Equity-based pay: the compensation paradigm for the re-engineered corporation.

Traditional pay-for-performance rewards individuals, not the teams created under re-engineering. Equity-based compensation rewards collaborative efforts and aligns the interests of companies, shareholders, and employees.

Whether your company is actively engaged in the re-engineering revolution or not, it is a given that the contract between employee and employer has been permanently altered. Today, shareholders prosper from lower costs and higher customer satisfaction, as employers demand more from their workers while providing them with less security and opportunity than before.

CEOs managing leaner organizations are working hard to mitigate the often demoralizing effects of change. But the reality is that changes will continue, because competitive pressures require companies to constantly review and improve their work processes. A central issue in today's employee-employer dilemma is that traditional pay-for-performance systems neither fit today's team-based work processes nor reward the right behaviors.

The challenge is to turn re-engineering from a zero-sum game, in which shareholders benefit from the pain suffered by employees, into a win-win solution for all constituencies. For many companies, the solution is to replace the historic compensation system with an equity-based pay approach that creates employee-owners, rewards team performance, and aligns the interests of shareholders and employees. The payoff: Studies show that companies with significant employee ownership - including General Mills, SAIC, and Southwest Airlines - outperform both their industry peers and the broad-based stock indices.

The traditional system - call it merit pay, pay-for-performance, or whatever - exists in a contractual environment. It tells employees, "If you do what I ask, here's what you'll get." The new system, which requires a five-step implementation process, creates a partnership environment. It says, "Let's work together to build wealth and security for all."

WHY MERIT PAY DOESN'T WORK ANYMORE

For the last 40 years, most companies have used an entitlement-based paradigm called merit pay as the foundation of their compensation systems. It fits the old way of doing business - when jobs were static, work was organized functionally, and opportunities for "moving up the ladder" were plentiful. This makes no sense today. Most jobs are unique, but accurate competitive pay analysis requires cookie-cutter, "benchmark" jobs. Work processes are organized in teams now, but merit increases reward individual performance. Employees can't play the promotion game, because flattened organizations have eliminated most of the ladder's rungs.

Most important, though, the entitlement-based merit pay system ignores the company's economic condition. To "stay competitive," companies raise salaries every year - regardless of how shareholders fared. The system also does not encourage excellence. For the employee earning $30,000, a 6 percent raise is worth only $23 more per week than a 2 percent raise. The extra pay is not worth the extra effort.

THE NEW COMPENSATION PARADIGM

Equity-based pay - the new compensation paradigm has three basic components. First, ownership opportunities are big enough to make a difference in how people do their work. Second, incentives and retirement benefits are based on the increased value created for shareholders. And finally, salaries plus basic health and welfare benefits are sufficient to attract and retain people but forego guaranteed annual increases.

We encourage companies to follow a five-step process in moving to the new compensation paradigm.

1. Establish an equity-based pay philosophy. A company's equity-based pay philosophy must focus on employee-ownership objectives, such as aligning the interests of the company, its shareholders, and employees; making ownership a variable reward for performance; or creating an entrepreneurial culture. It also should answer basic design questions, including: How much ownership? Should all employees participate? Should reductions in fixed remuneration "fund" employee ownership? For most companies, the initial task in developing an equity-based pay philosophy is to assess the current level of employee ownership and the appetite for more.

Purchase, NY-based PepsiCo's Share-Power program provides an example of a philosophically driven equity-based pay system. PepsiCo management believes every employee can impact the company's stock price - whether delivering Fritos to a convenience store, managing a shift at KFC, or designing a promotional campaign for Diet Pepsi. To help drive home this message, management designed Share-Power, which grants options each year to every full-time PepsiCo employee. The options reward PepsiCo employees for their combined contributions to gains in shareholder value.

2. Rank each position based on the value it adds to the company. The traditional approach ranks positions based on their market pay rate, with adjustments to reflect internal equity considerations. The new paradigm ranks positions based on their value-added to the team.

A company establishes a job's position value in two ways. First, it calculates how much it would cost to buy the service on the outside. Second, it quantifies the incremental gain to the company for staffing the position with an outstanding performer versus an average one. This approach recognizes that certain jobs are "game-breaker" positions, which require the best people available. The extra shareholder value produced by the "game-breakers" far exceeds the additional compensation they may earn.

3. Divide the position value into three components - fixed, variable cash, and stock-based. Lower-value positions might deliver as much as 90 percent fixed value, because these employees aren't in the financial position to accept much risk. On the other hand, higher-value positions might deliver over half their position values through stock-based vehicles.

Wal-Mart, based in Bentonville, AR, made one of its rare management mistakes when it applied the same cash-versus-stock approach to all employees. As a result, employees have virtually all of their retirement funds invested in company stock. This is too much financial risk for low-wage earners. When the stock started to tumble in 1994, employee morale plummeted - all because Wal-Mart's management failed to adjust the split between cash and stock components based on each job's position value.

4. Determine how to deliver the stock component. Most companies already have stock compensation vehicles, but they fail to coordinate them. Therefore, they lose the motivational and operational benefits of employee ownership. Some equity-based pay vehicles are qualified - employee stock ownership plans, 401(k) matches, and profit-sharing contributions, for example - while others are non-qualified, such as stock options and performance shares. A well-designed program utilizes both qualified and non-qualified vehicles and coordinates them for maximum effect.

Like many other companies, General Mills of Minneapolis has several different programs to encourage employee ownership. Unlike others, though, it does an excellent job of linking the programs so it can measure progress toward its goal of 10 percent employee ownership. One program provides matching shares for every share held following exercise of options. Thus, General Mills converts a compensation program - stock options - into a vehicle for long-term employee ownership.

5. Develop and implement a communication program. In many respects, this is the most important step. The company must show how the new compensation paradigm works, why the firm has adopted it, and how it can help employees increase their earnings.

EMPLOYEE OWNERSHIP AND PERFORMANCE

The evidence is mounting that companies with significant employee ownership outperform both their industry peers and the broad-based stock indices. One such study has been conducted over the last several years by American Capital Strategies, an investment banking firm headquartered in Bethesda, MD. ACS has created an Employee Ownership Index of 350 public companies with at least 10 percent broad-based employee ownership. From January 1991 through December 1994, EOI stock price performance was more than double that of both the Dow Jones Industrial Average and the S&P 500 (see graphic). Other studies by the National Center for Employee Ownership provide additional evidence that employee-ownership companies are high performers.

Some people might be surprised at the correlation between employee-ownership levels and shareholder performance. For others, though, this has been an important investment strategy for years. Wall Street's most sophisticated investors - venture capitalists and major buy-out firms - long have insisted that senior executives own a significant portion of the companies in which they invest. Now they also expect down-the-line employees to hold significant stakes. According to Henry Kravis and George Roberts of New York LBO firm Kohlberg Kravis Roberts & Co.: "Ownership is the most powerful incentive for business change, and broad plans embed a sense of ownership deep within an enterprise."

THE POLAROID STORY

Polaroid Corp., a Cambridge, MA-based imaging company, demonstrates the power of linking re-engineering with the new equity-based compensation paradigm. In 1988, Polaroid fought off a takeover attempt with an ESOP-financed recapitalization. ESOPs had been around for years, and like most companies, Polaroid designed its ESOP as a financial transaction. However, management began to recognize that employee ownership could be a powerful lever to compel desperately needed organizational change.

The company launched a re-engineering effort, which it called "Total Quality Ownership." It reorganized workers into high-performance, cross-functional teams that took full responsibility for accelerating product development, reducing cycle times, cutting costs, and boosting customer service. Management began a communication and training program that educated employees on the meaning of ownership. TQO also provided employees with the knowledge, skills, resources, and authority to make decisions that would enhance the value of their investment.

The result? Today, Polaroid's employees earn more than ever - thanks to increases in performance-based variable pay, dividends on the shares, and increases in the stock price.

GOVERNANCE AND CONTROL

Many CEOs recognize an equity-based compensation system's ability to unleash the power of re-engineering, but they fear losing control of corporate governance. Key concerns include: Will employee-owners prohibit necessary staff reductions? Will they veto important management decisions? Will they try to shift wealth from outside shareholders to insiders?

The truth is, these fears are groundless. The equity-based compensation paradigm does not compromise corporate governance. When employee-owners vote their shares, they normally follow management's recommendations. That's because these companies link re-engineering with equity-based pay, thus involving employees in the decisions where they can add the most value - their own work and that of their team.

The airline industry provides several illustrations of how employee ownership can foster labor peace and increase financial viability. For example, Dallas-based Southwest Airlines spends only 28 percent of its revenues on labor costs, one of the lowest rates in the industry. The company has made employee ownership the centerpiece of its labor-relations strategy. Last year, it announced a new agreement with its pilots, in which they waived all salary increases for the next five years in exchange for stock options.

THE SAIC SYSTEM

Few companies demonstrate the long-term power of equity-based pay systems as effectively is Science Applications International Corp., a $1.6 billion high-tech company headquartered in San Diego. Founder and CEO Robert Beyster launched the company in 1969 with a simple philosophy: Those who contribute to a company should own it, with their ownership proportional to their contributions and performance. The success of this philosophy is obvious: $500 invested in SAIC founder stock is worth over $1 million today.

Although SAIC is a large company today, with over 16,000 employees, its history shows how a small business can grow rapidly by applying an equity-based compensation philosophy. It gives the company a significant competitive advantage when recruiting talented scientists and engineers. It underscores the company's commitment to pay-for-performance, because management has granted options and shares as rewards, not entitlements. Vesting schedules - usually four years, with the bulk of the shares or options vesting in the fourth year - encourage the best performers to stay. The patience of employee-owners helps the company resist short-term earnings pressure so it can concentrate on investing for growth, quality, and customer satisfaction. And stock purchase plans have provided significant working capital.

SAIC uses a variety of employee-ownership vehicles - options, stock bonuses, discounted purchase plans, ESOPs, 401(k) matching, and profit sharing. A comprehensive communication plan helps them all succeed. The cornerstone is a booklet entitled, "Objectives of the SAIC Stock Programs." It explains why the programs exist, how employees earn and purchase stock, how stock is valued, and how the company balances the competing needs for employee liquidity and working capital.

THE OWNERSHIP MENTALITY

Re-engineering requires employees to think and act like owners. All employees today must focus on customer needs and on the good of the entire organization. The performance focus is on customer satisfaction, teamwork, cost savings, and the simplification of work processes through technology.

There is only one surefire way to motivate employees to think and act like owners: Make them owners. This means replacing today's entitlement-based compensation and benefit programs with an equity-based pay system. By doing so, companies will align their reward systems with the way they organize work. This will enable compensation to change from a cost of doing business to a powerful management tool.

RELATED ARTICLE: SELF-ASSESSMENT

CEOs who are serious about exploring the power of equity-based pay should ask themselves four questions:

* What is our current level of employee ownership?

* What is our goal?

* How are our compensation and benefit expenses apportioned between fixed cash, variable cash, and stock-based vehicles?

* Do our compensation and benefit programs support the way we've organized the work?

Jack L. Lederer is president of, and Carl R. Weinberg is partner in COMPO Consulting Group, a Westport, CT-based management consulting firm specializing in compensation, organizational effectiveness, and executive development.