In this environment, innovation is critical; companies can benefit from linking innovation to pay and wealth creation through effective incentive programs. While this article focuses primarily on the high-tech sector, the following observations can easily be applied to other industries with an innovation focus.
Long-term performance plans have been steadily growing in prevalence in the high-tech industry, mirroring the trend in general industry. While there are many similarities between high-tech and general industry performance plan design, the tech industry has a particular challenge in selecting goals that emphasize the right balance of innovative thinking and financial success. Innovation goals can encompass not only new products or services, but also improvements in business models, strategy or processes. Traditional long-term performance plan metrics tend to reward end-result profitability or total shareholder return (TSR). However, intermediate goals that encourage exploration and entrepreneurial behavior can be just as important as financial and market measures for aligning executives with successful business strategies.
Why Rewarding Innovation Makes Sense
Recent studies by University of California, Los Angeles Professor Florian Ederer, Ph.D., and University of California, Berkeley Professor Gustavo Manso, Ph.D., show that incentive programs that tolerate early failure and reward long-term success can lead to more innovation and better performance than fixed-wage or standard profit-sharing pay programs. Although some commentators, such as Daniel Pink in his much-publicized 2009 TED talk on the puzzle of innovation, claim that incentive pay models fail to promote creative thinking, this more recent research tailored to business-management decisions finds evidence that well-designed incentives do, in fact, correlate with more innovative performance in the long run.
How to Reward Innovation
For pay-for-performance programs to truly foster innovative thinking, they must tolerate (or at least not unduly penalize) early failure. The time invested in exploration and experimentation early on often leads to better and more complete information, which guides decisions on long-term strategy and success. If rewards are focused on long-term financial and operational success (with tolerance for short-term failures), executives have strong incentives to learn from dead ends and create better ways of improving a business strategy. They also will have the flexibility to take a certain amount of necessary risk in trying out new ideas.
The timeframe for measuring long-term success will vary by company depending on the market and product or service offerings. For example, small Internet startups need to develop and roll out new technologies very quickly, while new hardware products may take three to four years (or more). In developing an effective performance-based pay program for executives and employees, each company must examine its own innovation goals and timeframe. Incentives need to be built on a realistic timeline to measure long-term financial success while allowing an opportunity for near-term exploration that fosters creativity and balanced risk-taking.
High-tech companies in particular will want to focus incentive goals on a mix of short- and long-term innovation efforts, such as research and development (R&D) milestones or new product pipelines, rather than just short-term financial outcomes. For example, businesses in the startup phase or at the beginning of a major turnaround might use long-term incentive (LTI) plans with multiyear performance periods that involve shifting incentive goals throughout the performance period. In these hybrid programs, the first year or two can build wealth based on innovation efforts while the latter half of the performance period rewards financial success.
Performance Metrics and Goals
Ideally, high-tech performance plans should balance both R&D activity and external financial outcomes (especially to achieve a meaningful return on investment). Executives should be encouraged to develop a consistent pipeline of new innovation efforts and rewarded for bringing successful R&D efforts to market. Short-term incentive metrics can focus on evidence of innovation-related activities, such as the annual level of investment in R&D, value of intellectual property (e.g., new patents submitted or granted), achievement of key development milestones or enhancements to the product portfolio mix.
From an operational standpoint, metrics can also encourage a consistent stream of new products to market by setting goals that ensure an efficient pipeline of products in each development phase; measure speed to market; and/or reward new product success and survival rates. Likewise, the counterbalance of long-term goals pegged to the end of the performance cycle can link innovation goals to overall financial and strategic growth goals for the company.
A Balanced Portfolio
Rewarding innovation is not just about performance plans and goal-setting. More traditional long-term incentives, such as time-based restricted stock and stock options, can also play an important role in retaining and engaging key talent on the path to the innovation. As long-term performance plans continue to grow in prevalence, high-tech companies need to take a closer look at developing an effective incentive pay portfolio that balances metric-based rewards with more predictable payout vehicles, such as time-vested equity, that still deliver value based on long-term company performance. Performance plans in combination with equity awards offer a balanced approach for encouraging risk-taking in developing new ideas and rewarding executives for successful new products, while also affording some protection for the inevitable short-term failures during the experimentation stages.
The Bottom Line
The high-tech industry is already well-versed in using equity awards to attract and retain top talent. As performance plans continue to grow in importance, technology companies should select plan metrics that go beyond end-result financial success and create a customized approach that truly emphasizes the level of creativity and experimentation required to execute on the company's business strategy. By taking a multifaceted approach to LTIs that combines time-vested and performance-vested awards, along with a mix of innovation-focused and financial goals, executives are encouraged to make resource allocation decisions that sustain innovation capacity for the long term and remain nimble and competitive in fast-moving markets.
About the Author
Carl Schmitt is a senior executive compensation consultant in Towers Watson's Los Angeles office. He can be reached at firstname.lastname@example.org.
Katherine Edwards is an executive compensation consultant in Towers Watson's San Francisco office. She can be reached at email@example.com.
Read the August edition of Compensation Focus.
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