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How To Structure Your Bonus Plan

Thursday, February 17th, 2011

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I am a huge believer in bonus plans and yet I see far too many small companies not offer bonus plans. Let’s do a quick Bonus Plan FAQ:

Why don’t they offer bonus plans?

I suspect it is because they worry that they will not have the money to pay out at the end of the year.

Why should you offer a bonus plan?

Bonus plans, structured properly, can be motivating. They can align an employee’s efforts with the company’s objectives and can help drive retention.

When I started at Advertising.com, few things excited me more than my boss telling me: “Last year we hit 173% of goal. We are at 143% right now.” When I looked at my target bonus and did the math, I got excited. Low base be damned, that was a big check. It is exciting to crush your goals.

How big a bonus do people need?

The real question here is how large does the bonus need to be to change behavior. I think a 25% bonus creates a huge change in behavior. A 10% bonus makes people happy: That is more than a month’s salary! A bonus smaller than 5% does not create big behavioral changes. A bonus smaller than 2% might as well be zero.

At one place I worked, I was told that the bonus could be between 10% and 45% based on achievement of company goals. Lofty claim, but as every employee there will tell you, despite this claim, the bonus every year was 10%. As my former boss at this employer said to me: For a claim like that to be credible, there has to be a year, somewhere, sometime, when they pay out the 45%. Employees know what is crazy and what is real.

How would you structure a bonus plan?

Glad you asked. Here is a simple approach: Conventional wisdom says that a bonus consists of two parts: Funding the pool, then splitting the pool.

Funding the pool means getting the money to pay out bonuses. If you are just getting started with your bonus plan, I think you do that something like this: You have a revenue target this year of X and a profit margin target of Y. For example, you have a consulting company and your goal for this year is to get to $1m in sales and $200k in profits. That is like consulting company financial model 101. So the salaries you pay out to the company are probably on the order of 1/3 of the revenue: $330k. So if you want to offer a 15% bonus to all of your employees, you need to set aside $50k. This means that monthly you have an “expense” of setting aside $4k for your bonus pool. (15% of monthly salary expense) Including that expense, you want to get to 1m in sales and 20% margin. So we have a starting point for funding the pool. Now, the pool gets smaller for failing to achieve goals and the pool gets bigger for over-achieving. Typically, people talk about having an “accelerator” for over-achieving on goals. Regardless, the model might look something like this.

At less than $800k in revenue or less than 15% margins (whatever some reasonable number is – a number that would be bad but not completely disaster), the bonus goes to zero. At $800k and 15% margins, the bonus pool is funded at 5%. You can then draw some lines from there that help you fund the pool with varying amounts between 5% and 15%. Similarly, you might say: If we exceed $1.2m in revenue with margins at 25% or greater, the pool becomes funded at 25%. If we exceed $1.5m, the pool gets funded at some greater amount (40%?) – we accelerated it. The point is that at some not completely insane number greater than goal, it grows much faster. There is probably a margin component here as well, but my point is that if revenue goes up but margin stays flat, that is still pretty amazing for a small company and the ownership can carve out a little more profit to give back to the employees – that is where the acceleration dollars frequently come from. Typically the idea is that at a certain point, ownership starts splitting incremental profit dollars with employees (maybe 50/50 at peak acceleration).

Pick a number that can be achieved. When CEOs at medium or large companies with boards and investors and things like that pick this number, they pick it like they will be fired if they don’t achieve it. If you pick overly ambitious goals as your target, you set up everyone for failure. Stretch goals are for the accelerator. Realistic goals are for the basic number.

So now you have a pool of dollars – maybe 10%, maybe 20% of total employee salaries. Employee reviews suddenly mean a lot! Somehow you do them, but the point is that your top 10% of employees should get 2x their target percentage. And the bottom 20% get nothing. And the rest get something approximating the target and you have some extra funny money to spread around.

When do you distribute bonuses?

Annual bonuses can be distributed whenever. A lot of companies also use this to drive retention in ways that aren’t fun for employees. Tools like: We do annual reviews 30 days after the period ends (February 1 for people on the calendar year) and then payout bonuses on April 1. So now people would be crazy to quit before April 1 – You leave a free month or more of salary on the table!

What else could I do?

Once you have this framework, you can do a lot of different things. Some consulting companies, rather than having an annual bonus, have a per project bonus based on profitability calculations associated with that specific job. Some people do this quarterly.

Many (virtually every) large companies have different target bonuses for different titles (more senior people have larger targets – 10% for the rank and file, 15% for VP, 20% for SVP, 25% for CEO, stuff like that). This just requires that you accrue money into the pool at slightly different rates for salary by title. If you are big enough to have this kind of striation, then it is probably not hard to do the math.

Finally, many larger companies with more mature plans segment out the corporate achievement from the personal achievement to varying degrees. This recognizes the oft-claimed “I can’t affect how well the company does” whine. So a junior person with a 10% bonus plan may have that bonus funded regardless of corporate achievement. The CEO only gets paid if the company achieves its goal (100% tied to corporate performance). The VP may be 50% personal achievement (funded regardless of corporate goals, tied to his achievement of MBOs) and 50% corporate goals. But remember there is no accelerator for these people – there is just divvying up the pool of cash created by the aggregation of people at their level.

But I can’t affect GOAL X!

You hear this a lot from junior people, but you shouldn’t let that bother you. We gave people utilization targets at previous employers and heard from junior people all the time, “But I can’t control my utilization”. That might sound true on face, but let me tell you this: Our best consultants never had a free moment, yet our most problematic consultants struggled to find people that would take them on. Somehow, performance was correlated with utilization in a highly constructive way. The more awesome your work output was and the more awesome you were to work with for both our teams and our clients, the busier you found yourself.

Secondly, we wanted people motivated to get busy. You should look for work. If you think you are about to run out of things to do, you need to start asking around. If we offer you work, but it is not as “awesome” as you were hoping it would be, we want you to think for a second before you tell us that it is not good enough for you.

Thirdly, if we are struggling to keep people busy, your utilization is probably going to be the least of your bonus worries in a second.

Why did you recommend tying everyone to corporate goals then?

I kicked off this post with the supposition that you didn’t have a bonus plan yet. If you don’t, and you want to introduce one, the most pressing problem is usually arranging to have the cash exist to support one. Tying it to corporate goals is the best way to ensure that achievement of bonuses only happens if there is cash in the bank to support it. If the goals are missed, then the company simply transfers the “bonus reserve” expense into the coffers of profit to make the year whole.

Similarly, I recommended an annual plan because an annual plan gives you time to save cash, makes you less sensitive to AR/AP issues, and is easy to administer. Many people will tell you that more frequent bonuses motivate people more because they are more tangible.

How can ownership game the system?

There are a lot of ways to get ahead in this system if you are ownership. First, you typically don’t pay a bonus to people that join in Q4 of that year – yet you are taking dollars out to fund plan. These dollars later drop to the bottom line. Furthermore, many people quit through the course of the year – those people were having dollars reserved for them the whole time, yet their bonus goes “poof” when they quit.

In large organizations, typically the CFO socks those dollars in a rainy day fund for resolving any conflicts that arise in the bonus process (“OK, I will increase the pool for your division 1% more to help you out”) or if you need some extra money for a hire outside of budget.

This also helps when you have varying bonus goals and you want to move the needle a little more for a guy that gets a big payout. Now you have a little slush fund to help goose his payout a bit without taking money from other people.

Finally, another key trick is that you pay out on people’s base salary paid out, not on their actual base. So if someone joined July 1 and makes $90k/year with a target of 10%, then their eligible bonus at plan is actually 10% of $45k – they only received $45k in pay that year. This actually makes a lot of sense because the business was only accruing bonus dollars for that person for half the year – 10% of the $45k was accrued.

What kills an ad network?

Tuesday, February 15th, 2011

Many people commented last week on the AdWeek article about Ad.com’s decline – an article that I foreshadowed with my magnum opus dissection of ad networks: Whither Ad Networks.

While I agree with the gist of the article (obviously, based on my previous writings) – Ad Networks are screwed by the advent of exchanges – I think there is a bit more to the story.

  • Advertising.com sales organization basically disappeared for quite some length of time under Tim/Jeff
  • Advertising.com technology execution was not great/distracted during this key period

One of the things that shocked me – absolutely shocked me – was Tim’s approach to Ad.com when he took over Aol. Rather than treating Ad.com as the jewel in Aol’s crown, he focused on the content side of the business.

Maybe, coming from Google, he was spoiled by the best ad inventory in the world (pages with search results) and wants to recreate that awesome inventory, knowing that advertisers will follow. But what he had at Advertising.com was probably the third biggest aggregation of advertisers buying inventory in a marketplace after Google and Yahoo!. One would have thought that he would value that highly and focus on how to get more advertisers participating in that marketplace. His approach to achieving this was to minimize the sales force’s role in bringing advertisers into the marketplace and bet heavily on self-service. Unfortunately, self-service grew, but not in a Googly way. Google’s self-service was the way that people could access the most valuable inventory on the Internet (search results). The result was an incredibly strong gravitational pull. Further, the self-service platform was not production ready when he started to downsize the Ad.com sales focus.

I suspect (and I have no knowledge of this from an insider perspective) that some of the consultants and advisers he brought in from Google and/or internal Aol people counseled him that Google + DoubleClick would run Ad.com over and crush that entire business. The result is he became less invested in the business, took the sales force and diverted them to selling premium content.

Did Ad.com execute poorly? Did the market change? Sure. But if you take 75% of the sales people and tell them to go sell Aol, that is bad, too.

Ad.com technology didn’t execute crisply either. They are in the midst of an ad server consolidation project now that will hopefully leave them with a more nimble, flexible architecture, but as a result of this and previous, similar projects, following the market with mediation technology, APIs for programmatic buyings, DMPs, and other technologies didn’t really happen. Ad.com ended up bidding into exchanges to expand their reach (just do simply low frequency bids on run of network-ish inventory, low-tech), but not becoming an exchange because that required more technology execution.

So while it is easy to say that a new technology era happened, Aol failed to respond to that change and that is why they are no longer successful, that overstates the effect outside factors had on the state of Ad.com today. I agree with the insider comments in the AdWeek article that internal miasma played a role as well. The decision to aggressively shrink the Ad.com sales force and underinvest in the Ad.com technology stack no doubt had huge impacts on the business.

Now, maybe Tim made the right decision – maybe executing on the tech would have not been successful regardless, so Google would have won, so this was the right thing to do. There is no way to know. My point is divorcing the external pressures from the internal changes is impossible, so no single factor pointed the way to the decline of the organization.

When you look around online advertising, Ad.com DNA is imprinted on many of the most successful companies out there. Sadly, when you look at Aol, there is precious little Ad.com DNA left and the DNA there is no longer given the tools to build that business.

What is the best first step for starting a new company?

Wednesday, February 9th, 2011

When I was a senior in college at the Wharton School of the University of Pennsylvania, already hard at work on my first start-up, I found myself standing next to the Dean of Wharton, Thomas Gerrity. Dean Gerrity was a pretty impressive guy. He was renowned for being the only Dean of a business school that had actually run a huge business. He had gotten a double undergrad from MIT, been a Rhodes Scholar, then gotten a PhD from MIT, but then he started the Index Group and grew that to be a billion dollar consulting company.

Yeah, he is a lot smarter than me.

So I told him that I had a consulting company and asked for his advice on starting a company and he said simply, “Have your first customer before you start”.

It doesn’t get simpler or truer than that. The first paying customer is always the hardest one. Now you have a reference-able client, you have revenue, you have success stories. That is half the business right there. Getting that first customer is similar in many ways to finding a co-founder. If you struggle to find a co-founder and can’t find someone that is interested in buying before you start the company, you might be barking up the wrong tree. These are all good gating criteria to tell you if you are ready to be an entrepreneur or if your idea is credible.

Living Social’s Amazon Deal Was A Huge Failure

Tuesday, January 25th, 2011

Living Social raised $175 million from Amazon at the tail-end of 2010 and we saw thist week the benefit that could reap: A 50% off Amazon gift card offer sold more than 1.3 million copies, netting hundreds of thousands of new customers to Living Social and raising the profile of this Groupon competitor higher than it has ever been.

If you Groupon, you probably shop Amazon. The conversion rate for this deal must have been sky high. It was tweeted a ton. I saw it all over Facebook. Awesome deal, everyone bought it.

Even I bought it – my first daily deal purchase ever. Now I was on Living Social’s list and the next day I received my next offer: 50% off a pizza somewhere in the Penn Quarter of DC.

FAIL.

FAIL, FAIL, FAIL, FAIL.

You just added hundreds of thousands of new emails to your database and your first communication with them is a weak follow-up offer.

Here were a few of the other offers the day after Amazon:

  • 15 weeks of kids dance classes
  • Bikram Yoga classes
  • A coupon to buy some mussels

They needed a big deal to follow it up. Something mass market that had broad appeal. Instead, probably half the subscribers immediately unsubscribed because this looked like a once in a lifetime deal.

A great deal drives retention, they just lost a lot of the benefit of adding new participants. Why treat this like strictly one-time PR? This could have turned into real long-term customers.

Or maybe those deals sound great to you.

Einstein Thinks Entrepreneurs Are Insane

Tuesday, January 4th, 2011

A budding entrepreneur sent me a few questions the other day and I wanted to blog one of my answers up for you:

How do you decide when to pull the plug in one way or another?

This is a hard decision as well, with no obvious answer. I always tell people that the most important part of being an entrepreneur is know when to pivot. Every business plan is a little (or a lot) wrong and what you are doing that first two or three years is trying to figure out what dimension of wrongness you did. The hard part is that even when you are doing it right, it is usually quite hard, so the key moment for an entrepreneur is:

“I have been banging my head against this wall for a long time. One of two things is true at this point, either I should keep banging my head and the wall will crumble soon, or I should do something different and hope things get better.”

Einstein once said, “insanity is doing the same thing over and over and expecting different results.” Entrepreneurs must be insane because every entrepreneur will tell you that there comes a time when you have to keep pushing. So there you go: Do you keep pushing or do you pivot? Is this moment one of those moments? Is is incredibly hard to tell. People tell you to push and they tell you to pivot, but recognizing which of those you are supposed to do at any given point in time is incredibly hard.

I won’t try to fool you and tell you that the great entrepreneurs know the difference. My impression is that it is mostly luck.

You never really know.