The Salary Sage

How to Cut Salaries Without Slashing Motivation

As the economy worsens, and the economic slump deepens and broadens, many of my clients are faced with difficult choices about how to survive. I am getting daily calls from executives searching for ways to trim costs. Many are turning to layoffs or salary cuts, or both. Tough times require tough measures, and I suspect things are going to get worse before they get better.

But survival requires more than merely trimming expenses. Sure getting costs under control is important, but after that is done, what then? Employees who remain on the job must continue to be motivated to perform at their best -- a difficult task when they are fearful, nervous and depressed.

What they need most is hope, optimism, and confidence. But it is precisely at times like these, when it is needed most, that motivation goes out the window. It is easy to motivate employees during good times, but how can we do it now? How can companies avoid the debilitating paralysis that besets employees who are fearful of losing their job or experiencing additional pay cuts? The malaise that sets in at times like these can make a bad situation much worse.

I believe the answer can be summarized in two words -- fairness and incentives. Allow me to explain.

FAIRNESS

When it comes to cutting salaries, the principal of fairness is paramount. I too often see employers playing favorites and cutting some individuals pay more than others. They cite a range of reasons and excuses, but at the end of the day these fall on deaf ears and are perceived by employees as little more than favoritism. When it is time to make cuts, I favor the percentage (not the flat dollar approach). The reason is consistent with (but opposite to) my recent argument for base salary increases (see A New Slant On An Old Type Of Pay Discrimination); Flat dollar decreases are a non-starter because they disadvantage lower-paid employees.

INCENTIVES

Incentives, because they are self-funding and tied to measurable outcomes, are a great way to replace lost earnings from salary cuts. The worst thing you can do when cutting salaries is offer no hope or specific time-frame for replacing lost earnings. Yet managers and business owners are loathe to make promises in shaky times such as these. So employees are left hanging and demoralized at precisely the time you need the most from them.

It is essential to offer employees better direction that just "work harder." During times like these, effective leaders understand the importance of clarifying for employees exactly what they need to do to contribute to the company's success. Incentives are perhaps management's best tool for creating this clarity. Without them, employees can be left wandering in a fog and waiting to be fired.

THE PERFECT PAY PLAN

Based on numerous recent meetings with business owners and executives, I am more convinced than ever that developing goals and implementing incentives will be key to surviving and thriving in these exceptional economic times. This is because goals will help focus executives and staff on critical business outcomes, and incentives will allow you to flex your costs and pay only when you get results.

In fact, I am strongly urging my clients to freeze base salaries this year (or even implement across-the-board salary cuts) to make their business more competitive. But the trick is to replace lost (or frozen) salaries with incentives so employees remain motivated to perform. Instead of seeing this down turn simply as an obstacle, I see it as a golden opportunity to do something that is nearly impossible to do in good times – namely, shift the mix of pay from fixed base salaries toward variable pay. Many companies have wanted to do this for a long time but resisted for various reasons. Now is the time to consider taking this action which will put your business on a more solid footing for future growth.

I believe the best approach would be for all employees to take a 10% to 15% pay cut. This would provide immediate cost relief to the business and is an amount large enough to make a difference and small enough to be survivable by employees. I would then structure incentive plans for every employee tied to company, team and individual outcomes that are measurable and related directly to the near-term and long-term financial success of the business. I would set the Threshold payout at 5% of salary, the Target at 10% and the Outstanding at 15%. In this way, employees could re-earn all the money they lost in salary cuts if both they and the Company have a successful year. I would make sure that goals were realistic and achievable given the current business outlook, and be certain that owners and shareholders benefit from the results as much or more than employees (which is accomplished through careful goal-setting).

This approach not only gives employees the opportunity to earn back an amount as large (or larger) that what has been taken away, but it has the added benefit of positioning the company very well for the recovery. Rather than build back to original salary levels, I would hold the line on salary increases and instead transfer more and more money into the variable pay (incentive) plan. In that way, your company we will be in good shape for the next recession which, as we all know, will appear not long after the current one fades away.

Goal Setting -- How Much Should You Stretch Your Employees?

All goals should involve a certain amount of stretch. How much stretch depends on many factors, but below are some helpful guidelines to follow when setting goals:

TARGETS

I like to set Targets so that incentive plan participants have a slightly better than 50/50 chance of hitting them. I may be a softy, but I prefer to look at it this way; Success breeds success. I would rather people develop confidence by achieving their Targets, than have them constantly falling short, getting demoralized, and giving up.

Yes, you may say, but aren’t you giving away money? No, because I always make sure that the company’s return on performance is substantially greater than that of the employee. That way, I can always be certain that the company is better off having the results than not having them. Yes, you might add, but what if the company would have gotten the results anyway? To this I would answer, you might get away with that for a while, but eventually employees are going to feel used and undervalued and either leave, or worse yet, their body will keep coming to work but they’ll leave their brain at home.

Set Targets so that employees have an approximately 60% chance of achieving them in any given year. In other words, when Targets are set properly, they will be met 3 out of every 5 years, or 3 out of 5 competent performers, given the same Target in the same year, should meet or exceed that Target. 60% (3:5)

THRESHOLDS

Thresholds are a different story. There should be a 1 in 5 chance they WON’T be met. This is important. Thresholds should never be set so low that they are virtually guaranteed. When that happens, the company very well might be making payments and getting nothing of value for them.

Therefore, I recommend setting Thresholds so that employees have an approximately 80% chance of achieving them in any given year. In other words, when Thresholds are set properly, they will be met 4 out of every 5 years, or 4 out of every 5 people given the same Threshold in the same year should meet or exceed that Threshold. 80% (4:5) If setting Thresholds this low concerns you, feel free to adjust payouts so that very little money is earned when Thresholds are achieved.

OUTSTANDING

As for Outstanding, that should be a real stretch. I like a 20% probability of achievement because it suggests that two years in 10 someone will meet or exceed them. Going beyond Outstanding can be a very good thing for both the employee and the company (provided the goals are set properly). This is the stuff myths are made of.

When someone goes beyond Outstanding, the word gets out, and if you play your cards right, everyone will imagine it happening to them. And good things happen when people dream!

Set the Outstanding level of achievement so that employees have a 20% chance of achieving it in any given year. In other words, when Outstanding is set properly, employees will meet or exceed this level only 1 year out of every 5, or 1 out of every 5 employees given the same Outstanding level in the same year should meet or exceed that level. 20% (1:5)

SYMMETRY & SPACING

Although most goals are symmetrical around the Target (i.e., the distance from Threshold to Target is the same as the distance from Target to Outstanding) this need not always be so. Goals can be asymmetrical if you wish. However, it is important to ensure that there is sufficient spacing between performance levels so that a small change in performance does not propel the employee from Threshold to Outstanding too rapidly.

MEASURE OF THE MONTH -- Company Valuation

 

This month, we are featuring Company Valuation. At the end of each year, perhaps your first and best measure of success is increasing the value of the business. Here are some guidelines on how to make Company Valuation a successful incentive plan measure.

DEFINITION

The economic value of an owner's interest in the business.

CALCULATION

In publicly traded businesses, the company value is easily calculated based on share price. However, in privately owned businesses a different approach is required. In such circumstances, calculating the value of  the business is approached from several different angles in order to arrive at a reliable figure. This includes:

1. Multiples of earnings
2. Discounted cash flow analysis
3. Book value
4. Sales price of comparable companies

Because there is often so much riding on the actual valuation, it is almost always essential to rely on accredited valuation professionals.

WHEN TO USE THIS MEASURE

Valuation is used to determine the price that a buyer might pay to purchase the business. In addition, valuation tools are often used to resolve ownership disputes and to estimate the value of a partner's ownership interest for buy/sell agreements and other business and legal purposes.

Increasing company valuation is a primary goal for most business owners. It is rarely used in incentive plans, however, because acquiring a formal valuation is a time consuming and expensive proposition. The one exception to this is ESOP companies. Companies owned by their employees under an ESOP are required by law to secure formal annual valuations by accredited valuation professionals. And since increasing the value of the business is fundamental to the success of an ESOP, company valuation is an ideal measure to include on all incentive plans in ESOP companies.

HOW TO USE THIS MEASURE

Incorporating company valuation into an incentive plan is simple -- you merely estimate the desired year-over-year increase and add it to the prior year's valuation to create the target for the new year.

WHO IS THIS MEASURE BEST FOR?

This measure is suitable for any employee in an ESOP company, but it should be weighted most highly for executives (i.e., 40 to 60%). It is also useful for lower-level employees, but since they have little influence over the final valuation, it should not be highly weighted (i.e., 10%).

CAN THIS MEASURE BE GAMED?

There is some potential for gaming this measure. Assuming you are dealing with an ethical and honest valuation professional, there are two likely possibilities. The first is that the company may have consciously or unconsciously withheld critical information that might effect the valuation. The second is that the owners of the business might do things which have an adverse impact on the valuation (such as taking out a loan, making major purchases, taking cash out of the business, etc.). It is important when setting valuation goals to take these things into consideration up front so they don't have an adverse (and unexpected) effect on employee incentive payouts.

New Alliance Strategy for Innovative Companies -- Success Sharing

Most of you are probably familiar with the term Profit Sharing, and a few may even have heard of Gain Sharing, but there is something new on the horizon you should know about -- Success Sharing.

Every year, the struggle to conduct business in the increasingly complex world of international commerce intensifies for companies in all industries. The labyrinth of confusing and often conflicting laws, regulations, tax schemes, coupled with an atmosphere of financial instability and political uncertainly have settled like a thick fog on American companies, making it hard to chart a clear course and increasing the risk of a nasty collision that might sink the business.

In response, more and more companies are getting back to basics, shedding business units that do not contribute directly to their core operations. They are focusing on what they do best, and forming alliances and partnerships with experts in other companies who can provide much needed support in specialty areas. The magnitude of these divestitures can be staggering. Exxon Mobil, for example, has been quietly selling off their worldwide refining capacity for years, getting back to what they term "upstream operations" which encompasses mainly exploration and production. This is a radical shift for a mega-corporation with a famous appetite to own and operate everything.

This alliance strategy presents its own special challenges. When you depend on another business to provide operation-critical products and services, the risk of failure is intensified by the inherent lack of control. How can you be sure your partner will deliver? How can you be sure where they are prioritizing your needs relative to those of their other partners? The answer lies in your ability to align your interests. This is where Success Sharing comes in.

Simply put, Success Sharing is a financial arrangement whereby the business that has been engaged to provide a mission-critical product or service shares the risk of failure (and the benefits of success) with the company that is purchasing these services. Unlike traditional fee-for-service arrangements, Success Sharing ensures that both partners have skin in the game. Here's how it works.

Step 1 -- The company engaged to provide the service (Company A) conducts a needs assessment of the company receiving the service (Company B). This assessment includes (amongst other things):

• Defining the desired outcomes
• Quantifying the magnitude of these outcomes
• Determining the future value of these outcomes
• Developing a detailed roadmap for achieving these outcomes

Step 2 -- Company A and Company B enter into a Success Sharing arrangement whereby Company A agrees to accept as compensation for their future involvement a portion of the value that they create for Company B. This might be all Company A receives for their involvement, or it might be part of a larger compensation program. For example, if Company A is able to prove that their efforts on behalf of Company B will result in Company B enjoying a $5 million improvement in some area of their business, they may agree to pay Company A 15% ($750,000) when/if that improvement occurs. If the improvement is smaller, so is the payout. But if Company A manages to exceed expectations, they will enjoy a larger return for their efforts.

Step 3 -- Both parties agree on milestones and measures that will determine when/if results are achieved. This may involve qualifiers and/or modifiers related to quality, timeliness, and other factors.

Step 4 -- Company A goes to work, supported as necessary by representatives from Company B.

While simple on the surface, Success Sharing arrangements can be complex to manage. Here are some issues to watch for:

• Company A must take great care to ensure that Company B is dedicating enough of their own resources to the partnership to guarantee success. Without proper support, Company A can easily find their success being unwittingly thwarted by Company B, the very company they set out to assist.
• Company B must assign a "champion" to the effort to clear the way within Company B for Company A to succeed.
• Both companies must understand and agree to this relationship from the beginning. I have seen it happen where Company A invests huge sums of money and time in developing a roadmap to success, then having the rug pulled out from under them by Company B who decides to go it alone.

Despite these obstacles, more and more innovative companies are entering into Success Sharing arrangements. The reason is that Success Sharing more completely aligns the interests of a service provider and a client company than any other arrangement. It spreads the risk and shares the return in a manner that is difficult to achieve by other means.