I heard the most remarkable thing the other day from none other than the brilliant Alan Greenspan. When questioned about his feelings about the current financial crisis, he said (I’m paraphrasing a little here) that he believed that self-interest in protecting shareholders would keep corporate executives from taking unnecessary risk.

First, with the increased deregulation, encouraged by Mr. Greenspan himself, there was less exposure to risk.

Second, and more importantly, executives of public companies generally are not incented on long-term corporate health. Instead, the focus is on short-term corporate gains. Shareholders are different from investors. Investors take a stake in a company with, generally, an eye toward the long-term. Venture capitalists are excused from this consideration, as their main function is to get companies in a position to sell. Shareholders, on the other hand, buy shares hoping for them to perform a certain way before selling them again for a profit.

Thus, executives are compensated by their ability to maximize that value. That is what drives their self-interest.

If you want to mitigate your risk as a shareholder, create a compensation plan for the executives that adequately reflects that desire. But that will only work if you are more concerned with the long-term health of the company and not the quarterly profits. That means sacrificing a little now to build something for later.

As we have learned from the current crisis, there simply aren’t many willing to do that.

Compensate for the Right Goals

Last week, there was a story on the news about a guy in Tucson who followed a speed camera van around and held a sign warning drivers the van was there. He reasoning was that there was insufficient notification to drivers that the van was there to catch them speeding. The van is a contract role for the police department, paid, most likely, per ticket issued or collected.

That is the problem.

Follow me on this. The ultimate goal should be speed abatement. In other words, the desired outcome needs to be a reduction in the number of people who speed in a given area. Compensating based on catching people doing something wrong, is going to drive the company to catch as many people as possible doing that thing wrong.

Turn it around and compensate the company for a reduction in speeding, then you will find far fewer people speeding. But doing it that way is much harder. First, you may have the wrong company/employee. Second, you may be taking the wrong approach to reach the desired outcome. Either way, it won’t be the simple way to devise the compensation. That is a guarantee.

When designing a variable compensation system (salary plus bonus, for example) be sure to understand what your desired ultimate outcome is, as well as, and this is critical, what it will take to achieve that outcome is the most desirable manner.

For instance, let’s say you have a sales goal in place. You could compensate based on the employee reaching a certain number. Then their objective is simply hitting that number, doing whatever it takes. On the other hand, you can identify the key steps in the sales process that best match your brand promise and compensate based on the employee successfully achieving those steps, along with the desired overall results. If they do all the steps as they should, and the results don’t follow, you need to change the steps, not the desired outcome. Fix the steps, then start it up again.

In the end, you are going to get what you pay for. Just make sure you’re paying for the right thing.

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