At Puryear IT, we’ve long struggled to find the best incentive model for our employees. As an IT service and support firm in Baton Rouge, our biggest asset is our staff. And, no, we don’t just say that because it sounds cool. For a service-oriented firm, we must have top-notch staff that WANTS TO WORK HERE. We look for career-minded people, not those looking for jobs, and we want our staff to do things right, not just quickly.
That’s a tricky mix.
Note: Download the example spreadsheet attached to this post, but be sure to read the entire blog so that you fully understand the concept.
So what do we incentivize? After trying various models, we’ve decided to go with a model we call the Team, Effort, Loyalty (TEL) bonus. The TEL bonus rewards:
- Team. Every employee should be motivated to not only consider their own self-interest (at least not directly), but also view their team and the entire company as part of their own “incentive”.
- Effort. Most employees vary in their efforts towards a goal, with some exhibiting more effort one month and others in another. But overall, effort is pretty stable and we want to take this into account.
- Loyalty. For a service-oriented company, this is HUGE for us. The longer an employee stays with our firm, the more efficient we become.
So how do we mix and match all of these together into an effective bonus model, i.e., the TEL bonus?
Before going further though, let’s define “effective”. To us, it means behavior that is profitable and team-oriented while still including self-initiative. If you don’t properly define what “effective” means to you, your use of the TEL model will be broken and incentivize the wrong behavior.
That begs the question of “wrong behavior”. For us, we could look at effectiveness as follows, although we would be wrong:
- Profitable = Billings to Customers
- Team-Oriented = Consultants help one another when in need
- Self-Initiative = Consultants put in the time and energy to close out tasks
This looks logical, but, for us at least, it’s wrong. Let’s break this down:
If Profitable means “Billings to Customers”, then our consultants will simply bill as many hours as possible, even if those hours are unnecessary. That’s very dangerous.
And if Team-Oriented means that “Consultants help one another when in need”, then nobody else in the company need bother. The bonus is for only the consultants, which makes them a team outside of the rest of the company, or, if the bonus is company-wide, consultants will resent bonuses to non-consultants because the non-consultants have no incentive to really dig in and help.
So instead, we define it this way:
- Profitable = Valid Billings to Customers
- Team-Oriented = Employees help one another when in need
- Self-Initiative = Employees puts in the time and energy to close out tasks
The biggest change here is “Valid Billings”. Every day, I and my administrator review a report indicating closed tasks and the amount of time to bill. We then verify that the time spent passes the gut test (i.e., “is the time spent above and beyond what is really needed for this task?”). If the time doesn’t pass the gut test, we write some of it off, which reduces profitability! Doing this means we also need to let each consultant know how much of their time we are writing off so they can address that issue with additional training.
Also, notice that we say “Employees” and not “Consultants”. If I want everybody walking down the same path, then, by golly, everybody should have the same set of incentives! By seeing things this way, I can ensure that our Office Admin or Inventory Manager will drop everything to help out a Consultant if there is a billable item that needs to close and the Consultant needs “I have no time left!” help. That helps us focus on Profitability and being Team-Oriented.
Of course, you can’t focus only on the team. If you do, there may be some people that ride the wave and allow others to do the hard work for them and let the great employees average out the bad employees. Our solution to this is pretty simple:
- We don’t joke around when we tell people that during their 90-day probation, that they are proving they deserve the job, not that they are trying to keep the job they were given. If we don’t find you up to snuff, we let you go.
- We don’t keep people around that are negative or are not carrying their weight. It’s surprising how often companies keep bad employees around. Don’t.
So far, we have the Team + Effort part of the bonus handled. However, what about incentivizing self-initiative and retention? For us, that’s Effort + Loyalty. To me, employee compensation is the same as “employee value to the company”. So, assuming we keep good employees, then we should reward employees that have been here for a while based on their salary (value) and years of service (loyalty).
Now, we need to be fair in all of this. In a service company, employees have a huge amount of control of Cost of Goods Sold (COGS) and thus Gross Profit (GP), but usually very little control over expenses (overhead).
That said, providing bonuses based on GP can be dangerous so clearly we need to have a strong control over our numbers. This means we know our average overhead averaged out over the year and how much we want our Net Income (NI) to be. If you have a good understanding of your COGS, overhead, and NI needs, then that means the real lever is where it should be: Efficiency of service delivery. That’s the lever that your employees control!
So to use TEL, you need a strong understanding of the following:
- Your average monthly overhead. If your overhead varies significantly over time, then your books are wrong and you need to fix them (e.g., you have COGS items in overhead).
- Your debt service needs (Debt Pay).
- Net Income, including how much you want the company to retain for growth (NI Ret) and how much you want for distributions to owners (Owner Ret).
And that’s it for understanding when you hit what we’ll call “TEL profitability.” TEL profitability is when you meet your overhead needs + debt service + NI retention + owner retention. It’s what spills over the top after all of that is met.
As an example, we may have:
Avg. O/H: $50k
Debt Pay: $4k
Owner Ret: $2k
NI Ret: $6k
Min GP: $62k
This means we have to hit $62k GP every month on average to reach TEL profitability. The first penny over $62k is the TEL profit!
Notice the “on average”. For us, we monitor monthly and pay quarterly (on the second month of the following quarter). So in our example we have this for our GP for the 3 months of the quarter:
That averages out to $16,029 over our Min GP, meaning we have $16k in TEL profits for the quarter.
Once we have this TEL profit number, the question becomes: Now what? Well, share it with your employees. They helped you make that TEL profit by working very hard, so reward them so they keep working hard! Our method is to retain a certain percentage for the house (i.e., Puryear IT) and distribute the rest to the staff. Owners are not included in the bonus since that is already handled by Owner Ret.
This means we need to break it out like so:
If you wonder why we retain some additional GP (25% in this example) in the company, we want to leverage some of that TEL profitability into marketing and sales to further accelerate healthy growth. Remember, healthy growth means the pie gets bigger and bigger for everybody, owners and staff.
So those percentages leave us with:
But wait, we’re still potentially in a dangerous position! We may have a strong GP, but be low on cash and have a long tail in our A/R with a big bump at 90+. That means we could be paying out a bonus on fake revenue (A/R that can’t be collected) with money we have to borrow from the bank since we don’t have the cash on hand. Employees may not understand this risk (if it’s billed it’s revenue, right?), but you should.
To protect against low cash and a bad A/R, we also need to define the minimum cash on hand we need (our collections have to be strong) and the maximum percentage we have in A/R that is 90+. For some it may be 60+, and others it may be 120+, but for us anything over 90+ is fake money and we assume we’ll never see it.
This gives us:
AR90 $24k (8%)
This means we’re “safe” to distribute a bonus because we have enough cash on hand to cover our current needs and our A/R is relatively safe. We’ve been in business for ten years, so we know what is safe and unsafe in terms of our A/R. For younger companies, you’ll want to be much more conservative in what you allow here to ensure you don’t bonus yourself into bankruptcy.
Finally, we need to break out TEL and determine how to bonus off of it.
We have Team + Effort and Effort + Loyalty, which we define this way:
Team Split: 50%
Merit Split: 50%
The Team Split is a bonus that is EQUAL FOR EVERY BODY. So if 50% of $12k is $6k, that means that you evenly divide that $6k up and give the same check to each employee. That rewards team-work because everybody knows that the pot grows as each person becomes more productive, so somebody that is idle is incentivized to pick up somebody else’s excess work because otherwise that excess work will probably not be done on time and thus won’t make it into the Team Split profit pool.
Now let’s focus on the individual bonus, which we consider Effort + Loyalty. We earmark 50% of the TEL bonus pool to this, which is $6k. We then score each employee by calculating Salary * Years of Service. You can make this calculation more complicated, but in most cases Salary is the same as Value (that’s the general idea in a market based economy) and Years of Service is Loyalty, and since we assume you don’t keep around bad eggs, this calculation is a reasonable way to weight employees.
Let’s wrap this up by talking about who should receive the bonus. Here, you have to work full-time for us as a W2 for a specific amount of time to play the bonus game. We are contract-to-hire for the first three months, meaning new staff aren’t eligible until they hit 9 months. You could make this a full year or something more fitting to you. We do use the 3 + 6 model since the first 3 months are all training and they aren’t contributing overly to the profitability for that period. It keeps it fair for the rest of the staff.
I want to thank Josh Ford, CEO at Giraphic Prints, a fellow EO Accelerator, for giving me the kernel of the idea for this bonus model and our consulting CFO Rene Schexnaildre for firming up the logic we use while I thought this through over the past few months.