Incentive pay can be a good way to recognise and encourage employees, motivating them to work better for your business. A badly thought-out scheme, on the other hand, can be divisive and demoralising.

You need to think carefully about the best kind of incentive to use and how to introduce the changes.

Setting objectives

Design your incentive pay scheme to achieve specific objectives. Your targets should be 'SMART' (specific, measurable, achievable, realistic, and time-limited).

Decide what business results you want to achieve. For example, you might want to hit a certain sales target during a sales campaign for a new product or encourage specific improvements in customer service. Targets should be challenging - but not impossible - to achieve. Aim for a marked improvement in performance. You need to be confident that the benefits of the scheme will outweigh its costs.

Decide which employees should take part. For example:

• a specific group of employees, such as the sales team, whose work directly influences the result you are aiming for;
• the management team, so you can retain the key individuals your business needs;
• all employees, to raise general productivity and morale in the business.

If you only reward one group of employees, there is a danger of alienating the rest, or being accused of discrimination.

Decide how long the scheme should run. If you want to concentrate on one particular result, limit the time. For example, until a backlog of orders is cleared. Consider adopting a scheme as a permanent part of your business' culture. Incentives will often become less effective over time. Change the scheme according to circumstances.

Using cash

Cash is always popular with employees. It is the most widely used form of incentive payment. But it has some disadvantages, too.

Incentives to increase sales almost always take the form of commission

• Commission is generally set as a flat percentage of sales.
• The rate of commission depends on the selling price and the degree of effort involved in making the sale. It could range from 5%, where the item sells readily, to 30% or more where the effort required is substantial.
• High-performing sales people may be able to earn huge amounts under this system. Very high earnings may cause resentment if the sales depend on a team effort.
• Guard against sales people cutting corners to clinch sales.
• Time the payments to ensure that staff can always see another payout coming.
• It is difficult to curb an over-generous commission agreement later, without upsetting and demoralising staff. Start by offering basic pay plus a moderate rate of commission. If business justifies it, you can raise the rate later.

For production employees, an element of piece work pay is the equivalent

• Payment is directly related to production. If nothing is produced, nothing is paid.
• Pressure to produce and earn more may lead to a decline in standards. Link quality standards to the production targets.

One-off improvements can be encouraged with bonuses

• These can be used in non-sales areas - for example, production or support.
• Bonuses can be offered on either a team or an individual basis.
• Unless there is a clear-cut benefit to the company, the bonus is just another cost.
• Bonuses are often paid out of 'gainsharing' cost savings. With gainsharing, any gains made from cost reductions - for example, a cut in hours worked for the same level of production - are shared with employees.
• Audit improvements in productivity carefully. Things may not be as they seem.
• With team bonuses, make sure that all team members are contributing. One freeloading individual can demoralise the whole team.

Continuous improvement can be encouraged with performance-related pay

• You must set demanding but realistic goals for each employee or team.
• Provide feedback on progress towards these goals at intervals during the year.
• Determine the pay increases by the progress made.
• Use objective measurements, or you risk accusations of favouritism.

For the incentive to work, the after-tax amount must be reasonable. Employees are unlikely to respond positively to anything less than an extra 10% in their take-home pay. Tax and National Insurance contributions (NICs) have to be paid on any cash payments to employees.

Using shares

Offering shares in your business is more complicated than offering cash. But share schemes can be much more effective in linking the interests of the business and the employees, as well as encouraging long-term commitment. Grants of shares through approved schemes will generally be free of tax and NICs.

Offer key employees the chance to participate in a Company Share Option Plan

• You give senior executives or selected employees the right to buy shares at their current price, at a later date.
• If the shares increase in value in the meantime, they will make an immediate profit when they exercise their options.
• Each employee may hold options on shares worth up to £30,000.
• The option can be exercised after three years, but not later than ten years.
• Employees who own 30% or more of the company's shares cannot participate.
• No income tax will have to be paid when the option is granted or exercised.

Offer share options to employees through the Enterprise Management Incentive scheme

• You must be a small company (gross assets not exceeding £30 million). Companies can seek advance assurance from HM Revenue & Customs (HMRC) that they meet the scheme's requirements.
• All employees can take part in this scheme, if the employer so chooses.
• The total value of shares under option must not exceed £3 million.
• The employees must spend substantial time working for the company. This means at least 25 hours a week or 75% of working time.
• Provided the options are exercised within ten years and at the market price when they were granted, employees do not pay income tax or NICs.
• The value of the shares under option must be agreed with HMRC when the grant is made.

Consider setting up a Sharesave (or Save as You Earn) scheme

• All employees must be able to take part on similar terms.
• All members get the right - but not the obligation - to buy a number of shares, normally at a discount to their current price, after three or five years.
• They save a regular amount with a bank or building society in the meantime, to pay for the shares. They can save from £5 to £500 per month.
• If the shares rise in value, employees have a profit when they buy shares. If the shares fall in value, they ignore the option and take the savings instead.
• No income tax is payable on the grant or exercise of the option, or on the interest.

Many companies set up non-approved share schemes

• These are usually reserved for executives, senior managers and other key employees.
• There are no limits on the amounts that can be granted under such schemes.
• Employees who receive benefits generally have to pay income tax on the full amount.
• Conditions are normally imposed. The idea is to ensure that the rest of the shareholders benefit as well.

Capital Gains Tax (CGT) may be payable on gains made from holding shares

• For example, if you exercise an option to buy shares and choose not to sell then until later.
• In the longer term, shares have been a much better investment than cash. But they can fall as well as rise, for reasons outside your control.
• Any gains may be subject to capital gains tax (CGT), if they exceed the individual's annual exempt amount (£11,300 in 2017/18).
• Higher-rate income tax payers are liable to pay CGT at 20%. For those paying the lower income tax rate, CGT is charged at a flat rate of 10%.
• In some circumstances, shares may qualify for Entrepreneur's Relief. This reduces the rate to 10% on the first £10 million of qualifying gains.
• Consider taking professional advice on the impact CGT may have on any share scheme you offer.

Valuing unquoted shares

Employees who hold shares could make big gains if an unquoted company floats on the stock market, or gets taken over. They are therefore likely to be more committed.

But putting a fair value on unquoted shares is difficult. Different methods will be fair for different types of business. Whichever method you choose, you may have to clear it with HMRC first, if you want to offer your employees an approved share scheme.

• Valuing your business at a multiple of after-tax earnings. Select the multiple by reference to the ratio of price to earnings on quoted companies in the same business, allowing a discount to this ratio if your company is unquoted.
• Valuing your business at a percentage of gross profits. Particularly in a cyclical business, this could produce big swings in value.
• Valuing your business by reference to the asset value. This is difficult to apply to a business where the assets are largely intangible.

Share Incentive Plans

The Share Incentive Plan (SIP) is a tax-advantaged plan which encourages employees to buy shares in their company from pre-tax pay.

• You can give your employees free shares worth up to £3,600 a year. The amount can be linked to performance.
• Employees can allocate up to 10% of pre-tax salary up to a maximum of £1,800 a year to buy shares through the trust tax free.
• You can provide up to two matching shares for each share bought by the employee (up to £3,600 a year).
• Shares are free of tax and NI as long as they are held for a minimum of five years.
• You can require your employees to give up free or matching shares, if they leave within three years.
• SIPs can create a market for the shares in private companies.
• You may receive capital gains tax relief if you sell shares in your own business through a SIP.
• For a small company setting up a Share Incentive Plan, HMRC suggests set-up costs of £5,000 to £15,000, as well as compliance costs.
• The costs of setting up a SIP and any money you pay into it can be set against your company's taxable profits.

Other incentives

Incentives other than cash and shares can give your employees more fun and cause less hassle.

A company car may be necessary to the job. A top-of-the-range model is certainly an incentive to some employees. Company cars can be a big overhead. Be aware that the employee will have a 'benefit in kind' tax charge if they use the company car for private use.

Membership of a health club can be an effective incentive. Set minimum performance requirements that will comfortably pay for it. It can help keep the work force healthy.

Incentive award vouchers are becoming increasingly popular. Whereas cash payments tend to be spent on an employee's monthly outgoings, vouchers are spent on something specific. This visible reward usually acts as a more effective incentive than cash. NICs are payable on non-cash vouchers.

Implementing a scheme

In order for an incentive pay scheme to work, your employees must be fully committed to it.

Explain the reasoning

• A written explanation will answer most questions.
• Agree a strategy and list of objectives.
• Agree the way to measure improvements and calculate incentive pay.
• Discuss specific responsibilities and goals with each employee. Employees should feel that they own the scheme.
• Act quickly to defuse any conflicts between different objectives or between employees.

Continue to manage your employees. Provide regular feedback to help employees achieve their goals. Listen to their suggestions. Agree targets at a regular review.

Analyse the success of your incentive pay scheme regularly. Amend the scheme if it does not work.

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