Increase base pay to adjust for: cost of living, promotions, increased responsibility, sustained high performance, relative market rates.

Tenure alone is not a good reason to give people a raise.

Quarterly Priorities, Critical Numbers, KPIs are great ways to assess high performance that can be rewarded with raises in base pay or payout incentives.

For smaller companies, a pragmatic way of reviewing performance and comp is for the direct manager to suggest increases and run them by a compensation committee (CEO, CFO, HR, trusted first-line employee).

A raise is only a raise for 30 days. After 30 days, a raise is just someone’s normal base salary.

It’s a sad fact that the majority of workers are financially weak, vulnerable, and living paycheck-to-paycheck.

Peter Drucker believes a healthy CEO:worker pay ratio is about 25:1.

Consider paying your workers weekly.

Consider teaching your workers personal finance management.

It’s hard to predict how people will react if they learn what their bosses or peers make. Until you have a very well thought out compensation system, keep your salaries confidential.

Ch 3. Easy on the Carrots: Using Individual Incentives Effectively

There are 8 conditions in which monetary rewards are effective, but they only rarely apply. Thus, go easy on the carrots.

Egon Zehnder does not pay any kind of performance bonus.

The main rationale is to foster tight cooperation and the long-term view that Zehnder adopted as a core element of its strategy.

Egon Zehnder uses its unique compensation system to retain long-serving consultants and to reward time invested in building client relationships instead of chasing the next deal.

Zehnder looks for consultants with two characteristics: in it for the long haul, team players.

Jeffrey Pfeffer and Robert Sutton explain 3 effects of financial incentives in “Do Financial Incentives Drive Company Performance?”

1) Selection Effect: Do I want to work here, with people who care about this incentive?
2) Information Effect: What is important here?
3) Motivation Effect: Try harder for the reward

Some studies show financial rewards have little or no influence on work performance and can even be detrimental. Other studies show that financial rewards can have a positive effect on performance.

Bottom line is that financial incentives do work. The question is rather how they work and how they can best be applied in practice.

Inappropriately applied incentive schemes can have multiple “side effects”.

Unwanted side effect: too much of a good thing. Employees focus on the incentive at the expense of other job duties.

Unwanted side effect: too complex or too simple. A too-simple model ignores relevant variables and will not deliver optimal results. The right balance is rarely achieved.

Unwanted side effect: cooking the books. People can get creative about hitting the metric but not achieving the intended goal.

Unwanted side effect: performance measures tainted by biases. It’s rare to find a task that is measurable and dependent only on one person. Performance evaluations are subjective. 97% of executives believe they are among the top 10% of performers.

Eight conditions for successful incentive schemes: 1) role is repetitive and focused on one task; 2) goals are unambiguous and one-dimensional; 3) easy to measure both quality and quantity; 4) employee has complete control of process and outcome; 5) cheating or gaming the results is practically impossible; 6) role is independent; 7) employee is not expected to help or support others; 8) employee considers the incentive as meaningful and payout is frequent.

TMC abolished all individual and group incentives (except sales) and tied 80 percent of everybody’s bonus to the company’s financial performance.

Bosch eliminated all individual bonuses for all 378,000 employees.

Rockstar companies like Netflix, Mayo Cliic, and SAS Institute never had any performance bonuses.

Intrinsic motivation is much more powerful and sustainable than extrinsic motivation.

SAS avoided trying to attract people with money so that they don’t also leave for money.

For sales teams, it does make sense to additionally motivate people with monetary incentives.

Smaller firms often have difficulties competing with larger competitors in terms of base salary and benefits. But they can make up for the difference, especially if they are growing, by generously sharing the upside with their people.

“People now join us for our culture, development opportunities, and many other reasons, and we like that. Pay is still very attractive and up to 30-40 percent above industry average, but it is only one of several decision factors.”

Compensation is anything but an exact science. Human psychology is too complex to capture in universally valid formulas.

Ch 4. Gamify Gains: Driving Critical Numbers Through Play

Shorter-term gain-sharing plans are used to gamify the business and add a level of fun and excitement (and dopamine addiction) to achieving FAST (vs SMART) goals.

In a gain-sharing scheme, teams or even the entire company commit to moving the needle on what Jack Stack would call a critical number, i.e., a metric that points to a challenge of the business (productivity, spending, quality, customer service).

Because people engage and change their behavior purely to have fun, the monetary incentive becomes secondary or even irrelevant.

You can apply gain-sharing schemes as one-time thrusts to accomplish a particular objective and then move on to the next thing.

Group incentives have the advantage of fostering collaboration and teamwork.

Drawbacks are: 1) First, most people don’t want to depend on others when it comes to their pay. 2) Second, top performers are the least fond of group schemes. 3) Third, the free-rider effect (people slack because they trust that others will carry their load) can bring average performance down instead of up.

If you use gain-sharing schemes, make sure that individual performance is monitored as well.

A way to reduce unintended side effects of group incentives is to link rewards to metrics that reflect the overall performance of the organization, like company profit.

Organizational learning is an important by-product of gain-sharing schemes. People understand causalities and make better decisions because of these plans.

Walters tied everybody’s compensation to the achievements of the firm’s three annual priorities. Team members received a percentage of base salary when hitting the target for each priority.

Axiometrics’ priorities were operationalized through FAST goals (Frequently-discussed, Ambitious, Specific, Transparent–an update to the acronym SMART goals).

The real payout at Axiometrics was quarterly yet based upon YTD performance so that late performance could catch up with early non-performance.

Another example of a simple yet highly effective gain-sharing scheme is Continental Airlines’ punctuality bonus. It wasn’t the size of the bonus that mattered as much as the focus it brought to the airline’s on-time performance.

Sebastian at TMC paid a small bonus (= 0.5% of annual salary) to everybody when the team achieved the goals of the quarterly theme. It wasn’t the money that moved people to put in the extra effort but rather the game-like spirit these schemes created.

Read Great Game of Business by Jack Stack

Intermittent Reinforcement Schedules: Using financial and non-financial rewards in an irregular, ad hoc matter is an excellent tactic to increase the motivational effect and avoid the creation of entitlements.

Surprise bonuses are fun and tie into the one-minute manager concept of catching people doing the right thing.

“These surprise bonuses are one-time nonrecurring expenses,” concludes Berman. “They help to build culture and have been highly effective for me for a long time.”

TMC has the Invisible Hero Award. Anybody can suggest a colleague they think has made an extraordinary contribution or effort. The suggestion is presented and decided informally at the weekly senior leadership meeting. The award can be anything from a dinner for two to a voucher to a material gift. The upper limit per award is $ 1,000.

Verne advised HSN to turn its call centers into casino-like environments. Instead of earning a consistent bonus, reps earned the right to spin a big wheel installed in each call center.

Read Bringing Out the Best in People by Aubrey Daniels.

Non-monetary rewards come in countless forms: extra vacation days, sabbaticals, special projects, training or educational events (i.e., paying for a conference at an exotic location, including spouse or family), travel privileges (business class flight, 5-star hotel), or simply throwing a great party for your people.

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

People won’t remember the zeros on their bank statements, but they will never forget how you made them feel with that trip to Hawaii.

Paying for education is also more impactful than just handing over a check. Eg. Starbucks.

Spending money on others (whether coworkers or charity) increased the happiness and job satisfaction of givers and receivers and improved team performance.

Yes, many companies give to charity. But the twist of letting the employee choose the organization and deliver the money is crucial – the employee receives direct recognition by the charity for the gift instead of the company.

Some employees and teams will value non-monetary rewards over monetary. The idea of non-monetary rewards also allows you to customize your compensation for specific employees.

Incentives can trigger a great variety of responses in people, and the exact causes of behavior changes are difficult to establish. Variables like leadership, culture, or training influence heavily, regardless.

Ch 5. Sharing Is Caring: Getting Employees to Think Like Owners

Profit-sharing is also a way for mid-market firms to compete for talent. Longer-term value sharing (stock and stock options) goes even further in aligning the interests of owners and employees.

Phantom stock is a special form of value sharing that retains control for the owners but can create liquidity issues.

Rothschild of Access Fixtures implemented a profit-sharing plan in 2019 where 20 percent of the firm’s annual pre-tax profit is distributed on a pro-rata salary basis among his employees,

“For me to make serious money, the employees need to get a serious bonus.”

Profit-sharing often leads to sharing P&L information with employees.

Improving individual and group performance with financial incentives can be tricky. Yet as discussed, pay schemes like Zehnder’s or Access Fixtures’ that link rewards to the performance of the entire organization produce far fewer issues.

What’s the effect of profit-sharing on employee behavior? First and foremost, it is a way of aligning the interests of shareholders and employees (the information effect). Employees tend to decide more like owners when they have skin in the game.

Profit-sharing also helps attract employees and keep them loyal (the selection effect). If profit sharing is a significant component of overall compensation, employees are incentivized to stick around until their share is paid out.

At Allied Printing, 50% of the annual bonus is paid sometime after the end of the year, so it doesn’t get lumped in with base pay in employees’ minds. You don’t want annual bonuses to become entitlements.

The other 50% of the bonus then vests over the next six years, and is divided equally into six chunks. These future buckets of money increase with each year, and employees only receive them if they are still with the firm.

But as Steve Rothschild found out, profit sharing is not effective if you want people to work harder (the motivation effect). A profit goal is too aggregated and detached from people’s work, and first-line employees generally have little influence on the outcome. The payout is also too far away from the task.

The problem can be partially overcome with an open-book policy and financial education as promoted by Jack Stack and the Great Game of Business approach.

Cascading priorities, KPIs, and a planning process that drives top-down strategy and bottom-up execution, which are at the heart of the Scaling Up methodology, can also provide this critical line-of-sight between the employee’s task and the firm’s profits.

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.

Read Ownership Thinking by Brad Hams.

1) It is best to include all employees in the plan, from the cleaning staff to the CEO.

2) Profit-sharing shouldn’t happen from the first dollar. Start from a minimum threshold that allows the company to serve a return on capital, be it in the form of a minimum dividend to shareholders, debt repayment, or recapitalization of profits.

3) The amount of profit that you aspire to generate in the upcoming period should be determined.

4) Decide the percentage of profits (beyond the minimum threshold) that you want to dedicate to the pool. He would not cap the plan but generously share whatever profit was generated beyond the profit goal.

5) Decide how to distribute. One option is to distribute equally. The more common solution is to pay the amount in proportion to the employee’s base salary. A third option is to differentiate the percentage according to job levels (first-line, coordinators, managers, execs, etc.).

6) Profit sharing is generally done on an annual basis but consider half-yearly or quarterly payouts

7) Consider conditioning the payout based on available cash flow as profitable years can occur with poor cash flow. You also want to pro-rata the payout for people who have recently joined or already left the company.

8) An open-book policy is critical for any profit-sharing program. Management maverick Ricardo Semler, who implemented a generous profit-sharing program at the Brazilian equipment manufacturer Semco, shares regularly financial updates with employees.

9) To avoid entitlements, don’t give consolation prizes when profits are down.

The danger of profit-sharing programs is that they can incite short-term thinking, i.e., sacrificing future “good” profits for today’s “bad” profits.

That’s why it is best to combine such short-term programs (which are appreciated by employees because they also provide short-term payouts), with long-term, value sharing programs, (e.g., stock, stock options, performance units),

If you would like to share profits with your team but want to avoid the dangers of short-termism, then value sharing schemes are an option to consider. Value sharing is the category name for financial instruments that grant employees either real ownership (stock or stock options) or similar economic rights linked to the value of the company (phantom stock, performance units, etc.).

Read and

Once people are on board, value-sharing programs also have a retention effect because of the long payout and vesting periods of these instruments.

Value-sharing programs also communicate what is important to employees (information effect). Partial ownership is enough to reinforce the role of employees as stewards of the company’s assets and interests. Owners and employees share the risks and rewards associated with the business activity and align their interests through these programs. Employees who are also owners think and act more long-term, strategically, and holistically.

As with profit-sharing, it is beneficial to allow all employees to participate in the growing value of a company. Freeman’s research shows that the broad-based programs are the most successful.

Industrial firms like Chobani and Harley Davidson have granted large amounts of stock to their team, including all their blue-collar workers.

There are several ways of implementing a value-sharing program.

Do I allow employees to participate in the full value of the company or only in the appreciation of the value from the moment you grant these titles?

An Employee Stock Ownership Plan (ESOP) is a form of equity sharing with significant tax advantages for owners and employees that is unique to the US.

An ESOP is costly to maintain, given compliance and administrative burdens. Get solid legal and financial advice before you pursue an ESOP.

Phantom stock is a private contract between company and employee wherein the company promises to pay cash to the employee upon certain conditions. The agreement replicates the financial outcomes of granting restricted stock but with fewer strings attached.

Phantom stock will not be the right choice for everyone (e.g., stock options are much better if you are going for an IPO), but we would encourage you to explore this less-known option.

Closing: Get Pay Right and Out of Sight

The plan needs to be fair in the sense that employees feel their salary is an expression of your respect, appreciation, and equitable treatment.

First, your compensation plans consider the inscrutable nature of human psychology–the counterintuitive and irrational perceptions and reactions people have to compensation decisions.

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