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