Companies often ask how much they should give to their value-producing stars.
Let’s look ahead to the definition of a job (which we will cover in much greater detail in Part 6 of the book). A job is an opportunity to create more present or future value than it costs to employ you. Working from that understanding of what a job is, ask yourself: what is the full cost of an employee's job? For most employees, it will be somewhere between 50% to 200% markup on top of their salary after taking into account hiring costs, training, healthcare, unemployment compensation, Social Security, Medicare, retirement, vacation and sick days, and pro-rated overhead, such as a manager’s salary and building space/equipment, along with all other benefits. So, a job that pays a salary of $100,000 a year will cost the company $150,000 to $300,000 when all these additional factors are taken into account.
Next, ask yourself what return the firm expects to get on any capital investment they make, whether in new equipment or new products. The minimum requirement is usually the current Treasury Bill rate or the current cost of capital, such as the prime interest rate. In other words, they need to get at least the same return they would get from investing the sum they plan to spend on an employee in the safety of government treasury bills. It makes sense: why invest in anything riskier if you cannot get a better return?
However, most firms will tell you that they need to make at least as much as the average return for their industry. Some will say that they need the return that will keep their stock attractive in the marketplace, i. e., the rate that will keep investors willing to push up the value of their stock.
Let's say that our $100K employee’s full cost is $300,000 (including all expenses) and that the company needs a 15% return on every investment that it makes. This employee, then, needs to create $345,000 ($300K + $45,000) for the company to get the return it expects on her job. If every employee does this, then the company should earn its overall 15% return target on its employee investment.
This amount gives us a benchmark against which we can measure the value-added outcomes the employee produces and how to compensate (or de-compensate) her. If she misses this target, she should be de-compensated proportionately and you should consider her potential to meet/exceed the target in the future. If you think she can, then you might increase your investment in her by sending her to more training or provide her a mentor. If you think she can’t deliver future value, then it’s time to end her employment.
On the other hand, if she exceeds her target, she should share in the extra value that she creates. How you split the overage says a lot about what kind of company you are, what your reward philosophy is, and what kind of employees you want to attract/retain.
In my experience, this is when companies get cold feet. They don't want to share much for the extra value produced by their star performers. In their defense, they will say that the company created the environment and provided all the tools, colleagues, and contacts in which the star performer could produce high value-added outcomes. Or, the company takes on all the risk that companies face, such as lawsuits or potential bankruptcy, and it must get a return on that risk-taking. Similarly, the company assumes the risk that some of its employees will get paid but not produce the expected value. Consequently, the company in effect has to “tax” the star performers to create a risk pool that will cover all the costs of the lower performers. If company founders are running the company, they will say that they put in all the hard work, endured the lean years, and shouldered the risk of failure, and so they should get a recurring annuity for all that went before. These are all valid arguments.
But from the employee's perspective, they look at the value of what is produced above and beyond their targets. They feel that they should benefit in monetary terms in some proportion. If our example employee’s target is $345,000 in value, yet she produces $1,000,000 in value for the company, she might reasonably want to share in that $655,000 excess in some substantial degree. Remember our earlier example of LeBron James and the value he created for the owners of the Miami Heat. These, too, are valid arguments.
My advice is the same as what Felix Dennis gave to Tom Hodgkinson, the magazine and bookstore owner profiled in an earlier Lesson: “Pay the Talent.”
The company needs to ask both what they think is fair and what they think they need in order to keep their star performers. Employees should do the equivalent. Then the two sides can come together and negotiate what is mutually satisfactory and beneficial. Perhaps the company’s claim of taking on greater risk and providing the right environment is compelling to the employee. Plus, she may be a relatively unknown quantity, and thus may be willing to opt for a 90%-10% split in the company’s favor during the first year. However, in subsequent years, it will be in both the company’s and her interests to give her a greater split as she exceeds her targets. This increase incentivizes her to produce greater bottom-line outcomes for the company since she has more to gain. It might even get to the point where she gets half (or more) of the split.
Oprah Winfrey did just that. Her first TV talk show in Baltimore failed to take hold in other markets. When she created a new show based in Chicago produced by WLS-TV, the local ABC affiliate, she gave them the rights to syndicate it nationally, hoping it would do better than the Baltimore show. It quickly became the most popular talk show in Chicago. Her agent negotiated a salary of $230,000 per year with a yearly $30,000 jump over the next four years. ABC thought that the agent had negotiated a good deal for Oprah.
Oprah didn’t think so. She sacked her agent in favor of a new one who would help transform her from a well paid employee into an ownership capitalist. She figured that she was earning huge profits for ABC, and she wanted a cut of that action. She negotiated back the right to syndicate her show, and brought in King World Productions as the distributor. The syndicated show brought in $115 in revenue million in its first two seasons. She went back to the negotiating table and fought to get back ownership of the show from the local ABC affiliate. By doing so, she eventually made over $70 million in profit each year.
Why did ABC agree to all this? The reason is simple. Oprah had a loyal following who tuned in every day, and the advertisers wanted that market segment. As importantly, those viewers stayed tuned to the same ABC station for the evening news. The news programs that followed Oprah took the top spot in those markets. In big markets like Chicago or Houston, one rating point translates into a $1 million. This is why local stations would pay Oprah about $100,000 per week to air in on their channels
Similarly, she extracted a bigger share of the show’s profits from King World Productions. Winfrey was so important to King World that, when the Wall Street Journal printed a rumor that she might cut ties with King World, its stock price took a big hit. King World reduced its cut of the shows revenues from 35% to under 30% in order to keep Oprah. In addition, each year she renews with them, she gets 250,000 stock options in King World to add to the 1.5 million she already owns. Those options are worth north of $30 million.
Oprah could have a stayed a very well paid employee. But, she recognized the value added outcomes that she created. She was willing to trade the security of a salary in order to share in the upside she created, becoming the first black woman billionaire in 2003.
Now, you might be thinking that you are no Oprah or LeBron, or if you own the business, you have no Oprahs or LeBrons. But do you believe enough in the value you create or that your star performers create that you are willing to “pay the talent”?
Critical Path Action Items
What is the baseline you need to provide to your company to cover the cost of your employment?
How much more would you like to earn for any outsized contributions?
As an owner or manager, how much more would you pay a star performer who makes outsized contributions?