Designing A Great Bonus Compensation System

One of the tasks faced by Early Stage companies (ESCs) is the need to design powerful, sustainable compensation plans. This includes the issue of equity sharing, but that generally involves a small number of employees and is not discussed here. What needs to be considered from day one, however, are bonus plans for managers and profit sharing incentives for other employees. This topic is as old as time.

Erwin Kelen is a legendary investor in the Upper Midwest. Now in his 80s, he continues to back Early Stage companies.

To help ESCs get started on a well-designed “comp plan,” we adapted some work done by the new CEO of a small public company in the computer chip industry. We think you will find the principles helpful, even though every point won’t be relevant to every company. As if to prove that the fundamentals of human behavior rarely change, it is worth noting that this work was done in 1984 by Erwin Kelen – one of our most successful co-investors and a mentor to many.

First, some observations on the principles of “comp systems.” These are unchanging “truths” which we have seen proven over and over again:

  • Companies of all sizes should have incentive compensation systems.Sounds obvious, but sharing a piece of the sales or profit pie tends to drive interest in growing the pie. The ideal plan is so well aligned with the interests of shareholders that the no investor should ever feel bad when bonuses are earned or paid.
  • All added compensation plans should be easy to understand, be fair and (more important) appear to be fair. They should be based on principles the company is prepared to live with. They should aim to provide meaningful incentives to the employees and be “affordable” to the company given its industry and competitive set.
  • The more directly a manager controls his/her group’s profit, the easier it is to design a meaningful profit-based bonus plan.By contrast, the further down in the organization, the more debatable the individual’s contribution to the bottom line and the less meaningful a straight profit-based bonus plan will be.
  • The more objective the plan (the more tied to actual numbers), the better.The more subjective (i.e., the more tied to the boss’s opinion), the more debatable and less well received the plan will be.
  • A plan that allows the employee to know during the year how he/she is doing is more desirable than one which creates year-end questions about “how much will I get paid?” Year-end surprises, good or bad, are often the result of discretionary bonus plans or a plan with a significant subjective component. Don’t guess and don’t make your people guess.
  • “Formula plans” which impose an upper limit on total comp cause problems..Pragmatically speaking, the plan should be designed so that the organization is delighted to pay the extra increment for truly outstanding performance. This applies particularly to sales people, who should (particularly in Early Stage companies) consistently out-earn the CEO!
  • Sometimes there are valid company goals that cannot be measured in a given yearAchievement of these results can be best rewarded in some combination of soft and hard goals – or better yet, a rolling 2-3 year profit-based bonus plan.
  • All employees who participate in an incentive type pay plan should only participate in one plan.For example, Sales people should participate in a quota-based sales reward system, but not in the general profit sharing plan for all other employees.
  • The top management bonus plan should pay out annually – after all the numbers are in.Other plans, for lower-level employees should pay out quarterly, as the cash flow impact should be recognized as closely as possible to when the bonus is earned.

Types of Plans – Generally speaking, there are five different types of added compensation plans, as described below. There are numerous variations, but the general advantages and disadvantages listed here seem to hold true

  1. Discretionary Plan –The Board approves a total amount based on sales or profit targets for the Company. Management divides the total among the various number of participating executives, using a formula known generally to everyone but administered “confidentially” by the Added Compensation Committee.
  • Advantages:
  • The company has total control each year over the amount distributed. By definition, it never gets out of whack with the company’s results and the Board is never surprised.
  • The company has total control each year over the amount distributed. By definition, it never gets out of whack with the company’s results and the Board is never surprised.
  • The company can control the amount, the number of participants and the makeup of the group. Some people can be in it one year and not the next.
  • This system allows disproportionately large awards for outstanding achievements that are not tied to a single year’s profit (i.e., outstanding technical achievements for a software developer or a very important customer win.)
  • Disadvantages:
  • Appears paternalistic and is often resented because there is no clear basis. Fairness is always debatable and debated.
  • The allocation formula always gets out, no matter what.
  • Year-end “surprise bonus awards” create year-long anxiety.
  • Doesn’t answer the question of “How am I doing?” during the year.
  1. Multifactor Formula Plan – The formula includes performance of the overall company goals and the individual’s performance against his/her own agreed upon goals. Beyond the question of how each of the factors is weighted, the following comments seem to hold true:
  • Advantages:
  • Broad-based. Can include everyone.
  • The plan can be closely aligned with specific corporate goals.
  • Disadvantages:
  • Somewhat distant from individual responsibility and contribution; not everyone has influence over how the company performs.
  • Tends to lead to game playing in “negotiating the bogey”; deciding what items in the base year should be deducted before the growth goal is calculated, etc.”
  • Very time consuming to administer.
  1. Straight Percentage of Pretax Profit or EBITDA – While there are many different “return on asset” yardsticks, using pretax profit seems to be the most closely aligned with the ultimate organizational yardstick: Net earnings. For private companies, this measure is often recast as EBITDA. While this is good in that it reflects what employees can actually influence, it is misleading in that it fails to acknowledge the cost of capital required to grow the business – interest expenses, returns to preferred shareholders.
  • Advantages:
  • Clear and direct.
  • Totally aligned with the most important corporate goal.
  • Disadvantages:
  • Only lends itself to top decision makers who control the profit. It is less meaningful down the line – and of no motivational value to many employees.
  • If the pool of dollars gets too large, the percentage payout may have to be reduced to be affordable – a step which is always poorly received.
  • Tends to lead to low salary and very high bonus (with good performance) structures for the company as a whole.
  • Can be a disincentive for essential long-term investments which are “EBITDA painful” in the short-term.
  1. Bonus Based on Profit Improvement – The company bonus “pool” is computed on a percentage of that part of a given year’s profit which is in excess of the preceding year’s average profit. (For Early Stage companies, this could also be done on the basis of sales growth.)
  • Advantages:
  • The bonus never gets too large because the basis keeps moving up.
  • Disadvantages:
  • Can be a real demotivator when the company takes an “investment year” or when a big customer is lost – through no “fault” of the individual employee.

One variant of this approach is a two-part structure. Part One pays a straight percentage for improvement over the accepted annual plan. Part Two pays the same with the upside limited.

  • Advantages:
  • Straight and clear.
  • Reset each year, therefore, always in line with the company’s actual results.
  • Disadvantages:
  • Leads to sandbagging at the end of each year; the habit of holding new sales or other initiatives until the “profit will mean something to me.”
  • Pays as much for the accuracy of the prediction as it does for the value of the performance.
  1. Employees are given an individual annual bonus potential expressed as the product of a percentage of their annual salary multiplied by a company performance factor (CPF). The CFP comes from a matrix showing various combinations of annual sales and EBITDA growth. For example, the chart below might be appropriate for a fast growing company that is rolling out new, more profitable technology. Here, the CPF can be from 0.2 to 3.4, with 1.0 being at the nominal “acceptable objective”, i.e., 50% annual sales growth and 10% improvement in pretax profit. But the matrix can be set in any of several ways to inspire different mixes of sales, profit, etc.
  • Advantages:
  • Recognizes that increases in profit and sales are both, not either/or.
  • Performance objectives are clear and are not renegotiated year to year.
  • Everyone lives or dies by the same CPF, as a team, irrespective of their level or function in the company. Everyone has to “work together.”
  • Disadvantages:
  • Can be very tricky to formulate without unanticipated consequences.

Which Works Best? Early Stage companies are by their nature focused on maximum possible sales growth; to achieve a leading position as their market develops. Ultimately, however, their gross margin has to be “brought down to the bottom line.” The game, therefore, is a continuous three dimensional tradeoff between investments for future payoff, rapid current sales growth and the need to prove that the company can make money.

To maximize the likelihood of achieving the “triple-threat” target of sales growth, profits and investment for the long term, we believe all employee profit sharing or bonus plans should be closely aligned with these goals. To achieve this, you might think about two separate plans, both of which are based on the CPF system. A specific example, again using the CPF chart above, might look like this:

  • For Top Managers/CEOs – The plan would pay a multiple annually of the target bonus potential in the 10% to 25% range of salary, depending on the position, level and seniority.

Example:Assume a manager earns $80,000/year and is given a nominal bonus potential of 10% or $8,000.00. If the Company’s performance for the year is 60% sales growth and 8% pretax margin, then from the CPF matrix, we get a factor of 1.0. Therefore, the bonus will be $8,000. Note that setting the “target bonus” is very important, and that sales people might have a higher percentage of their total comp in “target bonus” than an engineer or HR manager.

  • For All Other Employees – The plan would pay quarterly based on quarter versus year ago comparison. The target bonus would be available to all eligible employees.

Example:If an employee earns $40,000/year, and the target bonus is 5% of salary, he or she will have a 5% of $40,000/4 = $500 quarterly bonus potential.

Of course, there is no one right system for every company. But reviewing the options here with your Board of Directors may help produce a thoughtful outcome.