The Operator’s Blog

As the end of the year draws closer, I‘ve had a number of discussions with clients, and fellow executives and entrepreneurs about year-end performance bonuses. The conversations, for the most part, revolved around the formulas used to calculate the amount, or the benchmarks used to determine the actual performance achieved.  Having been on both sides of the equation multiple times – the recipient of the bonus as well as the determinant of the amount – these “mechanics” conversations are relatively simple and straight forward to have.  What never ceases to amaze me, however, is how often there is relatively little thought invested into understanding what long term behavior the year-end bonus plan encourages, or how the thinking in the design does not extend beyond the current bonus-plan year.  I think that short-sightedness is a failure of executive teams in understanding human nature.  After all, as Upton Sinclair once proclaimed, “It is difficult to get a man to understand something, when his salary depends upon his not understanding it” let alone get the man, or woman, to do something about it that would impact it negatively in such an obvious time frame; twelve months.

Over the years I have seen one-too-many times executives make decisions totally against the long-term interest of their firm, their shareholders, their employees, or their customers, and sometimes downright unethical, just to reach some poorly designed short term objective that impacted their individual year-end bonus.  The sad part, had some forethought been applied to the establishment of the plan by the executive team – instead of assigning the task to some poor HR analyst and hoping he gets it right even though in many cases he doesn’t understand the business – many of the problems could have been averted.

The story below is a cautionary tale and a classic example of what happens when the year-end bonus is not well thought out.  Any language in “brackets” is from company records or interviews and, as usual, comments are welcomed either on the website, or via e-mail.

The new year-end bonus plan for this particular company (not an Ideasphere client at the time) was developed by HR and launched with great fanfare.  Everyone who was on the bonus program took it apart and quickly realized that it assigned almost 90% of the formula to achieving revenue growth.  Both the CEO and the CFO, even though familiar with the Balanced Scorecard framework, signed off on this un-even weighting approach for a “good reason.”  The company planned to file for an IPO within the next couple of years and revenue growth velocity was a critical component of the eventual valuation by the underwriters.  Since the CFO and CEO had a significant equity position in the company, a high valuation was their “retirement ticket”, as one of them put it in an interview.  So starting at the top, the incentives were not tied to profitability, long term customer satisfaction, production quality, or any other associated performance metric.

Even to someone not as sophisticated as these two executives, it was obvious the Ying of Revenue was not harmonized with the Yang of Profitability, and the whole plan could backfire; but that too was rationalized because, after all, this was only a two year approach until the IPO.  After the IPO, the company would have the right environment to “do it right and restore a Balanced Scorecard approach.”  To further “secure alignment up and down the chain,” the plan weighting was applied universally to all managers across the company, regardless if they were in sales or in operations.

Things went great the first year, revenue grew exponentially and year-end bonuses were the highest they have ever been.  It looked like the plan was working as expected, so it was simply re-deployed for the second year without any changes.  Unfortunately, by the time the end of the second year rolled around, the IPO market dried up and, along with it, the potential of a public offering.  Also unfortunate was the fact that because of the focus on the IPO nobody spent any time reviewing the bonus plan, so HR, to meet their deadline of publishing the plan by January 1st,  released it unchanged for the third year.  By the middle of third year profitability had dropped to unsustainable levels, and customer satisfaction, after an initial spike up, went down through the floor into the bowels of hell.  By the end of the third year, finding themselves in a negative cash flow position, the company had to be put up for sale at a “fire-sale price,” as the CFO put it.

So what happened?  During a due diligence performed on the company by yours truly on the behalf of a potential buyer, it became clear that the year-end bonus plan the CEO and CFO hatched a few years prior was the major culprit in the company’s demise.  Because the plan was almost exclusively based on revenue growth:

  • Sales teams focused on selling any deal they could, at any price, to meet the revenue objectives, frequently undercutting, even their lower-priced, competitors by 15-25%.
  • Sales managers frequently approved ridiculously low-priced deals that would normally be rejected, by classifying them as “loss leader deals” justifying the frequent exceptions on imaginary “expected pull-through incremental revenue” from the client.
  • Operating managers, whose bonus was also based on a similarly structured plan, and who were supposed to “pull the cord on potentially unprofitable deals” during the operational risk review process, also ignored the low pricing and approved the deals based on “expected cost savings from operational optimization and economies of scale after on-boarding”.  This basically meant laying off the more senior, and higher paid, customer support folks and the off-shoring of work to the lowest bidder.  To compound the problem,
  • Market Executives, who owned the revenue levels after the deal was sold, approved the deployment of numerous dedicated customer support teams for large clients who threatened to switch because of the bad service, which drove the cost up and wiped out any savings from the layoffs and the off-shoring.

There are a few more details to the story that also contributed to the demise of the company, but if one was to point to the turning-point event that started the death spiral, the launch of the year-end bonus plan is the clear winner.

So, as much as I believe in providing performance-based incentive compensation to as many people in the company, I also believe the year-end bonus plan must be carefully considered and designed with more than twelve months of performance in mind.