Navigating Psychological Contracts in Small Business

February 12, 2024

It’s no secret that employee retention is one of the biggest pain points for small business owners. Companies in the United States lose $1 trillion every year due to turnover. And it’s not just keeping employees that’s problematic – it’s finding them in the first place. Creating a cycle of obtaining great employees and then getting them to stick around seems to be more challenging than ever.

According to the latest jobs report from the National Federation of Independent Business:

  • The majority of small businesses are looking for employees – 55% of them either hired or tried to hire in January
  • 89% of small business owners who are hiring said there were few or even zero qualified applicants
  • Almost 40% of small businesses raised compensation in January; that same number also reported job openings they couldn’t fill last month

What can be done to better these numbers? The solution starts with understanding the psychological contract formed between employers and employees.

What is a psychological contract?

Think about the physical or digital employment contract you may have with some of your employees. It might be a document that’s a few pages long that both of you have signed. When was the last time you or your employees looked at that contract? Probably not since the day it was signed.

A psychological contract, on the other hand, is more of a philosophical concept, but one that has very tangible effects. The contract is the unwritten, often unsaid “rules” that bound an employer and an employee. It encompasses the expectations and perceptions that underlie the relationship. From an employee’s perspective, an example might be the belief that there is a certain level of job security, despite the at-will nature of most U.S. jobs. On the employer’s side, an example might be the belief that an employee will go above and beyond in certain situations, even if that means working extra unpaid hours.

Upholding a psychological contract on both ends leads to a happy, productive workplace. While there is no formula to follow in order to draw up the perfect contract, success mostly comes down to the same things that make a friendship strong: compromise and not letting each other down, both of which are rooted in trust. It shouldn’t be surprising that the same emotional and psychological factors that impact us outside of work also play an important role at work; afterall, we’re all people, regardless of where we are or what we’re doing.

When the contract is breached, employees can feel undervalued and unmotivated, which leads to much of the “quiet quitting” narrative. This of course results in problematic hiring and retention, which is seriously detrimental to company growth.

Upholding and repairing the psychological contract

It’s inevitable that the contract will break at one point or another; the key is upholding it as often as possible, and repairing it quickly. While a psychological contract is a two-way street between small business owners and their employees, owners are in the position of power, making it best practice for them to lead in this regard.

Be transparent

Did you recently do a round of layoffs? Are you skipping promotions and bonuses this year? While these things can be tough to talk about in an open and honest way, it’s important to address them head on with your employees in order to prevent further fraying of the psychological contract you have with them. Explaining why you’ve made certain business choices can go a long way. Employees who feel like they understand the reasoning behind their employer’s decisions are almost 4 times more likely to be engaged at work.

Consider holding quarterly meetings with your employees in an effort to treat them like stakeholders. Share insights into your business’s financial health, as well as any plans or projections for the coming months.  

Go a step beyond pay

In a competitive hiring market, base salary is only the starting point. Giving your employees a sense of autonomy and ownership at work increases productivity and retention. One of the best ways to give your team “skin the game” is by utilizing phantom stock, an ultra flexible form of equity that has upside for both employers and employees.

Thinking beyond salary means being open to getting direct feedback from your employees. What do they value from a job? Are there certain benefits that are more meaningful to them? Collaborating on a benefits package and being open to evolving it as your employees’ needs change shows respect for the autonomy of your staff.

Champion company culture

Much like the psychological contract itself, company culture can be a hard thing to measure but is often the most important part of an employee’s experience at work. In a world where the lines of work life and home life are blurred, and where people are working for more years of their lives, culture becomes more important than ever. Fortunately, culture is where small businesses can win at recruiting and retaining employees. Employees who choose to work at small businesses versus larger enterprise companies are significantly more likely to prioritize a company driven by values that match their own, as well as a happy, collaborative culture.

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