Bonus and Incentive Plans: Designing Variable Compensation

Variable compensation—bonuses, incentives, profit sharing—creates a direct link between performance and rewards. When employees see that results matter, they focus on what drives those results. For context on what business owners pay themselves (including bonuses), see our owner compensation benchmarks.

This guide covers how to design bonus programs that motivate the right behaviors, are financially sustainable, and are perceived as fair by participants.

Types of Bonus Plans

Company Performance Bonus

All eligible employees receive a bonus based on overall company performance.

• Pros: Simple, promotes teamwork, aligns everyone with company goals
• Cons: Individual contribution not differentiated, high performers may feel undervalued
• Best for: Companies wanting to emphasize collective success

Individual Performance Bonus

Bonuses based on individual goal achievement (MBOs).

• Pros: Recognizes individual contribution, motivates personal performance
• Cons: Can reduce collaboration, requires robust goal-setting process
• Best for: Roles with clearly measurable individual impact

Hybrid (Company + Individual)

Bonus determined by both company and individual performance.

• Pros: Balances company alignment with individual recognition
• Cons: More complex to administer and communicate
• Best for: Most companies—provides balance

Profit Sharing

Distributes a percentage of company profits to employees.

• Pros: Self-funding, aligns everyone with profitability
• Cons: Unpredictable, less motivating when profits are volatile
• Best for: Profitable companies wanting to share success broadly

Setting Bonus Targets

Target bonus is the expected payout when both company and individual goals are met at target levels.

Typical Target Bonus by Level

Upside and Downside

Bonus plans typically have:

• Threshold: Minimum performance required to earn any bonus (often 80% of target)
• Target: Payout when goals are met (100%)
• Maximum: Cap on bonus payout (often 150-200% of target)

Example: 20% target bonus with 0% at threshold (80% achievement), 20% at target, and 40% at maximum (150% achievement).

Selecting Bonus Metrics

The metrics you choose determine what employees focus on. Choose carefully.

Company Performance Metrics

• Revenue: Simple, growth-focused
• EBITDA: Balances growth with profitability
• Operating income: After all operating expenses
• ARR/Bookings: For SaaS companies
• Customer metrics: NPS, retention, satisfaction

Individual Performance Metrics (MBOs)

Good individual goals are:

• Specific: Clear what needs to be accomplished
• Measurable: Objective criteria for success
• Achievable: Challenging but realistic
• Relevant: Aligned with company objectives
• Time-bound: Clear deadline or measurement period

Bonus Pool Funding

How do you determine the total bonus dollars available?

Funding Approaches

• Target-based: Sum of all individual target bonuses, adjusted for company performance
• Percentage of profit: Fixed percentage of operating income or EBITDA
• Discretionary: Board/management determines pool after results known
• Formula-based: Predefined formula based on financial results

Example: Target-Based Funding

Company Performance Multiplier

The company performance multiplier adjusts the pool based on overall results:

Allocating to Individuals

Once the pool is funded, how do you distribute to individuals?

Hybrid Formula Example

Example: $100,000 salary × 20% target × 1.1 company × 1.05 individual = $23,100 bonus

Individual Performance Ratings

Convert performance reviews to bonus multipliers:

Timing and Communication

Payout Timing

• Annual bonus: Paid after year-end close (typically Q1)
• Quarterly bonus: Paid within 30-45 days after quarter end
• Project/milestone: Paid upon achievement

Communication Best Practices

• Beginning of period: Communicate plan structure, targets, and how bonuses work
• During period: Share progress toward company goals
• End of period: Communicate results and individual calculations
• Manager training: Equip managers to explain bonuses to their teams

Documentation

Create clear plan documents that specify:

• Eligibility requirements
• Target bonus percentages by level
• Metrics and weightings
• Calculation methodology
• Payout timing and proration rules
• Clawback provisions if applicable

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