How to Create a Compensation Philosophy

Creating a cohesive Compensation Philosophy is one of the most important things that the leadership team can do as they work to create the culture of the company.  Developing a compensation philosophy is similar to defining your company’s core values; it outlines your beliefs about pay, equity and benefit plans.  Just as your core values dictate the business decisions you make as a company, your compensation philosophy explains the rules of the road – and the “why” – regarding compensation.

A compensation philosophy need not be a complex, lengthy document.  In fact, a well-written compensation philosophy can fit onto a single page.  I recommend that your compensation philosophy contain the following key sections; I’ve included some questions that can serve as a framework:

Management Priorities

  • What financial outcomes should be optimized in order for the company to maximize shareholder value?  (Revenue growth?  Gross margin expansion?  EBITDA?  Which of these are the most important?)
  • Why does the management team believe that these priorities are the most important ones?

Components of Compensation

  • What are the individual components of the company’s compensation structure?  Examples include base salary, commissions, performance bonus, stock options/grants, 401(k) matching, and employee stock ownership plans (ESOPs).
  • What is the role of base salary?  Is base salary intended to pay people full value for the work performed?  If not, why?
  • What is the role of performance bonuses?  Should employees expect to be paid their bonus if the company makes its budget, or does the company need to exceed budget in order to fund the bonus pool?  Why does the company do it this way? Do you pay bonuses quarterly or annually?  Why?
  • Will employees and/or management have the opportunity to earn stock options or grants?  What’s the reasoning behind that answer?

Pay Practices

  • Where do we want to fit regarding compensation in our industry and market?  Bottom quartile? Industry average?  Top quartile?
  • Do we set firm pay ranges for positions?  Are we willing to make exceptions for candidates when necessary, even though it might cause wage disparity within a team?
  • What’s our take on matching offers made to existing employees?  Do we believe in paying up to keep good people if they resign for a “better offer”?
  • What role do benefits (health, 401(k), etc) play in our overall compensation package? Do we want our benefits plan to be below market, at market, or above market?  Why?

When you’ve completed this exercise, you’ll have a working outline for how your company approaches compensation.  It will serve you well as your company grows; hundreds of situations will inevitably crop up around pay and performance, and your compensation philosophy will serve as a guiding light as your team works out an answer.