No Rules Rules

by Reed Hastings

  If you’re like many managers, you’d choose option 2. Why put all that money into salary when you could use it to give the new recruit an incentive to do his best work?

  Pay-per-performance bonuses seem to make a lot of sense. Part of an employee’s pay is guaranteed and part of it (usually 2 to 15 percent but up to 60 or even 80 percent for senior executives) is linked to performance. If you bring a lot of value to the company, you get your bonus. If you miss your goals, you don’t get paid. What could be more logical? Performance-related bonuses are almost universally deployed in the US, and frequently elsewhere.

  But Netflix doesn’t use them.

  BONUSES ARE BAD FOR FLEXIBILITY

  In 2003, we learned that bonuses are bad for business at about the same time that I came across the rock-star principle. Patty McCord and I were preparing for a weekly management team meeting. On the agenda was a new bonus structure for the executive team. We were excited to be a grown-up company and we wanted to offer our senior managers at Netflix the kind of packages they’d get elsewhere.

  We spent hours coming up with the right performance objectives and trying to link them to pay. Patty suggested we link the bonus of our chief marketing officer, Leslie Kilgore, to the number of new customers we signed on. Before Netflix, Leslie had worked for Booz Allen Hamilton, Amazon, and Procter & Gamble. Her compensation at all these places was metric oriented, with compensation tied to achieving predefined objectives. So she seemed a good person to start with. We wrote down Key Performance Indicators (KPIs) to calculate how much extra Leslie should make if she achieved her goals.

  At the meeting I congratulated Leslie on the thousands of new customers we’d recently signed on. I was about to announce how this would bring her a huge bonus if she continued like that, when she interrupted me. “Yes, Reed, it’s remarkable. My team has done an incredible job. But the number of customers we sign on is no longer what we should be measuring. In fact, it’s irrelevant.” She went on to show us numerically that, while new customers had been the most important goal last quarter, it was now the customer retention rate that really mattered. As I listened, I felt a wave of relief. Thankfully, I hadn’t already tied Leslie’s bonus to the wrong measure of success.

  I learned from that exchange with Leslie that the entire bonus system is based on the premise that you can reliably predict the future, and that you can set an objective at any given moment that will continue to be important down the road. But at Netflix, where we have to be able to adapt direction quickly in response to rapid changes, the last thing we want is our employees rewarded in December for attaining some goal fixed the previous January. The risk is that employees will focus on a target instead of spot what’s best for the company in the present moment.

  Many of our Hollywood-based employees come from studios like WarnerMedia or NBC, where a big part of executive compensation is based on specific financial performance metrics. If this year the target is to increase operating profit by 5 percent, the way to get your bonus—often a quarter of annual pay—is to focus doggedly on increasing operational profit. But what if, in order to be competitive five years down the line, a division needs to change course? Changing course involves investment and risk that may reduce this year’s profit margin. The stock price might go down with it. What executive would do that? That’s why a company like WarnerMedia or NBC may not be able to change dramatically with the times, the way we’ve often done at Netflix.

  Beyond that, I don’t buy the idea that if you dangle cash in front of your high-performing employees, they try harder. High performers naturally want to succeed and will devote all resources toward doing so whether they have a bonus hanging in front of their nose or not. I love this quote from former chief executive of Deutsche Bank John Cryan: “I have no idea why I was offered a contract with a bonus in it because I promise you I will not work any harder or any less hard in any year, in any day because someone is going to pay me more or less.” Any executive worth her paycheck would say the same.

  * * *

  • • •

  Research confirms Reed’s hunch. Contingent pay works for routine tasks but actually decreases performance for creative work. Duke University professor Dan Ariely describes what he found in a fascinating study that he wrote in 2008:

  We presented eighty-seven participants with an array of tasks that demanded attention, memory, concentration, and creativity. We asked them, for instance, to fit pieces of metal puzzle into a plastic frame, and to throw tennis balls at a target. We promised them payment if they performed the tasks exceptionally well. About a third of the subjects were told they’d be given a small bonus, another third a medium-level bonus, and the last third could earn a high bonus based on how well they performed.

  We did this first study in India, where the cost of living is low, so we could pay people amounts substantial to them but within our budget. The lowest bonus was 50 cents—equivalent to what participants could receive for a day’s work. The highest bonus was $50, five months’ pay.

  The results were unexpected. The people offered medium bonuses performed no better, or worse, than those offered low bonuses. But what was most interesting was that the group offered the biggest bonus did worse than the other two groups across all the tasks.

  We replicated these results in a study at the Massachusetts Institute of Technology, where undergraduate students were offered the chance to earn a high bonus ($600) or a lower one ($60) by performing one task that called for some cognitive skill (adding numbers) and another one that required only a mechanical skill (tapping a key as fast as possible). We found that as long as the task involved only mechanical skill, bonuses worked as would be expected: the higher the pay, the better the performance. But when we included a task that required even rudimentary cognitive skill, the outcome was the same as in the India study: the offer of a higher bonus led to poorer performance.

  This finding makes perfect sense. Creative work requires that your mind feel a level of freedom. If part of what you focus on is whether or not your performance will get you that big check, you are not in that open cognitive space where the best ideas and most innovative possibilities reside. You do worse.

  * * *

  • • •

  I’ve certainly found this to be true at Netflix. People are most creative when they have a big enough salary to remove some of the stress from home. But people are less creative when they don’t know whether or not they’ll get paid extra. Big salaries, not merit bonuses, are good for innovation.

  The big surprise when we decided not to pay bonuses on top of salary was how much more top talent we were able to attract. Many imagine you lose your competitive edge if you don’t offer a bonus. We have found the contrary: we gain a competitive edge in attracting the best because we just put all that money into salary.

  Imagine you were looking for work and received two job offers. One place offered you $200,000 plus a 15 percent bonus and another offered you $230,000. Which would you choose? Of course, you’ll choose the bird in the hand over the bird in the bush: $230,000. You know your compensation up front—no games.

  By avoiding pay-per-performance bonuses you can offer higher base salaries and retain your highly motivated employees. All this increases talent density. But nothing increases talent density more than paying people high salaries and increasing them over time to assure they remain top of market.

  PAY HIGHER SALARIES THAN ANYONE ELSE WOULD

  Shortly after committing to pay whatever was necessary to hire and retain the best employees, Han, a director of engineering, came to me and said that he’d found an amazing candidate for an open position. This candidate, Devin, had a rare skill set that would be an enormous asset to the team. But the salary he was requesting was nearly double what the other programmers on the team were getting. It was even more than Han was making. “I know he’d be great for Netflix, but is it right to pay that much?” Han wondered.
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  I asked Han three questions:

  Were any of the programmers on his current team good enough to take the job at Apple that Devin had just left? No.

  Would three of Han’s current employees collectively be able to make the same contribution that Devin could make? No.

  If a fairy godmother suggested he could silently and without duress swap a few of his current programmers for Devin, would that be good for the company? Yes.

  I suggested that Han could easily afford to hire Devin. We would hire a fewer number of programmers in the future and use that money to pay Devin what he was asking for. Han looked thoughtful. “Devin’s skills are in really hot demand right now. If we are going to change our hiring strategy to pay Devin, I want to make sure we pay him enough not just to convince him to take the job, but to assure he isn’t soon lured away by another higher-paying competitor.”

  We decided to scour the market to find out how much our competitors would be willing to pay for Devin’s talents. Then we would pay him just over the very top of that range.

  Devin’s team went on to create many of the foundational features that make up the Netflix platform today. I wanted all of our employees to be as influential as Devin had been, so we decided to apply the same method to determine the salaries of all future new hires.

  PAY TOP-OF-PERSONAL-MARKET SALARIES

  At most companies, negotiating a salary is like buying a used car. You want the job, but you don’t know the maximum the company is willing to compensate, so you try to guess what to ask for and what to accept. The company uses your ignorance to hire you at the lowest salary possible. This is a great way to get an employee for less than she’s worth, only to have her spirited away to another company at a higher price point a few months later.

  Following this logic, the book Negotiating Your Salary: How to Make $1000 a Minute by Jack Chapman recommends the best way to get a good deal with a new employer:

  HIRING MANAGER: We’ve squeezed our budget and found we can offer you a salary of $95,000 a year! We’re excited and hope you are too!

  YOU: (Stay silent. Sing a song in your head. Count the spots on the rug. Roll your tongue over your braces.)

  HIRING MANAGER: (now nervous) We may be able to go up to $110,000 however. That will be a big stretch but we hope you will accept.

  YOU: (continue to sing silently to yourself)

  Netflix, on the other hand, wants to pay what will attract and keep talent, so their conversation with employees is focused on making it clear that (a) they estimate well what their prospective employee could make at any other company and (b) they’ll be paying just above that.

  Take the experience of Mike Hastings (no relation to Reed). If you go to the Netflix website, you might wonder why the film Okja is recommended for you. It’s because every show and movie on Netflix has been tagged into a group of categories. Okja is categorized as Fight the System, Cerebral, Visually Striking, and Offbeat. If you watch other Cerebral, Fight the System movies, Okja will pop up for you. Mike’s one of the people who makes this possible.

  Mike was working in Ann Arbor, Michigan, for Allmovie.com when he got an interview to join the Netflix team that does the tagging. He was keen to move to Silicon Valley, “but the cost of living is so high in California, I didn’t know how much money to ask for.” So he read some books on salary negotiations and talked to a few friends. All of them recommended he keep any precise information close to the chest. “You’ll probably undervalue yourself, and Netflix will try to take advantage of that,” one friend said. With a regional salary converter, Mike determined that, if he got cornered, he’d ask for double what he was currently making, “which seemed like a lot.”

  He rehearsed how he would politely dodge all salary questions, “but during the interview I told the recruiter what I was making and what I was hoping to make and then kicked myself all the way back to Michigan for being so stupid.” Mike was lying on his bed in Ann Arbor, staring at his favorite Hitchcock poster, when the Netflix recruiter called. “They offered thirty percent more than the hundred percent salary increase I’d asked for! I must have gasped because my boss-to-be clarified, ‘That’s top of market for your job and skill set here.’”

  STAYING ON TOP

  At first, a new hire will feel motivated by his top-of-the-range salary. But soon his skills will grow and competitors will start calling to offer higher salaries. If he is worth his salt, his market value is going to rise, and the risk that he’ll move will grow. So it’s paradoxical that when it comes to adjusting salaries, just about every company on earth follows a system that’s likely to decrease talent density by encouraging people to find a job elsewhere. Here’s an email from PR Director João describing the problem he had at his previous employer:

  Before Netflix I worked for an American advertising agency in São Paulo and I loved it. This was my first job out of college and I gave every ounce of myself. Sometimes I slept on the floor of the copy room in the office to not lose work minutes in commute. I was incredibly lucky signing four huge clients and within twelve months I was bringing in more business than those who had been at the company for many years before me. I was so excited to build my career at this company I loved. I knew my senior colleagues had great salaries—double, even triple mine and I trusted at annual salary review time I’d get a big raise bumping me up closer to my contribution level.

  End of year, I had my first performance review and received overwhelmingly positive feedback (98/100) and the company was boasting their most profitable year to date. I wasn’t expecting my salary would double, but my boss promised he’d take care of me. In the back of my mind I expected a ten percent to fifteen percent raise.

  The day of the raise meeting I was so excited I sang with the radio all the way to work. Imagine my disappointment when my boss offered me a five percent raise. To tell the truth I nearly started crying. The worst part was the way my manager conveyed it, with an enthusiastic “congratulations!” and saying this is the best raise he was giving this year. I responded shouting inside my head “Do you think I’m stupid?”

  After that, my relationship with my boss plummeted. I kept lobbying for a bigger raise. My boss wailed that he didn’t want to lose me and raised the five percent increase to seven percent. Beyond that he said my expectations were “unreasonable” and “naive” and that no company gives annual raises bigger than that. That’s when I started looking for another job.

  João was extremely valuable to his company. His boss hired him at a salary that motivated him. But in just one year João’s own growing accomplishments made him infinitely more valuable to his employer and attractive to competitors. Why would his employer offer him a raise that so clearly failed to match his market worth?

  The answer to this question is that when it comes to review time, instead of looking at what that employee is worth on the market, most companies use “raise pools” and “salary bands” to determine raises. Imagine that Santa has eight elves each currently paid $50,000, and every year on December 26 he increases their salaries. He and Mrs. Claus put aside a big pot of money for raises, let’s say 3 percent of total salary costs (between 2 percent and 5 percent is standard for American companies). Three percent of $400,000 = $12,000.

  The Clauses must now decide how to divide it up. Sugarplum Mary is their top performer, so they want to give her a 6 percent raise—leaving $9,000 to distribute among her colleagues. But she insists she’ll leave if she doesn’t get a 15 percent raise, which reduces the pool to just $4,500 for seven other elves, all with large families of elf mouths to feed. Santa has to punish all his other little helpers to pay Sugarplum her market worth. This is likely what happened to João. Assuming his boss had a 3 percent raise pool, that 5 percent he offered was already extremely generous. Going up to 7 percent meant the rest of the team really had to suffer. Paying João the 15 percent higher salary he could get on the open marke
t? Impossible!

  Salary bands create a similar problem. Let’s say at Santa’s workshop the salary band for an elf is $50,000 to $60,000. Sugarplum is hired at $50,000, and the first three years Santa raises her salary 5 to 6 percent, to $53,000, then $56,000, then $58,800. But by year four, although Sugarplum is now more experienced and high performing than ever, she can only get a 2 percent raise. She’s at the top of her band! Time to look for a new workshop, Sugarplum.

  Research confirms what João and Sugarplum already suspected. You’ll get more money if you change companies than if you stay put. In 2018, the average annual pay raise per employee in the US was about 3 percent (5 percent for top performers). For an employee quitting her job and joining a new company, the average raise was between 10 percent and 20 percent. Staying in the same job is bad for your pocketbook.

  Here’s what happened to João:

  Netflix hired me at nearly triple my salary and I moved to Hollywood. Nine months later salary adjustments were the last thing on my mind. I went for my weekly walking meeting with my boss Matias around the big block of the Netflix Hollywood building. Partway around the block there is a big dim sum dumpling with blue eyes and a red tongue painted on the wall of a restaurant. At that spot, Matias mentioned that he was going to give me a twenty-three percent raise in order to keep my salary at top-of-market rate. I was so shocked I had to sit down next to the dim sum.

  I continued to have lots of success and felt I was very well paid. A year later, at annual salary review time, I wondered if I’d get another enormous raise. Matias surprised me again. This time he said, “Your performance has been excellent, and I’m delighted to have you on this team. The market for your position hasn’t changed much, so I’m not planning on giving you a raise this year.” That seemed fair to me. Matias said if I didn’t think so, I should come to him with some data showing the current market for my position.