Crypto Pay Guide - Designing Performance Pay
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May 3rd, 2022

The Crypto Pay Guide is a series of articles that will be authored and released by C3 over the coming weeks. Each article will cover a separate compensation topic, focusing primarily on full-time employees in the web3.

What has the Crypto Pay Guide covered so far?

  1. Objectives & Compensation Risk
  2. Compensation Model
  3. Compensation Process
  4. Compensation Governance
  5. Token Grant Practices & Vesting

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In our last article, we summarized best practices when granting token compensation, such as grant denomination, service timing, vesting, and frequency. In this article, we cover the importance of performance-based pay and the considerations when designing such incentives.

Tokens / Restricted Token Award (RTA)

Before we dive into performance pay, it is important to cover the current state of web3 token incentives. The most common type of incentive is a service-based token which vests over a pre-determined period. Since we will cover many different types of tokens (e.g., performance tokens), C3 will define this type of incentive as a restricted token award (RTA)” based on the universal use of a similar equity incentive type among traditional organizations, the restricted stock award (RSA).

An RTA is the simplest and most common token incentive type, although the least effective at meeting key talent objectives, such as attraction, motivation, and accountability. A RTA is easy to understand from the participant’s perspective and achieves long-term retention. In theory, RTAs should incentivize the participant to grow token price, although, in practice, few participants understand the performance drivers of token price, especially given exogenous market factors that affect return. RTUs also do not provide leverage because no performance goals are set, which limits attraction, accountability, and motivation.

To create a robust incentive plan that achieves all talent objectives, traditional companies utilize other performance incentives, such as annual bonus plans, stock options, or performance shares, which are still uncommon in web3.

Importance of Performance Pay Performance

Performance pay is a critical tool available to communities, investors, and protocols to achieve the following talent objectives:

  1. Retention
  2. Attraction: compensation should have sufficient upside potential for achievement of stretch performance goals, thereby attracting talent seeking wealth opportunities.
  3. Motivation: communities and investors should utilize compensation as a tool to motivate behaviors and indirectly drive token return.
  4. Accountability: performance pay ensures that employees are rewarded when tokenholders are rewarded. This creates a pay-for-performance model that promotes accountability and fits well within the ethos of web3.

There are many types of performance pay incentives to choose from and there are a variety of different ways to structure any one incentive type. Generally, for traditional organizations, there are three types of common performance pay vehicles, each excelling at a different talent objective via their design features.

* May be more effective than restricted stock if performance is strong, and less effective when performance is weak
* May be more effective than restricted stock if performance is strong, and less effective when performance is weak

It is important to note that although restricted stock is variable, it is not performance-based. The value of restricted stock is tied to a company’s stock price, but performance goals are not set such that the ultimate number of shares earned fluctuates (i.e., there is no leverage).

Bonus plans are the most common incentive type among traditional organizations because they are effective at meeting most talent objectives, albeit on a short-term basis, and are simple to understand and administer. Performance shares, although uncommon, are one of the most effective performance pay types. Performance shares are like bonus plans, except denominated in equity and measured over longer periods of time. Equity-denomination provides more leverage, thereby making them more attractive than standard bonus plans. Stock options are prevalent, especially among start-ups, and they achieve a bit more talent objectives than restricted stock, but are quite limited in design, thereby making them less effective than other performance pay alternatives. In future articles we cover these incentives in more detail and summarize how web3 organizations can mimic them with token incentives.

Performance Pay in Web3

There are more tools that make performance pay more feasible (and attractive) for web3 organizations now than ever before, yet it is still rare in practice, likely because of historic precedent:

  • Performance goals were difficult to define and measure. In the early days, web3 organizations were unsure about which performance metrics drove token return. Today, there is greater understanding, structure, and definition around key protocol measures that will drive performance. There are also plenty of third-party tools that measure such goals, thereby ensuring independence measurement.
  • Performance goals were difficult to achieve. Volatile market conditions lead to uncertain performance achievement, which limits the overall effectiveness of performance pay. Volatility makes it difficult to set reasonable performance goals given error in estimation. Volatility is not going away, but it can be managed through thoughtful design (read more below).
  • Undeveloped compensation governance processes have limited the ability to design, approve, and implement performance incentives. Compensation governance is constantly improving, and the prevalence of Compensation Committees and councils is increasing in web3. These entities provide the flexibility to work with outside experts to design performance incentives. After development, the committee can submit the plan for approval to the community. At the end of the cycle, the committee can provide an update on performance tracking and achievement, while also submitting the next plan for approval. This system of accountability ensures that there is sufficient rigor in the performance targets set by the protocol. A protocol should ensure it has an appropriate governance mechanism in-place that allows the community to regularly evaluate performance pay programs.

Looking ahead, we believe the use of performance pay will increase in web3 because it is an important mechanism to align the incentives of contributors with tokenholders, which fits within the ethos of decentralized compensation, and it achieves talent objectives that are otherwise unmet with time-based tokens. Additionally, unlike traditional corporations, web3 organizations can be creative on the design of performance tokens by mixing-and-matching traditional design types . This allows for greater customization.

Performance Token Design Considerations

The list below outlines major features web3 organizations and communities need to consider when designing performance incentives:

  • Payment Type: will the incentives be paid in stablecoins or native tokens? Stablecoins will limit upside and thus the attractiveness, although it will protect the participant from downside risk.

  • Performance Period: what is the time period that performance be measured over? A longer performance period will promote retention, although limit the accuracy in setting reasonable goals given market volatility.

    A performance period is not the same thing as a vesting period. An incentive can have a shorter performance period (e.g., 1 year), but a longer vesting period (e.g., 3 years) to ensure retention following performance achievement.

    To manage market volatility and performance achievement, a protocol can shorten the performance period such that goals are set on a more frequent basis. A shorter performance period limits error when setting goals and ensures performance cycles can be reset frequently.

  • Leverage/Payout Range: how is leverage incorporated within the incentive? Does the participant receive less/more tokens for under/over-achievement of target goals? What is the range of payouts? Communities should ensure that they are not providing “free leverage”. Upside should be earned when stretch goals are met.

    Another way to mitigate volatility is to tweak the performance goal ranges. For example, protocols can set a flat payout around target. Or, set wide threshold and maximum goals to ensure a payout at either end.

  • Metrics: Determining which metric will reward contributors is often the most important consideration because it affects what type of incentive will be used.

    When selecting a performance metric, web3 organizations should make sure it meets the following expectations from the community and the participant:

Ideally an organization achieves all expectations via appropriate metric design:

  • Metric Type: what metric will be used to determine payout? Will the metric be market-based (e.g., token price) or operating-based (e.g., Total Value Locked)?

  • Metric Measurement: will the metric be measured on an absolute basis or on a relative basis?

    By measuring performance relative to similar peers, a protocol can strip away exogenous market factors and focus on value-added performance (more on that in later articles). Of course, this incorporate additional complexity.

  • Goal-Setting: what are the appropriate goals that determine payout at target, below target, and above target?

Finally, it is important to note that performance pay is not for every type of employee. Generally, employees with greater risk profile should have a greater percentage of total pay in performance incentives. As you move down the risk profile, LTI should focus more on retention, and less on performance.

In our next articles we will cover the performance pay types seen among traditional corporations and how similar constructs can be used for web3:

  • Bonus Plans (+Coordinape)
  • Stock Options
  • Absolute Performance Shares
  • Relative Performance Shares

And, then we get creative by idealizing how incentives can be different for web3.

C3 can assist communities, protocol leaders, and investors design appropriate performance tokens.

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The Crypto Pay Guide is a series of articles that will be authored and released by C3 over the coming weeks. C3 is the world’s first Crypto Compensation Consulting group.

We advise crypto organizations and communities on compensation levels, incentive design, and governance practices. We have experience advising both large public corporations and small technology start-ups.

Please read more about our firm and services on our website. If you are a leader, investor, or community member who would like to work with us, please contact us at info@c3.email or via Twitter.

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