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Recognition instead of incentives
To put it in a nutshell: Yes, I strongly belief that performance, particular extraordinary performance, must be recognized and that such recognition is a source of motivation. No, I do not deny that recognition can be monetary. So, how to do it?
Look at total compensation
Decide where your company should be positioned with regard to total compensation. While you cannot avoid market trends entirely, it seems worthwhile to think twice before introducing bonuses schemes just because the others do it or some consultants push it. Try to sell all benefits as a package. Remember: People who go for a highly flexible salary are likely the people who can easily be pinched with a more attractive bonus scheme.
Pay for function
If you hire somebody for a function, expect that person to fulfill it. Expect 100% performance and pay 100%. If somebody does not meet these expectations, make it an issue. Ask for improvement instead of “punishment”, e.g. cutting the bonus.
Clarify expectations, set goals and review performance
People are not “square”. In other words: Nobody fits a job entirely. People have talents, strengths and but also limitations and weaknesses. Supplement job descriptions with clear goals. Assess performance regularly. Do not link the meeting of the goals with a bonus: Remember: You are paying somebody 100% to do the job.
Recognize special efforts
Acknowledge, celebrate (!) and award special efforts immediately. Recognition can be shown with money. But it should never be money only. Show your personal appreciation by thanking the person for the particular effort. Tell the person why you are grateful what he/she did, i.e. what it means to you that it was done.
I suggest to budget a certain amount per annum to recognize special efforts.
Share profits with everybody of total compensation.
Special efforts can be awarded separately (see above).
Offer everybody a stake in the company
Encourage employees to invest in the company, e.g. by offering restricted shares whereby the company pays part of the share price. Request management to hold a certain amount, e.g. one annual salary, in shares. Encourage long-term investment.