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Article | Executive Pay Matters

Incentive compensation in a founder-run organization

Governance Advisory Services |Executive Compensation

By Don Delves and Scott Hippen | January 6, 2020

Nonpublic, closely held companies are unique, and their special needs should be reflected in their compensation systems, as we learned in a recent case study, Wattage 360°.

The design of effective compensation systems in nonpublic, closely held companies requires a deep understanding of the business, with each aspect of operations defined by the owners. As discussed in chapter 6, we considered the case of Three Pillars Corp., a fictitious company that had appointed its first nonfamily CEO and tasked him with revitalizing the company’s core business lines post-recession.

Three Pillars’ stated purpose reflected a conflict between the family’s desire for greater returns to realize its lifestyle- and community-related objectives while simultaneously reinvesting significantly in core brands.

While the case study reflects a compilation of actual companies and situations, it does not represent the full spectrum of issues in nonpublic companies. The variety of privately held companies and their nuances make it worthwhile to consider another example, the case of Wattage 360°, Inc., a $3 billion-dollar alternative energy business that develops and operates large-scale, electricity-generation projects using wind, solar and gas-turbine technologies.

A founder-run organization, Wattage is known for hiring smart, dynamic people who are passionate about their jobs and highly pragmatic in their approach to developing cutting-edge solutions. Though the right team is in place, the leadership team has faced challenges related to its incentive structure. The issues at hand included:

  • Managers were employed with the understanding that the company would be sold in five to seven years, allowing them to cash out. However, by 2015, Wattage 360°, Inc. had been in operation for 10 years and showed no signs of a near-term exit.
  • Incentives were based on a combination of profits and a “founder happiness factor”: a completely discretionary compensation plan with a narrow range of rewards. The incentives didn’t align and engage the management team — or hold it accountable. The incentive plan pleased the founder but failed to motivate the team or show a clear path for them to earn greater rewards.

Consequently, the founder’s goals were unrealized, and he was frustrated by the team’s lack of direction and motivation. Eventually, the founder came to realize the shortcomings of an incentive program that pleased him but no one else on the team, and the company developed and implemented an annual incentive plan with clear goals, well-specified ranges of performance and payouts, and better communication of all components.

In the longer term, the company planned to develop a long-term incentive plan tied to both financial performance and enterprise value in an effort to enhance alignment, engagement and accountability, and also support its purpose of sustaining its reputation as a high-impact alternative energy provider. Though both Three Pillars and Wattage 360° are closely held, privately owned companies, the overarching and guiding principles needed for Wattage 360°, Inc.’s incentive plan were different.

First, Wattage 360°, Inc. lacked both a clear definition of enterprise value and an understanding of how the company’s activities increased that value. There was a tenuous connection between employees’ activities, their pay, and their contribution to sustainable enterprise value. As such, it was critical that the compensation plan reinforce the responsible creation of sustainable long-term value and a clear understanding of the activities the organization was undertaking (and would need to undertake in the future) to generate this value.

Also, the company’s existing incentive plan had little connection to market pay practices. That said, market rates were paid to recruit and retain high performers. Current compensation practices needed to be built into the system, including target annual incentives that accurately reflected levels of responsibility and authority — not to mention a range of potential incentives that reflected differentiation in individual performance.

Transparency was another guiding principle the company needed to incorporate. As evidenced, Wattage 360°, Inc.’s original rewards strategies were not cohesive, well-articulated or understood—common among young, high-growth companies. The compensation plan had shifted opportunistically based on short-term hiring needs and growth rather than evolving as part of a systematic plan.

To adjust for the lack of systems and structures and the lack of knowledge and understanding of its core components beyond a small group of top executives, management thoroughly communicated the new plan to employees via a company-wide rollout meeting, distribution of materials describing how the plan works, individual meetings and regular communication on company performance relative to plan goals.

To improve its target setting, Wattage 360°, Inc. selected three key performance measures, down from 15, that employees could focus on and understand. Management also engaged in rigorous target-setting to help set goals and target levels that were reasonably achievable for most employees in most years. Additionally, the new compensation system stretched out performance and payout curves so that performance would be rewarded over a broader time horizon. This created more meaningful upside and downside within the incentive program.

Circuit breakers—a minimum performance level required for payout— were introduced within the system for senior executives, ensuring that poor performance was not rewarded. This was particularly important to the founder because control was maintained over rewards while accountability and engagement were promoted.

As mentioned, Wattage 360°, Inc.’s original plan had been almost entirely discretionary — something that’s common in early-stage, high-growth companies. It was critical to develop a mechanism that applied discretion more clearly and determined bonuses using an objectives-based formula. However, the CEO and senior team also could apply a discretionary adjustment to allow senior leadership to maintain overall control of the framework and adjust rewards up and down.

The case of Wattage 360°, Inc., showed the importance of understanding when an organization embraces a purpose that includes nonfinancial objectives. A key part of the company’s success has been its focus on the environment, going beyond the broader physical world to also include the environment and culture of the business itself. This influenced the development of the right incentive systems. 

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