Pay-for-Performance

Pay-for-performance+ is a positive spin on risk-sharing. If the prototype+ is successfully commercialized you get paid handsomely for your performance. If it fails you risk losing a significant portion of your pay. As a vendor or one of the firm’s internal service providers you will be asked to reduce your compensation up-front (recall you’re being contracted by the franchisee+, which is a separate legal entity) in exchange for potentially much greater compensation at the end. You’re at risk and your total compensation will be much higher due to its incorporation of the risk premium.

We seek ways that everyone on the commercialization+ team can find significant reasons to want the prototype to succeed: to become a blockbuster+ product. The product succeeds and they succeed. With financial incentives, individuals (and their companies) begin to mentally spend the money that comes from success: they put it in their financial forecasts. This incents them to push harder for the success of the prototype. But, there are limits.

Can you imagine. We did this for free, as our hobby, and we really enjoyed it. Now we’re getting paid, and reporting to someone else, to do the same thing. It’s turned into just like any other job. Professional Surveyor, Mammoth Cave National Park (1990's). Personal communication

Pay-for-performance, a financial incentive, works perhaps better at the level of the company. Entrepreneurs are often motivated much more by the intrinsic uses of money: many have had to start up companies on a shoestring. Financial incentives, done well, work. But often they work better for some individuals than for others. They should never be used alone (i.e., to make up for a lack of emotional incentives).

By performance we mean end results. We declare success, measure the level of success, and disburse performance rewards. We measure performance by the value of the end product. If it’s a blockbuster then you’ve succeeded. Excellence in execution along the way is not in itself rewarded, rather only as it gets reflected in the end valuation. We’re not here to be good at the means; we’re here to be good at results.

Product valuation+, the basis of performance bonuses, is singular. There is one product valuation that affects performance bonuses across all providers of commercialization services. Different vendors may have different percentages of their earnings derived from the performance bonus, but all derive a good portion of their earnings from the bonus.

I just contribute a small portion to the overall success of commercialization+. I’ll do a great job, but you’re asking me to risk part of my compensation on the quality of the work of many other vendors and individuals with whom I have no commercial relation. Illustrative Pharmaceutical Industry Quote (2010)

Pay-for-performance (and effectiveness in general) requires that everything go right, that everyone does a great job, from beginning to end. All the hundreds of details laid out in the September World Class R&D website home page need to be flawlessly executed. Elsewhere we stated that success at commercialization depends on success in the other three investment categories+ (i.e., pre-game+, mid-game+, and end-game+). It's critical the franchisee (or whoever's in charge) give vendors a sense, up front, that they have a handle on all the variables and players that will contribute to product valuation.

There are just too many moving parts that have to be synchronized for this approach to succeed. I just have two highly skilled guys and a computer. I can’t risk the compensation of my small firm on this! Illustrative Vendor Quote (2010)

The vendor bid determines the current payout vs. the performance payout. All else being equal we give preference to vendors who are more interested in the performance payout. Superior skills can often outweigh a vendor's participation in pay-for-performance. Note: the franchisee is also ‘one of the vendors’ in the sense they get pay-for-performance. They get a minimal payout up-front for the purchase of their prototype, and a large bolus of funds after the successful conclusion of commercialization.

We use pay-for-performance to drive greater efforts at moments when they most matter. They matter most when individuals can take timely corrective actions, or proactive actions, to protect or improve the eventual product valuation. Having a great idea in hindsight is too late. We’re often dealing with uncertainty, so we need a process that estimates the likely impact of a pending action (both positive and negative), records the action, and measures the impact of that action. We drive greater efforts by shining a bright light on the consequences of individual efforts, both good and bad, shortly after those efforts are made. Simply calculating results at the end does not drive greater performance – it becomes too abstract in the minds of individuals.

Exhibit 1. Shows capabilities that must be in place in order to support a Pay-for-Performance approach to reward external collaborators. For example, you need agreement on levels of performance, as defined by a Product Valuation capability, in order to be able to reward vendors.
Exhibit 1 shows the Pay-for-Performance support structure (i.e., the analytics). Product Valuation is our measure of performance, calculated using a Commercial Equation+. Changes to the Commercial Equation often come through Valuation Change Requests. We also have in place ‘penalties’ for the firm should they attempt to lowball product valuation prior to payout of the performance bonuses: Ratcheting Royalties+. Pay-for-Performance is adjusted upward only (hence the term ratcheting) should the commercial product prove to be more successful than estimated at the end of commercialization (i.e., the basis for pay-for-performance payouts). We prefer the firm over-estimate product valuation to better protect the incentives which drove success in the first place.

In addition to the supporting capabilities shown in Exhibit 1, we need supporting capabilities in how best to incorporate pay-for-performance into vendor proposals, and in how to help vendors cascade incentives down to their employees. For example, we want employees of the firm to be recognized for  exemplary performance. And, we recognize that pay-for-performance may not be appropriate in all situations. This is the domain of Organizational Behavior Management+ (a future topic), which tracks and adjusts all our management practices based on their demonstrated capability to improve effectiveness.

Why not just use equity or royalties and skip the end-of-commercialization payout? Because we want the franchisee, vendors and internal firm players to feel they are getting paid based on great performance during commercialization. This is not a reward for having lobbied to get placed on the prototype most-likely-to-succeed. You are compensated based on the efforts of the entire commercialization team.

Pay for performance includes agreements to swap-out players who are not performing well (as determined by our team representative from Independent Evaluation+). The franchisee pays for commercialization support, and will be quick to remove any support that is not living up to expectations. We also need to have in place mechanisms in case any firm needs to be removed midstream. Individuals and firms receiving the performance payout will be deserving of that payout as measured by their own efforts.

Pay-for-performance, done well, drives greater efforts (and creativity) on the part of vendor-partners during commercialization, increasing the likelihood of success. It also reduces bothersome meddling on the part of the firm's financial forecasters and their customers. This will perhaps not be viewed positively by these individuals, but increased success in the blockbuster pursuit has a way of compensating for this loss of control.