Over the past twenty-five years, I have observed many reward or incentive plans for leadership teams. Some are complex, and others are overly-sophisticated. I shepherd a few that tilt toward the overly simplistic.
If there is one thing I’ve learned, it’s this–there is no perfect incentive or reward plan for a leadership team.
Because I’m frequently asked about the best way to structure a simple payout plan of profits, I will offer my simple architecture in the video below. I’m erring on the simple side because most firms rarely think holistically. To clarify, the bonus in the example below is only based on earnings, not cash flow or return on structural or intellectual capital. I’ll discuss that limitation at the end. Here’s what my two-step process looks like.
The Biggest Flaw In Most Incentive/Reward Plans
Show me a business with weak financial acumen, and I’ll show you a leadership incentive/reward program based solely on profits.
In my video example above, I chose to keep the payout architecture simple for demonstration purposes only. However, the ideal payout plan will also include a sharing of profits based on two important concepts:
- ROAM (return on assets managed). ROAM is especially useful in manufacturing, wholesale, and retail. ROAM was the first-ever payout structure I experienced in my W-2 career, and I rarely see it being used in small businesses (it goes back to my comment on a company’s weak financial acumen).
- Free Cash Flow. Occasionally, when a company embarks on a fast growth trajectory, incentive plans have to be suspended even if profits are growing. The company might be hemorrhaging cash because working capital is becoming more inefficient. Owners that overly focus on the P&L will only dig a deeper hole for themselves by ignoring free cash flow when planning an incentive plan twelve to thirteen months in advance.
In summary, you can adopt a simplified incentive/rewards plan for a leadership team that’s holistic. It goes without saying that you need to model the plan about twelve to thirteen months in advance to ensure the free cash flow is available to finance the plan.