Faults of Gainsharing and Equity Based Compensation

Gainsharing and Equity (stock) based compensation plans have become commonplace in American companies. While there are differences between gainsharing and stock-based compensation, the goal of both plans is the same: to promote higher performance from employees by tying a portion of their earnings to the overall success of the company. Much like Communism, gainsharing and stock-based comp plans look great on paper but do not function as expected in practice.

Explaining Gainsharing and Equity Based Compensation Plans

Gainsharing compensation plans’ structures vary by company, but essentially an employee is eligible to receive a certain amount of incentive pay based on a performance metric, such as Operating Income. Incentive pay is additional cash received in regularly timed intervals, mimicking a bonus-type structure. The premise is based on the thought that employees who are financially rewarded when the company is performing well are more likely to invest more time and effort to ensure the financial success of the organization. The most succinct way to explain the sentiment that gainsharing plans are intended to address comes from the movie Office Space. The protagonist Peter Gibbons says to an efficiency consultant, “If I bust my ass and Initech ships additional units, I don’t see another dime.” By tying employees’ earning potential to the overall company performance it is believed that they will not only be more motivated to work, but also increase morale by giving the promise of financial incentives for outstanding results.

Equity based compensation has the same intent as gainsharing but uses a different type of financial reward to the employee. The most commonly known form of equity based compensation is the Stock Option. More often than not, employees eligible to receive stock options are managers or officers of the company. In some ways it makes sense for a corporation to pay executives larger portions through equity compensation rather than salary because the company then avoids higher payroll and Medicare taxes. Typically, executives are more than happy to receive such compensation because they have the ability to hold the stock for longer than twelve months and pay 15% long term capital gains tax instead of their normal marginal tax rate, which would be a minimum of 28%.

Examining the Faults of Gainsharing Compensation Plans

The following are pros of gainsharing from HR-Guide.com:

• Helps companies achieve sustained increases in productivity.
• Employees become more involved the productivity gains made by the employer. (no one ever said HR people were English majors…)
• Enhances commitment to organizational goals.
• Leads to improvements in other measures of company performance, including: teamwork, product quality, lower rates of absenteeism, defects, and “downtime.”

The list of cons:

• Adherence to the FLSA requires employers to recalculate each worker’s “regular rate” of pay. To overcome this limitation, employers may restrict this type of compensation to exempt employees.
• The formulas and program may be difficult to understand.
• Requires a shift to a more team oriented management style.

Both lists are fundamentally flawed. These lists are developed based on the theoretical implementation of gainsharing plans in a fictitious organization with employees that operate exactly like robots from an HR textbook. Not reality. Is it possible gainsharing leads to some of the outcomes listed as pros? Yes. Let me enter a few scenarios that I have personally seen with gainsharing in practice.

Gainsharing Fosters Cannibalism

You have store managers and salespeople operating out of stores that are in a given gainsharing territory. Instead of focusing on acquiring new customers, the managers and salespeople begin to woo existing customers from a different store in your company.  In the mind of a person who is trying to make as much money as possible with as little effort as possible, which is the mindset of many people, it requires less resources to lure an existing customer from a different store to their own in order to reap the sales benefits. They have cost your organization money in two ways, (1) by spending time and resources attracting customers that already belong to your organization, providing no incremental sales benefit, and (2) by increasing their incentive pay while not increasing the overall top line of the company. This is commonly known as cannibalism (one manifestation of it, anyway), and runs rampant in companies with gainsharing plans for employees based on Gross Margin or Operating Income metrics.

Gainsharing Confuses Priorities in Production Environments

The employees of a plant have gainsharing plans based on certain productivity metrics. If the gainsharing plan is structured poorly, and due to the propensity of people to try and make things easy this is often the case, then there may be an important piece left out of the calculation. That piece would be in the form of adding a qualifier to the productivity metrics, meaning that you must increase productivity without sacrificing quality and safety, or increasing defects. In this scenario it is possible for plant employees to meet a certain productivity goal by being careless and sloppy, leading to an increase in defects and a decrease in safety. This costs your company by increasing cost of goods sold due to scrap, devaluing your company’s reputation as a quality manufacturer, and increases incentive pay for those individuals who ultimately did nothing to improve your manufacturing while making their plant a more hazardous place to work.

Examining the Faults of Equity Based Compensation Plans

The focus here will be placed on stock options as the form of equity-based compensation as it is one of the more prevalent forms and has a higher risk of dangerous outcomes. Stock options are typically a grant of the right to purchase a given number of shares at a price (usually the market rate at the time of grant) to the employee. Theoretically, the stock is to appreciate over time giving the stock option value in the spread between the option price and the current market value.

The commonly accepted benefits to stock option incentive plans are that it aligns employees’ and managers’ interests with the company’s, affords incentive pay without a charge to earnings, and allows the company to share ownership with employees. Disadvantages of stock option plans are that the options can cause dilution of ownership and EPS, and if the stock price decreases below option price the options effectively become worthless.

Stock option incentive plans may encourage leaders of the company to manage the organization based stock price. At the executive level the majority of compensation is received through various stock option plans with the intent of making sure the executives have the shareholders’ best interests in mind. What actually occurs is a shift in ownership of stock such that the majority shareholders of the company are the executives (excluding organizations and mutual funds), leading to a situation where the executives of a company have the most to gain or lose by fluctuations in the stock price. This then causes those company leaders to manage with stock price at the top of their minds, which can result in short-sighted decisions aimed at driving up the stock price today. In dire times, executives need to be able to make the tough calls and think strategically, which sometimes means taking an initial loss inevitably decreasing the stock price in the short-term. A company may wind up having its best interests trumped by those of the executives’ wallets if compensating the employees and executives too heavily with stock options.

Making Sure Your Incentive Plans Work

Gainsharing and equity-based compensation plans are not evil, despite all of the flaws that are inherent to the philosophy. Success of these plans boils down to their implementation by an organization. It is of paramount importance for a company considering gainsharing plans to ensure that the metrics by which the gainsharing will be determined have as few loopholes as possible. If it is a productivity gainsharing scenario, make sure that safety and quality control metrics are included. For stock option plans, be sure not to weight any employee’s/executive’s compensation too heavily with options or else the company may find its decisions being made for the benefit of the short term stock price, which has lead to the demise of more than one major organization in the past.

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Lanschaftspark Duisburg courtesy of Flikr user extranoise under the CC license.