Many entrepreneurs neglect to establish formal compensation structures. It’s easy to see why: in small businesses’ early stages, entire workforces might be made up of owners and one or two assistants, which makes it possible to hammer out payment terms on an individual basis. Revenue is precarious and the future is in doubt. Businesses pay what they can; raises, responsibilities, and hours are fluid.

Put colloquially, many entrepreneurs’ early compensation plans sound something like, “Here’s what we can afford right now. As for the future, we’ll have to see what happens.”

At first glance, this appears to be sheer pragmatism, the product of entrepreneurs being honest with themselves and their employees. In reality, we’ve found it’s not pragmatic in the least. It suggests that when money starts coming in and expansions/raises loom, owners will be able to improvise viable short-term solutions even while drafting formal long-term plans.

The underlying message is, “When we have enough money to expand and give people raises or other incentives, things will work themselves out. We’ll see where we are and act accordingly.”

Things don’t often work themselves out, though, and it’s very hard to build a formal compensation structure on a foundation of hip-shooting. Small businesses that don’t develop formal compensation structures as soon as possible risk creating disastrous inequities in employees’ pay, and are too easily forced into reactionary patterns in which they must scramble to meet the demands of valued personnel.

In short, neglecting to establish formal compensation structures puts small businesses at risk. Such structures exist to: mitigate the chances of over- or underpayment, give business owners some form of control over how employees are motivated, and protect businesses from litigation. It’s obvious that these are critical aspects of any enterprise. They make a huge difference in productivity/profitability, and can be the deciding factor between businesses that continually increase in value and businesses that struggle to stay solvent.

This is why we tell clients that when it comes to compensation structures, they should try to follow in larger companies’ footsteps. It’s not something we say often. We don’t mean small businesses should seek to match their larger competitors’ base salaries—that’s rarely an option. Rather, we mean their business plans and budgets should be very specific in addressing three factors:

  1. Job Descriptions and Salary Research
  2. Incentive Plans
  3. Performance Reviews

Let us be clear: our goal here isn’t to tell entrepreneurs how much they should be paying their employees. Instead, our goal is to point entrepreneurs toward some tools they can use if they want to increase productivity and limit their legal exposure.

Job Descriptions and Pay-Scale Research

As noted above, small businesses’ first few employees (especially entrepreneurs themselves) often have a fluid set of responsibilities. They do a little of everything; they play hybrid roles. As a result, formal job descriptions never seem to capture every aspect of their contributions, unless descriptions include vague lines like, “Performs other duties as needed.”

This is a reality. But it needn’t be a permanent one, and entrepreneurs can plan to transition out of it. To be more specific, they can identify the skills and/or qualifications associated with high performance in each area of their businesses: sales, marketing, research, product development, human resources, office administration, facilities management, etc. What will it take for employees in those roles to succeed?

Constructing job descriptions—assigning clusters of responsibilities to specific titles—helps entrepreneurs decide which types of employee their businesses rely on. For instance, a wholesale goods company is likely to value management of its sales and shipping departments more than management of its facilities (Mayhew 2011).

Employees whose roles are highly valuable to the company should be compensated accordingly. This doesn’t mean they should make more money than anyone else, but that they should be paid well for their job descriptions.

Since the meaning of “paid well” changes drastically from job description to job description and market, entrepreneurs typically need to do some research to figure out what they can expect to offer skilled workers. Local salary data is often available through participation in salary surveys, and data for specialists can be found for free online. If these methods come up short, entrepreneurs can contact agencies (such as the Economic Research Institute) that provide salary data for a fee.

Drafting job descriptions and estimating what the employees doing those jobs will be paid can contribute to long-term budget outlines and business planning (ibid). As small businesses grow, they may encounter demand for increasingly complex skill sets, in which case they’ll need to hire increasingly expensive employees. Entrepreneurs who factor this into their financial schemes tend to make a good impression on lenders and investors alike.

Incentive Plans

Salaries don’t remain static. They increase year by year. These increases normally account for inflation, with a few percentage points tacked on to separate employees by competency (Employee). Within this traditional structure, it’s important to document how many extra points a high-performing employee will get, how many extra points an average employee will get, and so on.

We should note that incremental annual raises (i.e., salary increases beyond what’s demanded by inflation) rarely serve to motivate employees: the distinction they make between excellent and poor employees is simply too meager. Indeed, annual raises tend to be taken for granted and, thus, increase a business’s fixed costs without driving up productivity.

Annual raises are a venerable institution in American business, but they are not the only—or, perhaps, the best—way to reward employees for jobs well done. Other plans tie rewards more closely to employees’ achievements; doing so tends to be more motivational and has a much smaller fixed-cost impact. Alternative reward programs include variable pay, profit sharing, and stock options. None of these need replace annual raises, but can be a way of emphasizing the connection between employees’ compensation and employees’ contributions to business goals.

In the interest of brevity, we’ll only discuss bonuses and variable pay, which are most common in today’s marketplace. But first, we’ll go over some vital characteristics of any reward program. No matter the variety, a successful reward program always (Employee):

  1. Identifies the business goals it’s designed to support and correlates those goals with specific employee behaviors. Any organization that skips this step doesn’t actually have a reward program. That much should be obvious. What’s less obvious is that reward programs sometimes honor behavior that sounds productive but actually leads to net losses. For instance, it’s possible to improve individual productivity while detracting from the productivity of a team. A business that depends on its employees working together must be explicit about differentiating between individual and team accomplishments: one is rewarded, the other is not.
  2. Establishes performance metrics. Reward programs demand resources, and entrepreneurs need a way of determining whether the resources they’re investing in their reward programs are proportionate to the returns. This means they need to decide how they’ll measure improvements in employee performance. Higher sales is one metric; higher customer-satisfaction ratings is another. A reward program’s returns don’t need to be strictly monetary, but they need to be concrete—i.e., they need to have a real effect on the business.
  3. Matches particular metrics with particular rewards. How much is improved performance worth? One type of performance can be worth more than another. Negotiating a $500,000 contract, for instance, probably merits greater recognition than perfect annual attendance.
  4. Is communicated clearly to employees. A reward program that’s shrouded in mystery is more likely to create disaffected, enervated employees than enthusiastic go-getters. Employees need to know what they’re working toward and what they’ll get if they succeed. One meeting is rarely sufficient to convey these things: the introduction of a reward program should be followed by regular (not to say frequent) memos that remind employees of what they stand to gain.

Bonuses – Bonuses are about as venerable as annual raises; more often than not, the two go hand in hand. The mere idea of bonuses is meant to encourage continuous high-level work. They can be awarded to either individuals or groups, and in order to emphasize teamwork, many businesses go the latter route. Like annual raises, bonuses run the risk of being taken for granted. Small businesses that give out bonuses must be careful to articulate that each bonus is for recent work that went above and beyond. (Employee)

Variable Pay – Most often (but not exclusively) applied to sales forces, variable-pay plans tie a portion of employees’ compensation to concrete performance measures. There are endless subcategories of variable pay, each with its own set of mathematical algorithms and each designed to push employees’ performance as high as possible without putting employees under so much strain that they burn out and change jobs. Variable pay plans reduce a small business’s fixed costs, which is a good thing. But they, above any other type of incentive structure, must be linked to very specific outcomes and very specific methods of measuring those outcomes. Specificity is what gives variable-pay plans their great power to motivate.

Performance Reviews

Job descriptions, salary research, and incentive plans of every species converge in the performance review, which is the single most important aspect of a small business’s compensation structure.

Regular performance reviews reinforce employees’ understandings of their job descriptions and help them focus their efforts on their principal duties. They also give owners the chance to record the highs and lows of employees’ work.

Regularity and documentation are key. Employees who think they’re performing well but don’t reap monetary benefits will demand explanations, and may file lawsuits. The best way to avoid both morale-sapping bitterness and legal exposure is to keep employees well-apprised of where they stand in the incentive plan.

What tasks are they doing well? Where do they need to improve? Answer these questions at regular intervals. Write the answers down. Keep them on file. We can’t emphasize this enough: performance reviews are key to productivity and protection.

Takeaway

Small businesses typically start on such rocky financial ground that compensation structures seem impractical. But devising a compensation structure in the early stages of business planning lays a strong foundation for workforce expansion, and can be a selling point for investors and lenders.

Precise job descriptions and comprehensive incentive plans go a long way toward keeping employees focused and productive; moreover, they form the backbone of performance reviews, which relate employees’ work to business expectations and provide a legal buffer for owners.

People naturally care about how much money they make. But for small businesses with limited budgets, themethod of delivering money and the communication surrounding said delivery can be more motivational than raw numbers.

References

Mayhew, Ruth. What is a salary system. chron.com. http://smallbusiness.chron.com/salary-system-10652.html

Employee reward and recognition systems. Inc.com. http://www.inc.com/encyclopedia/employee-reward-and-recognition-systems_pagen_3.html