Designing the right incentives for your staff

Most technology start-ups employ some combination of base salary and performance pay to get the best out of their key executive, sales and operations staff. Performance pay may be based on indicators such as sales, the number of customers served, the number of units produced, lines of code written, overall company profits or other measurable indicators.
The basic principle of performance pay is:
Performance-based pay attempts to incentivize value-creating behaviour at a company but imposes a risk on its employees.

  1. Since there will always be factors outside the employees’ control that may influence performance indicators (the overall state of the economy, unforeseen changes in market conditions, and so on), any indicator is bound to be imperfect. Employees take on this risk when they agree to performance-based pay. A base salary must generally be used in combination with performance-based pay to compensate employees for these risks.
  2. When choosing the relative portion of performance-based pay to base salary, it is important to try to equate the added revenue that the company will receive from the increase in employee effort, with the cost of compensating them for the additional risk of a higher performance-based component in their monthly income.

Striking the right balance between performance pay and base compensation for each job area at your company can be determined with help from the following guiding questions:

  • Is the employee’s output sensitive to the level of effort they put into their job?
  • Is the employee less risk-averse?
    • Less risk-averse people tend to share some of the following characteristics: young, single, no young dependents, no large debts, adventurous personality, self-driven.
  • Does the employee have a high degree of control over the measured performance factors?
  • Is the employee amenable to hard work?

If the answer is yes to many of these questions, then performance-based pay may make sense as a powerful way to motivate your employees.

Additional Considerations

Objective vs. subjective performance indicators
Motivating the right behaviors is often difficult to accomplish using only objective performance measures like sales, units produced, or customers served. Sometimes it is necessary to incorporate subjective performance measures into the calculation of performance pay. Peer evaluations, customer satisfaction indices and quality assurance are good ways to balance objective performance measures and ensure that all the key value-creating behaviors are encouraged.
The teams problem
When people work in teams, it often happens that certain members do most of the work while the others coast. If team members are compensated individually from the fruits of overall team performance, the coasters will get the benefits without putting in the work. Adding a subjective measure of performance evaluation to performance pay for people who work in teams is an effective way to mitigate coasting. If team members are also evaluated based on their peers’ opinions of their work effort, they will generally perform better. The best performing teams are those that work together over long periods, are relatively small, are transparent, and are working toward some future payoff (ie. a successful product launch, project completion, important company revenue milestone, and so on).
A lot of thought should go into choosing the right indicators for performance pay. Important considerations include:

  • Noise: Is the indicator influenced by factors other than employee effort?
  • Comprehensiveness: Does the measure miss value-creating activities you’d like to encourage?
  • Adverse effects: Does the measure inadvertently encourage any value-destroying behaviors? (Examples might be internal competition, poor quality products, overly aggressive sales tactics, poor customer service)

Once you have a good sense of whether performance-based pay will motivate your employees to create additional value in particular job roles, you can set the performance and base salary components accordingly.


STRATEGY EXECUTION:  Designing the High-Performing Organization. INSEAD Professor Douglas H. Frank, January 2008.