True business success is driven by a powerful combination of innovation and purpose. New ideas, methods and processes are directed to creating new sources of value. And as executive compensation practitioners, we’re often asked how we design our reward programs to incentivize innovation.
The answer depends on the type of innovation. Clayton Christensen’s classic theory on disruptive innovation, first suggested in his 1997 book Innovator’s Dilemma, makes two important observations that may help us understand how purpose really shapes how organizations innovate.
- First, the book draws an important distinction between sustaining and disruptive innovation. While the former focuses on performance and margin improvements based on leading customers’ demands, the latter gains market share from redefining what different segments of customers need, often by targeting or opening up new customer segments.
- Second, the theory hypothesized why large market incumbents tend to win in sustaining innovation, while new market entrants are better positioned to win in disruptive innovation.
The differences between sustaining and disruptive innovation are primarily driven by resources allocation and its process. What makes large market incumbents successful — their perfection of attributes for their largest, most profitable customers — also makes them vulnerable to new disruptors. Incumbents are effectively prevented from targeting or opening up new customer segments with needs that may be very different from the largest current buyers.
Once we’ve acknowledged the fundamental difference between sustaining and disruptive innovation, we can begin to answer our often posed question on how incentives can motivate innovation. If marginal improvements on existing offerings to current customer segments for higher margins (i.e., sustaining innovation) are desired, the conventional wisdom on pay-for-performance still holds true (e.g., providing competitive pay, choosing the right performance metrics, setting the right goals, and obtaining the right mix of fixed and variable pay). For companies driving sustaining innovation, pay models are largely competitive-driven. There tends to be a lot of emphasis on competitive pressure when making pay decisions and setting performance goals.
Disruptive innovation, on the other hand, would be hampered when an organization adopts a conventional pay-for-performance model. When new business ventures are set up as independent subsidiaries, the definition of performance needs to be different from the parent company because of the fundamental differences in the business model and target market. The outcome is often highly uncertain, and a disruptive product or service may require many rounds of refinement until they’re commercially viable. And for these reasons, we argue that pay design for disruptive innovation should be value-based, meaning that pay level and design should have a direct linkage to the value created, rather than being driven by competitive practices.
Anecdotal evidence of our assertion is the rise of independent subsidiaries, with their executive compensation plan payouts tied to the business’ appreciated value rather than conventional financial metrics like revenue growth and profitability. These ventures also tend to have a greater long-term focus and adopt a more aggressive risk-reward profile in their pay programs compared to the parent companies.
The likelihood of a very high upside potential is one concern we often come across during our conversations about implementing a value-based pay model. But when designed correctly, there should be a symmetrical downside risk with the upside only achievable when significant value is created for the investor (often the parent company). The tie-in to value creation serves as an effective gatekeeper to keep pay levels within reasonable boundaries. A value-based model is most effective when applied to a broad-based population and shouldn’t be seen as a means to inflate executive pay levels. After all, it takes a team to pull off disruptive innovation.
If the essence of innovation is to challenge the status quo when creating value for the business, then it makes total sense to challenge the norm when we think about executive compensation. To think in this new way, we still need to answer a lot of questions about how to measure value creation and the appropriate value distribution across roles at various levels of an organization. Thought must also be given to how to determine the appropriate risk-reward profile for a business and whether it will vary by role. How would such a model be governed? We will explore these issues more thoroughly in the near future.
Kenneth Kuk, a director, and Chris Hamilton, a senior director, in the Executive Compensation practice, are both based in Arlington, VA. Paul Platten is a managing director in the Rewards practice, and is based in Boston, MA. Email Kenneth.Kuk@willistowerswatson.com, Paul.Platten@willistowerswatson.com,
Chris.Hamilton@willistowerswatson.com or email@example.com.