Six key principles for a value-driving compensation structure

Cogs cropped  2 - Six key principles

As owners or founders of consultancies, how we pay people through salaries and bonuses, as well as how we dilute our equity ownership, can have a dramatic effect on the results produced.

If we get it wrong by making compensation overly complicated, it could not only drive the wrong behaviours but could also be extremely difficult to unwind when the time comes to sell.

By structuring compensation in the right way, it’s possible to accelerate growth by having everyone pulling in the same direction. It will also help the business retain its best people and ultimately will make the company more attractive to acquirers because of the culture and drive within the business.

These are the six key principles to adopt to create the motivational engine that will help put the business into overdrive and create realizable equity value:

1. At the very top, the CEO, MD, or Managing Partner should be focussed entirely on shareholder value. Partnerships often use profit per partner but this is an inferior measure and reward structure, because profit growth does not always equate to equity value growth

2. At very senior levels there should also be an equity element to the compensation package linked to long-term equity value creation. Beyond founder shareholders or partners, who will have equity by default for starting the firm and investing ‘sweat equity’, best practice is to link the issuing of equity to the growth in overall equity value

As total equity value increases there should be a policy that shares the increase in equity value with those senior staff who help build it. These are likely to be those senior people who drive gross margin in their parts of the firm

3. Don’t fear dilution and operate share schemes intelligently to drive growth. 50% of $100m is worth a lot more than 100% of $10m! Aim to make 25% of equity value beyond the founder shares available to qualifying staff. However be selective as junior staff are often not motivated by share options

4. At director level, strike an equal balance between the annual gross margin achieved by individual divisions or operations and the overall company level earnings. This will reward personal effort and interests as well as collectively aligning everyone at the company level

5. Graduate the fixed and variable proportions of compensation to reflect the level of control over the outcomes achieved with the different tiers of responsibility. At the partner/director level it should be 50% fixed salary and 50% variable bonus based on performance. At junior levels it should be 80% fixed and 20% variable

6. The variable bonus should be linked to both overall company performance and individual personal performance. The most common way of achieving this is to set a policy, visible to all, which shares a percentage of company profits to all employees as an annual bonus

That ‘profit pool’ is split amongst employees based on a ‘value to the company’ factor. The variable percentage could be linked into personal performance for important measures like utilization, project margin, sector gross margin, or linked to a balanced scorecard of personal objectives. There are pros and cons of each method of linking to personal performance but the basic principle of starting with a profit pool and splitting that profit pool based on personal value to the firm is our recommended best practice

Adopting these principles, while tailoring them to fit your firm’s particular circumstances, will help get everyone working together towards achieving the right business goals. Furthermore, your future buyer will recognise the quality of the business culture, which will make you a more compelling acquisition for which it’s worth paying a premium price.

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