More Effective Financial Incentives

Over the weekend I had a long discussion with a friend about Occupy Wall Street and what is wrong with our corporations. A few themes emerged that may actually be interesting for R&D management as well. It has been shown that executive remuneration has grown much faster than average worker. It is also felt that the pay is disproportionately large.

A key problem with driving executive performance is the inability to tie pay to performance. Decisions made by executives have impact months (if not years) later. So, rewards based on current stock price do little to guide executive performance. Traditional approach has been to provide stock options that vest over a long period. However, stock options have shown to be ineffective in driving performance. This is mainly because the vesting of options does not have a direct relationship to the decisions made by the manager. Stock price in the future will depend on performance across multiple products. Furthermore, options will vest either with time, no matter what happens in the future.

So, here is a proposal: Why not tie rewards to performance based on actual performance of new products developed by a set of executives? R&D executives are responsible for deciding which products to develop and how. The primary and largest reward could be a fraction of the profits generated by these products when they actually reach the market (True Profit Sharing). Most organizations develop (and maintain) a business case for pursing any new product. Hence the executive reward can be built directly into that business case. Boards of directors can monitor performance using the same business case. This approach ties rewards to actual decisions executives make on new product development.

One concern of this approach might be that True Profit Sharing will generate bonuses over a long time frame. Executives are also responsible for managing R&D execution, operations and guiding sales. So, We need other bonuses that encourage performance for near and mid-term. To do that, we can tie a part of bonuses to operational effectiveness:

Health of R&D pipeline (various metrics can be used) generates annual rewards (bonuses)
Cost and schedule performance of each new product generates near-term rewards
Third party reviews and market reaction when the product is introduced contributes to mid-term rewards

We can construct similar approaches for marketing, sales, manufacturing etc. This model has the advantage that each decision has direct consequences to rewards. Just a thought…

A wake-up call for Big Pharma

Another interesting article in the McKinsey Quarterly “A wake-up call for Big Pharma” describes how big pharmaceutical companies are becoming less innovative. We had discussed the same trend in the past (Big Pharma’s Stalled R&D Machine). This chart from the article has great data about declining contribution of new products to the bottom line:

Some more evidence of this lack of innovation is in the Booze’s Global Innovation 1,000 list which does not rank pharma companies as very innovative. The article further suggests that some fundamental changes are necessary:

The good old days of the pharmaceutical industry are gone forever. Even an improved global economic climate is unlikely to halt efforts by the developed world’s governments to contain spending on drugs. Emerging markets will follow their lead and pursue further spending control measures. Regulatory requirements—particularly the linkage among the benefits, risks, and cost of products—will increase, while the industry pipeline shows little sign of delivering sufficient innovation to compensate for such pressures.

The article suggests that the pharmaceutical industry might evolve away from vertically integrated model like the automotive industry.

A look at the evolution of the automotive industry may offer some lessons. For many years, it was vertically integrated and dominated by large, primarily Western corporations. But the value chain has been disaggregated into companies specializing in narrow parts of the process. Today, component manufacturers, design houses, and basic-materials companies share much of the industry’s revenues: the automakers are responsible primarily for the design of major components (such as engines), assembly, sales, and marketing.

This whole article is a very interesting read. I suggest you consider reading it.

Creating Leaders

The article The NY Jets’ Mike Tannenbaum and SAP’s Bill McDermott: Creating Leaders On and Off the Field in Knowledge@Wharton has some interesting pointers for all R&D managers.

1. Provide precise and candid feedback (even when negative):

“The most important thing a leader can do is give people feedback,” McDermott said, recalling a meeting where an executive was complaining about a mistake made by an employee. “‘What did he say when you told him about it?’ I asked, but there was silence.” Employees deserve the respect of candor, McDermott noted, and they need to know what is expected of them and have a clear understanding of their employer’s strategy and culture.

2. Provide a big long-term vision that can get the team excited.

McDermott and Tannenbaum agreed that a leader has to focus on promoting an overall vision for his or her organization rather than dwelling on the small stuff.
…
“Our thing is to go big or go home,” McDermott said, noting that SAP has had many opportunities to buy companies that would catapult the firm into a new business category.

3. Be careful in selecting team members and look beyond resume / technical capabilities:

“When he was on the cell phone in the car, did he treat the person on the other end with respect? … How did he act with the waitress? Your character is what you do when no one is looking. That will make for a better team, where everyone knows what everyone else’s job is, and we all work together.”

Something we can all learn…