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A bonus post on bonuses

For those of us running small businesses or bootstrapping a startup, the AIG bonus debacle (and the upcoming Citi bonus debacle — we’re heading into the debacle of the week financial news cycle) seems like something happening on another planet, some sort of bizarro-world, which I’ve decided to call Vikrampanditland, where failure is rewarded and bailouts are jackpots. The general response to the bass-ackwards logic of these bonuses seems to be to lose all sense of proportion, as Congress goes the Mad Hatter route of confiscating all bonuses from financial instutions good and bad who have accepted TARP money.

But the bonus debacle is a rich source of takeaways for anyone serious about their business.

Perhaps the most galling aspect of the AIG (and upcoming Citi) bonuses is that a pretty heft chunk of them are going to people who rammed the boat into the iceberg. Now, some of these folks genuinely deserved bonuses. Sure, the Financial Products division for all practical purposes bankrupted AIG. When you read that Gerry Pasciucco, the head of that division, received millions of dollars in bonus money, it makes your blood boil. But Pasciucco was hired in November to wind down the Financial Products division and sell off the assets that are sinking the company. He has, in fact, managed to liquidate about 25% of those assets — a stellar performance in this market. He not only didn’t create the problem at AIG, he’s a major part of the solution and, yeah, he deserves a bonus. A big one. He’s doing a good job, Che Guevara t-shirt and everything.

The problem, though, is that most of these bonuses went to the folks whose activities sunk the boat. And a whopping 11 “retention” bonuses of over $1 million went to folks who have since left the company. What the financial crisis is proving beyond a doubt is that “performance” and “retention” incentives throughout corporate America have lost all touch with the baseline reality of running a business.

Everything you read about bonuses at the highest levels are contracts, in much the same way bonuses are structured even down to the smallest business. Like all contracts, they are designed to align the interests of both parties to the contract. You see, when a business owner brings on an employee, their interests don’t necessarily line up. An employee, as most of us know, is perfectly happy to collect a paycheck and do nothing. You, as a business owner, however, have a vested interest in performing to the utmost of your abilities. But your employees do not. So you put a performance regimen in place that is both punitive (your discipline system) and motivational (your company culture and bonus system).

Now there’s no doubt that bonus regimens produce the highest performance from employees. I have consulted with dozens of businesses in which at some point I’ve laid it on the line about instituting a bonus system because of employee underperformance. In nearly every case, the business owner or manager has told me why this isn’t possible, and their business continues to stagnate. In a minority of cases, I’ve worked out with the owners a very comprehensive rewards structure that is tied intimately to the baseline long-term health of the business and this has, in the end, significantly raised performance levels and produced long-term success.

But as the folks at AIG and Citi know, a rewards structure has no meaning if its unpredictable. I worked for two very wonderful gentlemen in an ad firm for several years who rewarded productivity with bonuses. They were often generous, but they were unpredictable. As a result, our firm suffered from employee underperformance at truly Belacqua proportions.

So the best way to structure a performance regimen is through clearly defining what rewardable performance is and what precisely the rewards are. In the case of employees with significant responsibility relative to the profitability of the business, then the only form these structured performance rewards can take are individual contracts.

But that’s where folks like you — and AIG and Citi — fall into trouble. Contracts are narrow instruments. For instance, Bear Stearns sunk its own boat by structuring its bonuses for senior management primarily on return on equity metrics. Now, the owners and governors of Bear Stearns have as their central interest the long-term growth and profitability of Bear Stearns. They write contracts with their senior managers that are supposed to align those managers’ interests with the owners’ interest. But instead, they strongly motivated Bear Stearns managers to leverage up as much as possible and to derive as much income as possible on “asset-free” investments, such as derivatives. A high amount of leverage and derivative investments meant the highest return on equity. It also created an unacceptable level of risk. So the Bear Stearns bonus structure, designed to maximize returns for the owners, put the entire shebang at risk. And, of course, Bear Stearns was the first investment bank to go belly-up.

The same thing happened at AIG with their financial products division. Employees were rewarded for writing derivatives and other contracts, but they weren’t being rewarded for keeping the company safe from unnecessary risk.

So, when you take on employees, you have plenty to learn from the AIG-Citi debacles.

1) Like Citi and AIG, you should institute a performance regimen that includes bonusing employees for high performance. That performance regimen should take the form of a contract, not a promise.
2) Performance has to be measurable, bu it also has to be linked with the long-term growth and profitability of the business. If a salesperson is drumming up a lot of business for you, but she or he is drumming up one-offs or short-term clients, that should affect compensation. Because a loyal or repeat customer is “cheaper” than a first-time customer, salespeople should get their biggest rewards for bringing in long-term, profitable, loyal customers, not just “customers.” The key is to reward employees not just for their job performance, but their contribution to the health and growth of the business.
3) You as the business owner have a long-term financial interest in the value of your company’s name and brand, so compensation has to be tied to furthering the value of that brand. I used to take my car to a Subaru dealer for repairs; every time I got my car back, something that had been working just great when I took the car in (like the air conditioning) would be broken when I got it back. This happened four times when the final straw happened the fifth time (they repaired the air conditioning hoses and, while they were test driving the car, the air converter “gave up the ghost”), I said no more and junked my Subaru, a brand I avoid like the plague. Why? Because I’ve never driven a car which “breaks” every time I fix something at the dealer. Now, the repair folks at the Subaru dealership made a pretty good pile of money (for which they were bonused), but both the dealer and Subaru lost a loyal customer and injected a bit of bad word-of-mouth into the mix. Now, auto repair fraud is on the rise among car dealers and more stories like this are going to be common. It is in the best interest of the dealers to structure compensation that preserves the good name of the dealer.
4) All good compensation structures are long-term and include clawbacks. You have a vested interest in keeping high-performing employees for as long as possible and aligning their interests with your long-term interests. For that reason, I’m a big believer in cumulative bonus structures, that is, bonuses that reflect the cumulative effects of an employees performance. For instance, if a salesperson brings in a loyal and profitable customer, I’m a big believer in rewarding that salesperson each and every time that loyal customer throws money at the business. That also means that “retention” bonuses should be tied to, well, retention. If an employee quits, is fired, or underperforms within a particular time period after the bonus, it should be clawed back. The best retention bonuses, of course, pay out over the entire time period you wish to retain the employee. And they’re usually called raises.

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