Compensation is difficult. Even more than that, it is sensitive, business critical, and often has almost nothing to do with the rest of your job as a leader. Here are some rules for making compensation decisions effectively and efficiently.
The Goal of Compensation is to Create the Most Talented, Enthusiastic Team That Your Budget Allows
It might seem obvious… but your foremost goal when running a compensation cycle is to maximize the talent and enthusiasm of your team. Full stop.
- Your goal is not to make people happy
- Your goal is not to retain your team at any cost (although retention is part of the equation)
- Your goal is not to get a “deal” on what you’re paying employees
- Your goal is not to match the market
- Your goal is not to match what <other company> is paying
- Your goal is not to match employee expectations
- Your goal is not to pay equally (although part of your goal is to establish fairness)
Creating a talented team means that you can get great people to accept your hiring offers. Creating an enthusiastic team means that these great people are motivated to work for you, engaged in their work, and (in the upside case), will work much harder than otherwise due to their compensation structure. And you need to fit this into a budget that allows your business to function.
You Can’t Buy Happiness
If you spend enough time as a manager, you start to realize that:
- You can never make someone happy with compensation alone. People who dislike working on your team will quit even if they’re paid well above market
- There is no amount you can pay that will permanently increase job satisfaction; eventually everyone’s expectations will adjust
- But there is an amount you can pay where compensation alone will cause 0 marginal unhappiness on your team
To hit that final metric, you roughly want to target paying at least the amount where team members can’t easily find another job that will pay them more. (And on top of that, of course you need to try to make your work environment as otherwise appealing as possible)
The intuition here is that many jobs basically kind of suck, so if you don’t mind your current job, switching jobs is risky – and most people know that. What you want in your team’s head is some version of “perhaps I could theoretically get paid more elsewhere, but it would probably take a lot of effort and maybe the new job would suck in other ways.” This will retain most otherwise happy employees, which is ultimately what you deserve and the best you can hope for in any case.
Of course, this is easier said than done! You need to track the market, both via surveys and seeing what new candidate offers are accepted / heavily negotiated / rejected. You need to watch for attrition on your team, observing where departing folks go and why. And when you get new signal you need to react – don’t allow your compensation to get out of line with your target market percentile. But all of that is tractable as long as you put in the work.
Unfairness Creates Unhappiness
But while you can’t make an unhappy team member happy with compensation alone, the converse is not true: how you compensate can absolutely make an otherwise happy team member unhappy.
What makes people absolutely furious about compensation is finding out that they’re paid the same, or less, than someone they think is less deserving. There are some people who will literally quit a company on the same day if this happens.
The best way to prevent a sense of injustice is simply to have clear compensation bands, and essentially never allow employees’ compensation to drift outside of them. Compensation bands are excellent at preventing some of the most common sources of unfairness – managers using their discretion to play favorites, and new hires making more than existing team members at the same or higher seniority (salary compression). The latter occurs regularly when market compensation shifts, hiring managers are captivated by a shiny new hire, and they allow their team to fall behind the market. Rigorous compensation bands prevent this from occurring (if you move your bands to accommodate a new hire, you need to move your existing team’s comp as well).
The most common cause of unjust compensation is simply laziness. Keeping track of everyone’s compensation to prevent unfairness or setting up a system that enforces standards takes effort, and many teams fail to do it. This is a huge mistake, as perceptions of unjust compensation are one of the ugliest and most acute sources of employee dissatisfaction. Additionally…
People Talk
Many people talk about their compensation with others. As a result, you should be willing to explain exactly why any team member’s compensation is set where it is, in front of the whole company. You won’t have to do this often, but it’s the standard to hold yourself to. The reasons that comp is uneven between employees can actually even be random or somewhat weak, but there needs to be some justification. Some common, defensible examples:
- “Alex makes more than you because they’re a distributed systems engineer and you’re a marketing associate”
- “Alex makes more than you because they’re higher in the compensation band; you were just promoted and they already have industry experience at this level”
- “Alex makes more than you because you were just hired and they have built trust over many years on the team”
- “We granted Alex their stock when our company valuation was low, so they’re making 2x market because they’re lucky”
- “Alex makes more than you because they’re better at their job”
Some of these reasons aren’t necessarily emotionally satisfying, but they’re all completely intelligible without any whiff of injustice. And injustice is the critical factor that drives people crazy.
Maximizing Upside
Since the goal of compensation is creating an enthusiastic team, there are additional ways that you need to think about pay in order to maximize return on your dollars.
The most immediate levers are performance-based compensation such as bonuses and sales commissions. The main heuristic to keep in mind for any performance-based comp is that:
- The further an action is from concrete compensation, the less it will motivate any change in behavior. Contrast the motivational impact of “Here’s a big bonus because you did a great job over the entirety of the last year” vs. “Here’s $25,000 because you closed that large enterprise contract.”
- Any action that is directly compensated will lead people to heavily optimize their behavior towards it. For example, the salesperson telling white lies to a customer in order to close a deal.
But equity is a much more powerful lever – specifically, a lot of equity.
If someone has 10% of their annual compensation in company equity, they will act like an “owner” the way that you act like an owner of your rental car. They’ll take care of things, generally be responsible, and won’t badmouth your company (much).
But if someone feels like their equity will change their life, most will act like a completely different kind of owner. They’ll start to treat your company like their child – they’ll stay up all night caring for it if there are issues, they’ll think about its well-being all the time. For your top performers it’s really worth getting them to that point via equity compensation if you can. If you want a quick heuristic, the most common amount of money that most people consider to be life-changing is roughly the price of a good-condition 3 bedroom home in their nearest metro area.
Takeaways
In summary:
- The goal of compensation is to create the most talented, enthusiastic team that your budget allows
- Minimally, aim to pay your most valuable team members at a level that it would be difficult for them to match in the market
- Don’t allow there to be injustice in your compensation system, and use compensation bands to enforce fairness
- You should be willing to explain any compensation decision on your team
- Maximize the value that you get from compensation via equity and well-crafted performance-based compensation