The counterintuitive math: Pay MORE cash and LESS equity → employees capture more value, work harder, AND it costs you less. This isn’t theory—it’s 40 years of behavioral economics that most organizations ignore.
A $300K LTIP vesting over five years? Employees perceive it as ~$47K. The company pays $300K but captures only 16% in motivation. That’s 84% leakage or deadweight loss, meaning that value that is being DESTROYED into thin air – and hence LITERALLY “free money” left on the table
Ask yourself: is a 5-year-out payoff or a 20% bonus really going to make someone work till 2am every night, or make those annoying $200 micro-optimizations 1000s of times that add up to millions? The answer is NO—and that’s why most comp plans don’t work.
Why Most Comp Plans Fail
A good comp plan should achieve 3 goals:
- Change employee behaviors in a way that they create more value for the company
- Be implementable (i.e., within constraints like cash flow)
- Be scalable (i.e., should not have significant implementation overhead)
Most plans nail #2 (LTIPs are great for cash flow!) while horribly failing #1, which is the most important value driver. Why? Most leaders misunderstand how humans (even very smart ones) value compensation:
- People discount future payments heavily—typically 33%/year, not the 8% from Econ 101. $100 today = $133 guaranteed in 1 year.
- People discount risky payments by an incremental ~16%/year—hence, risky future comp is discounted ~50%/year total.
- Discounting is hyperbolic—meaning that that 1-year out bonus is heavily penalized.
- Most incentives are too small anyway—a $50K bonus won’t change how hard a $300K CEO works.
These are well-established findings from Kahneman/Tversky (prospect theory), Thaler (mental accounting), and Laibson (hyperbolic discounting). Pepper synthesized them into a practical framework showing how much value traditional comp plans destroy.
What This Looks Like in Practice
Two core problems:
- Incentive comp is only 30-40% of perceived value—too small to change behavior
- Company pays for comp that doesn’t benefit management or motivate behavior—everyone loses
The Fix: A Better Compensation Structure
The solution is simple: shift compensation from deferred equity to immediate cash. Pay a generous base (25-50% above market) to compensate for the lack of LTIP. Then add a large annual cash bonus—75-100% of base for executives—tied to metrics that actually matter. No phantom equity, no complex vesting schedules, no motivation leakage.
Variable comp must be 50-100%+ of base to change behavior—10-20% bonuses don’t matter. And the metrics should be easily calculated from standard financials. Figure 2 shows how this translates by level:
| Level | Base | Variable Comp |
|---|---|---|
| Individual Contributor | Market + 5% | No bonus (or standard commission for sales) |
| Manager | Market + 10% | No bonus |
| Executive | Market + 25% | 80% of base, tied to company metrics |
The logic: ICs and managers get above-market base with no bonus complexity. Executives—whose decisions actually move the needle—get large, immediate cash incentives tied to outcomes they control.
Worked Example: A $10M SaaS Company
The example below uses a SaaS company, but the principles apply to any industry. Swap ARR for revenue, NRR for customer retention, and the math works the same. What matters is the structure, not the specific metrics.
Consider a 50-person company: 40 ICs, 7 managers, 3 executives. Under a conventional plan, executives get $200K base + $75K bonus + $300K LTIP. Under the proposed plan, they get $250K base + $150K cash bonus—no LTIP. Here’s how the numbers shake out:
| Group | Conventional Plan | The Fix | ||||
|---|---|---|---|---|---|---|
| Cash Cost | Total Cost | Perceived Value | Cash Cost | Total Cost | Perceived Value | |
| ICs (40) | $3.44M | $3.44M | $3.36M | $3.36M | $3.36M | $3.36M |
| Managers (7) | $966K | $966K | $925K | $924K | $924K | $924K |
| Executives (3) | $825K | $1.73M | $892K | $1.20M | $1.20M | $1.05M |
| Totals | $5.23M | $6.13M | $5.18M | $5.48M | $5.48M | $5.34M |
| Net Benefit vs. Conventional | — | — | — | +$253K cash | −$647K total | +$159K perceived |
Perceived value math: Base = 100%. Cash bonus = 67% (1-year delay at 33% discount). LTIP = 15.6% (5-year vesting at ~50%/year discount).
The results are striking:
- Total comp cost drops $647K annually. That’s a 6.5% boost to economic EBITDA margin, >$3M in cumulative pre-tax savings over 5 years, and in a levered LBO, an additional 0.5-1x on your cash-on-cash return. In PE terms, you’re turning a 2.5x deal into a 3-3.5x—an average deal into a top-quartile one.
- Executives perceive ~18% more value ($1.05M vs $892K)—they’re genuinely better off. More importantly, this structure is far more likely to achieve “aligned incentives,” i.e., them working nights and weekends to create value rather than coasting to a 5-year transaction and exit.
- Rank-and-file employees are mostly unaffected. Slight base increase, no bonus complexity. Junior employees’ decisions are driven by base salary, not deferred comp—so you’re marginally more competitive in hiring without adding cost.
- Cash outlay increases ~$250K (4.8%). That’s about 2-3% of total costs—a small investment for the upside above.
To summarize: You make a 2-3% investment in cash costs to boost equity returns 0.5-1x through cost savings alone (free money), while better incentivizing management to become relentless value creators (harder to quantify, but likely the bigger win).
For executive bonuses, tie payouts to 3-4 metrics that drive long-term value. In this SaaS example: revenue growth, profitability, customer retention, and business durability. For a manufacturing company, swap in metrics like gross margin, inventory turns, and safety record. The principle is the same: pick auditable metrics that executives can influence and that reflect sustainable value creation.
If It’s So Simple, Why Isn’t Everyone Doing This?
Ignorance: These findings don’t make it into MBA curricula. At HBS, my Organizational Management course spent zero time on behavioral economics. The standard MBA teaches WACC discounting and assumes everyone else discounts the same way.
Status quo bias: “Nobody ever got fired for doing what everyone else does.” Proposing a departure from norms creates career risk—if it fails, you’re the one who pushed the weird comp plan.
Misaligned consultants: Comp consultants get paid to benchmark against peers, not redesign from first principles. Simple frameworks don’t require $500K engagements.
Optics (and habits) trump economics—a personal example
I once proposed to a PE firm: “give management 50% of incremental EBITDA growth.” At 16x EBITDA, each $1 of growth meant 50¢ to management and $16.50 to equity holders—3,300% ROI. They refused. Not because the math didn’t work—it was positive ROI in every scenario. They refused because “high” cash bonuses weren’t what they were used to. Optics beat economics.
The opportunity: This is precisely why getting comp right is a competitive advantage. You can attract better talent at lower cost while competitors stay stuck in the status quo.
Why I Wrote This
It drives me crazy when companies leave free money on the table. I’m not talking about risky investments with uncertain payoffs—I’m talking about value being destroyed through bad structuring. Everyone loses: employees get less, companies pay more, and society suffers capital destruction (less capital to compound).
Some problems require rocket science. Compensation structuring doesn’t.
Foundational Research
Behavioral Economics & Discounting
- Pepper, A. (2021). The Behavioural Economics of Executive Incentives. NHRD Network Journal, 14(2), 186-192.
- Kahneman, D. & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263-292.
- Tversky, A. & Kahneman, D. (1992). Advances in Prospect Theory: Cumulative Representation of Uncertainty. Journal of Risk and Uncertainty, 5(4), 297-323.
- Thaler, R. (1999). Mental Accounting Matters. Journal of Behavioral Decision Making, 12(3), 183-206.
- Laibson, D. (1997). Golden Eggs and Hyperbolic Discounting. Quarterly Journal of Economics, 112(2), 443-478.
- Frederick, S., Loewenstein, G., & O’Donoghue, T. (2002). Time Discounting and Time Preference: A Critical Review. Journal of Economic Literature, 40(2), 351-401.
- Loewenstein, G. & Prelec, D. (1992). Anomalies in Intertemporal Choice: Evidence and an Interpretation. Quarterly Journal of Economics, 107(2), 573-597.
- Samuelson, W. & Zeckhauser, R. (1988). Status Quo Bias in Decision Making. Journal of Risk and Uncertainty, 1(1), 7-59.
Agency Theory & Incentive Design
- Jensen, M. & Meckling, W. (1976). Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics, 3(4), 305-360.
- Holmström, B. (1979). Moral Hazard and Observability. Bell Journal of Economics, 10(1), 74-91.
- Kerr, S. (1975). On the Folly of Rewarding A, While Hoping for B. Academy of Management Journal, 18(4), 769-783.
- Gneezy, U. & Rustichini, A. (2000). Pay Enough or Don’t Pay at All. Quarterly Journal of Economics, 115(3), 791-810.
Executive Compensation Research
- Jensen, M. & Murphy, K. (1990). Performance Pay and Top-Management Incentives. Journal of Political Economy, 98(2), 225-264.
- Hall, B. & Liebman, J. (1998). Are CEOs Really Paid Like Bureaucrats? Quarterly Journal of Economics, 113(3), 653-691.
- Murphy, K. (1999). Executive Compensation. Handbook of Labor Economics, Vol. 3, 2485-2563. Elsevier.
- Bebchuk, L. & Fried, J. (2004). Pay Without Performance: The Unfulfilled Promise of Executive Compensation. Harvard University Press.
- Core, J., Holthausen, R., & Larcker, D. (1999). Corporate Governance, Chief Executive Officer Compensation, and Firm Performance. Journal of Financial Economics, 51(3), 371-406.
Motivation & Organizational Behavior
- Deci, E. (1971). Effects of Externally Mediated Rewards on Intrinsic Motivation. Journal of Personality and Social Psychology, 18(1), 105-115.
- Frey, B. & Jegen, R. (2001). Motivation Crowding Theory. Journal of Economic Surveys, 15(5), 589-611.
- Lazear, E. (2000). Performance Pay and Productivity. American Economic Review, 90(5), 1346-1361.
