Incentives aren't just pay. Incentives are about giving people a reward in exchange for getting them to do something. Different people want different things, so we need to be able to provide different rewards depending on the person. The biggest thing to realise is that incentives work, whether we want them to or not.

First, let's lay out what kind of cheese we can lay out for people. Why do people do what they do?

• They want cash money, benefits, stock, or options.
• They want security, and would not like the threat of getting fired.
• They have an ego. Perhaps they like it when "my company is bigger than yours". This is a tough one when the best option for a company is to shrink. They might even want to create a legacy.
• They like solving problems. Isn't that why most of us became engineers?
• They want to make this a better place to work, perhaps by buying a beanbag, or employing a relative they like.
• They want to do good, either for society as a whole, or the employees. One hopes that most people have this somewhere.
• Sometimes for the peons, this is the best method. They can't be motivated by money (because they're not earning much), so they can at least feel good about what they're doing. This is why nice letters from customers are circulated among the troops - they'll appreciate that what they are doing matters to someone.
• They are just afraid of the boss. (This is how Skeletor, Lord Of Skull Mountain works.)

Incentives for Bigwigs

You can pay your bigwigs in a combination of base wage, bonuses, stock or options. Now, if we assume for a moment that executives are hard nosed capitalists and money is ALL they are interested in, here is what will happen. None of these are wrong, but they will elicit different types of behaviour from people.

• Base Pay: Your employee gets the pay pretty much regardless of what they do. I'm sure you know of people in large organisations who basically do nothing - this is why. Base pay is enough for them, and so long as they look busy, they just coast. And maybe that's OK.
• Bonuses: These might be performance related pay. For example, you could give a monthly bonus to a sales executive based on how much sales revenue they've made in that last month. Here's the potential problem - it can encourage short term thinking. Let's say your sales executive cuts price and tells all the customers that the price will go up sharply next month. Then, customers will stockpile, leaving your executive with a fat bonus, but the company screwed for the coming months.

• Stock: If you own a stock, you own a thing that has a value defined by the market, and you can get cash just by selling it. You get less cash if the market's good when you sell, and more cash if the market's bad when you sell. So the general idea is that you get money when the company is healthy.
• Stock options: These are, literally, the option to buy stock at a preset price (called the strike price.) If you get options at a strike price of $100, and you work hard to do well and drive up the stock to $150, you can exercise your options (i.e. buy the strike price and sell at the market price), and make $50 on each option instantly. If you suck and and the stock price goes down, you simply don't exercise your option, and you lose nothing except the opportunity to have made money.

From the list above, you might reasonably conclude that it makes sense to compensate people in stocks or options rather then hard cash. You're going to need a balance, because most people still need cash to come in from month to month. But even stock or options aren't perfect. Let's say that your executive has taken a finance course and realises that they've basically been handed an investment in one company, which is inherently risky. Any finance person will tell you that the best way to mitigate risk is to diversify. So, on the sly, your executive buys stock or options in the competitor as well, or companies not even in your industry. They are then hedging their risk, but they're not being paid on the basis of the company they're actually working for any more.

There's another complication - dividends. If you announce that your company is paying a dividend, the stock price automatically goes up until the payout date, and then goes down by the value of the dividend. If you choose not to pay a dividend, you can reinvest in the company instead. The weirdness is that if a big executive is checking out of the company and selling up their stock, they can deliberately decide to declare a dividend, converting a long term gain (reinvestment) into a short term one (share price). Some company require that their stock or options have to be held a certain amount of time after leaving to mitigate this.

So let's hear from the experts. Here's what Lou Gerstner, saviour of IBM thought when he took the reins.

From "Who Says Elephants Can't Dance":
Every executive had to be in the same position as a shareholder: stock up, we'll feel good; stock down, we'll feel pain (real pain - not the loss of a theoretical option gain). I bought stock repeatedly on the open market in the early days, because I felt it was important to have my own money at risk.

In fact, his guide was for himself to have 4x as much stock as cash, SVPs to have 3x as much, and so on. Seems sensible - you are aligning the incentives of those who have the greatest ability to impact share price with the people who own the company - the shareholders themselves.

Incentives for Minions

There are complications to these choices. For example, do you pay someone a monthly cheque, or by the hour? Inadvertently, you're telling your hourly people "the longer you work, the better, and that's more important than anything else." If you are paying sales commission, do you pay based on the number of sales made? The number of calls made? The value of the sales (i.e. revenue)? The value of sales minus costs (i.e. profit)? Again - none of these are wrong, but different types of behaviour result.

Here are some examples.

• Consultants are generally paid for their time - a kind of hourly rate. Their incentive is to make money, so they might take longer coming up with a recommendation than is necessary. The incentive of a client is also to make money, but this time on the back of the consultant recommendation. In order to align these, more clients are requiring their consultants to be paid on increase in revenue once the recommendation is implemented. It shifts focus away from areas like personal relationships and Powerpoint skill, while encouraging substance and demonstrable returns.
• Salespeople at Nordstrom are rewarded directly on the value of sales per hour - meaning that they can either make more sales (great for the company) or just report fewer hours worked. As a result, Nordstrom could potentially have their salespeople working unreported time. Sneaky - but the theory is sound.