The differences in how companies manage their compensation programs can be striking in that publicly traded firms tend to have more effective compensation systems than those that are privately owned. There are always exceptions to our observation, and we have seen many private firms with sound compensation systems.
Certainly, some of the differences occur because SEC and stock exchange listing requirements for public firms necessitate an independent compensation committee to oversee pay programs, which leads to a greater focus on the pay function. Additionally, private companies may not have the internal resources or perceive the need to engage external advisors regarding the design of their compensation programs.
When you consider that compensation can account for over 60% of total business costs, an effective pay program is critical to the success of the business.
Compensation programs should evolve as businesses evolve, adapting to new generations of employees or responding to a change in business strategy. Private companies can benefit from adopting three practices generally used by public companies in order to maximize the return from their compensation systems.
1. Establish a Foundational Total Rewards Strategy
Companies differ significantly in their size, industry, culture, and place in their business life cycle. Consider the differences between a family-owned business in Illinois with $250 million in revenue that has been in business for 70 years and a technology start-up in San Francisco that has existed for five years and is not yet producing positive cash flow.
The rewards programs for the two firms would be significantly different and should be articulated in a total rewards strategy that addresses all components of rewards that are important to the attraction and retention of the workforce (salary, incentives, benefits, work environment, and learning and growth).
A well-crafted total reward strategy considers a company’s business strategy, values, demographics, and capabilities of the workforce. Relevant external factors such as available talent, governmental regulations, and competition are also important to consider.
The outcome is a strategy document that articulates the various components of total rewards and their relative importance to an approach that is unique to the company. Committing the strategy to a written document ensures consensus among owners, executives, and other stakeholders prior to actually designing and implementing specific plans.
2. Consider All Available Levers in Designing Reward Programs
All of the different components of total rewards listed above should be considered as part of a comprehensive approach to total rewards.
In our experience, private companies tend to rely predominantly on base salary and benefits in their reward programs. Depending on the level of the position, variable pay (incentives) should be leveraged to create a link between pay and performance, especially for senior management.
Well-designed short-term incentive plans provide a direct, measured link to the annual business results of the company and can also be tailored to reinforce cultural norms such as teamwork or individual performance. In our experience, incentive plans that are discretionary, or without business measures, are not effective and are reminiscent of the Christmas turkeys handed out by companies years ago.
Long-term incentive plans can provide a link to the strategic goals of the business and have a strong retention value. These plans typically cover a multi-year performance period, with the potential payout occurring at a later date. In public companies, these plans are typically addressed through company equity, which the owners of private companies are often not willing to provide.
However, companies can choose from many alternative designs that support a long-term tie to performance and retention. Cash-based long-term incentive plans can be tied to a company’s valuation or multi-year business goals. Potential payouts can be structured to occur at the end of the measurement period or deferred to a later date. The short- and long-term plan design alternatives are almost limitless for private companies.
Broad-based retirement or health and welfare benefit programs have limited alternatives because of ERISA regulations. Companies have the ability to determine the cost-sharing ratio between the employer and employees, but typically provide the level of benefits needed to be competitive. Some companies provide additional benefit offerings, such as tuition reimbursement, sabbaticals, and parental/caregiver leave, which could provide a significant competitive advantage to employers whose workforces consider these to be important.
Perhaps the least expensive but highest-impact reward components focus on a company’s work environment and the learning and growth of employees. Companies that have developed effective programs in these areas experience lower than average turnover and are considered “Best Places to Work.” The components of work environment include the organizational climate, leadership style, and work/life balance, while learning and growth focuses on feedback systems, performance management, coaching, mentoring, skill development, and succession planning.
3. Add an Appropriate Level of Structure and Governance Processes
Companies often don’t add structure to their pay systems until they feel the pain of increased employee pay issues and realize that something has to change. Although there is no bright-line rule, our experience is that this occurs when the workforce population approximates 50 employees. Adding an appropriate degree of structure to compensation programs can lead to increased employee understanding and satisfaction with pay programs.
One of the first considerations for companies that are experiencing workforce growth is to develop a base pay structure that addresses competitive pay and the internal equity of jobs. A pay structure has a series of pay grades with different pay levels corresponding to the external and internal value of positions and is an important tool to manage pay in the organization.
Pay structures are typically accompanied by processes that help ensure the consistency of pay practices across a company and are especially important when more than one manager is responsible for making pay decisions. Pay practices should address processes such as merit pay, promotions, and new hire rates. Related to pay processes is the documentation of incentive plans and the specification of performance measures, the link between pay and performance, and what happens if an employee changes jobs, leaves the company, retires, etc. This is especially important with sales incentive plans when the potential incentive accounts for a relatively large percentage of total compensation.
After a degree of structure is added to the reward system, companies should decide what they want to communicate to employees. Pay transparency ranges from providing no information to employees regarding their pay to sharing the actual pay levels of all positions in the company. From our vantage, the right level of pay transparency for most companies is somewhere in between these extremes, but minimally, employees should know how their personal pay is determined and what they can do to influence their pay in the future. Private and public companies alike may be resistant to sharing information about their pay systems, but if the programs are well-designed, they can positively influence how employees view the company.
Private companies have the advantage of less outside regulation and the ability to evolve their pay systems more quickly compared to public companies. Private firms can leverage these characteristics and strengthen the effectiveness of their compensation systems by adopting the three practices listed above. Considering that compensation expenditures make up a significant percentage of the total expense for most companies, maximizing the return on this investment is important to business success. The idea of a strategic compensation system that tailors pay systems to the unique culture of the firm, links pay to performance, and is communicated so that employees understand their stake in the program creates a win/win scenario for companies and their employees.
Joe Kager and Dan Steele of the POE Group