Innovation has long been critical to a company’s sustained success. Yet many companies fail to innovate meaningfully and consistently—and compensation programs may be partly to blame for many firms’ failures.
In our experience, the compensation programs within larger corporations are typically not structured to appropriately reward entrepreneurial teams that are starting innovative ventures. For example, metrics are often wrong, measurement periods are frequently too short, and the size of the rewards are rarely commensurate with the incremental value they create. We know of three executives who were instrumental in launching $100 million-plus businesses. Despite the huge incremental value all three created for their corporations, their compensation plans failed to adequately reward them for creating such explosive growth. Although they received large bonuses and public recognition, they and their teams received only a tiny fraction of the value that they created. Sadly, all three of these executives left their companies to work in smaller, more entrepreneurial firms.
Well-considered special incentives can be helpful—even mission-critical—in launching new businesses. These incentives can be tailored to fit the specific facts, circumstances, and expectations for a new business much more naturally than the regular, ongoing incentive programs of the parent company.
These special incentive plans—designed to help launch new businesses—are generally guided by five key principles:
- Provide appropriate motivation and reward for a successful launch.
- Ensure a fair allocation of the value created between the new business team and the company.
- Reflect the “real” economics of the business. For example, business financials should include:
- All costs of the new incentive plans;
- Parent company overhead costs attributable to the new business, where feasible; and
- All capital requirements of the new business.
- Deliver an appropriate risk and reward tradeoff for participants to provide upside opportunity beyond traditional caps (perhaps even allowing uncapped rewards), balanced with no incentive payout if the new business fails.
- Ensure an adequate time horizon to gauge business success or failure.
Such incentives have three key benefits:
- Greater ability to attract outside talent to new startups, which can carry significant career risk
- Improved likelihood of retaining key talent after a successful launch
- More incentive to advance the ideas for startups in the first place
One such approach is illustrated by the design of a new business compensation plan for a startup within an established direct marketing company. The plan was requested by the company’s board in response to a proposal by a group of managers who wanted to launch a new line of business. Importantly, the board wanted a compensation plan that provided significant upside to the entrepreneurial manager group, and, at the same time, protected the broader business. The final design had the following features:
- To recognize the increased risk and to give the plan an entrepreneurial character, a risk premium was added to the compensation package that was also provided to company executives of a similar pay grade, and the long-term incentive opportunity was left uncapped. However, on the downside, if the launch was not successful, payouts were essentially limited to salary and a small short-term bonus.
- Part of the compensation was paid along the way through a short-term bonus with payments based on the achievement of key financial and nonfinancial milestones that were critical to a successful launch. Given the difficulty in predicting the exact timing of things, incentive payments were milestone-based, rather than tied to finite time periods. But, all milestones had to be achieved within a three-year period – a negotiated test period, balancing expectations for the new business and the board’s risk tolerance. Additionally, milestone bonuses were back-end loaded, with no more than 50% of the total opportunity paid within the three-year launch window.
- The bulk of the compensation was delivered through a long-term incentive that was specific to the business unit and was tied to the value created by the business unit over a seven-year period, less all costs incurred by the parent company including capital invested, corporate overhead attributable to business, and all compensation costs. Importantly, this approach ensured the incentive program was self-funded —an important protection for the board. Value was determined using a multiple of earnings derived from the parent’s historical financials.The upshot: the business had a promising start, but it faltered against latter-stage milestones and was shuttered in its first three years. The payout to the entrepreneurs was limited to salary and a single milestone-based bonus payment. Although there was a big upside opportunity, the company’s ultimate compensation exposure was very limited. Importantly, failure was not rewarded, as had been the case with prior plans.
Seymour Burchman is a retired managing director at Semler Brossy. Burchman, who has been an executive compensation consultant for over 30 years, has consulted on executive pay and leadership performance for over 40 S&P 500 companies. He may be contacted at firstname.lastname@example.org.
Barry Sullivan is a managing director at Semler Brossy. Sullivan supports boards and management teams on issues of executive pay and company performance. He may be contacted at email@example.com.