CHAPTER TWELVE

COMPENSATION

One of the most important—and most contentious—parts of any CEO's job is managing compensation. There's an art to determining compensation, especially for startups with limited resources. Nonetheless, following a transparent set of guidelines will help you make fair, informed decisions. Individual pay can and should be private, but compensation criteria should be very public.

GENERAL GUIDELINES FOR DETERMINING COMPENSATION

Above all else, it's important to keep the following universal truth in mind: most people, most of the time, feel undercompensated.

There's almost no getting around it: good and bad employees are equally likely to think that they deserve a raise. The only thing you can try to do is make them feel less undercompensated, and to remember a corollary that should play a large role in how you determine compensation: higher pay doesn't guarantee higher engagement. If people feel severely undercompensated, you'll lose engagement. It sounds like a catch-22, but it's really just a balancing act.

To maintain that balance, use the following guidelines:

1. When negotiating compensation with a potential hire, ask what they expect early and often. For senior hires especially, be sure to do this really early in the process to screen out mismatches before you fall in love. I've interviewed some great candidates before for senior roles, only to find out that their last job paid them 50 percent more than I could afford!
2. Make sure your top performers are earning enough equity to make them think twice before even picking up the phone when the headhunters invariably call.
3. Make sure team members who are at the same level and performance range wouldn't be pissed off if they compared notes at happy hour.
4. Make sure you don't get trapped by history. The person who started as an intern could someday be a VP, but not if you always think of him or her as an intern. Focus on how much equity employees are earning (e.g., vesting with respect to equity) relative to their level and performance as opposed to how much they have earned in the past or already vested. Pay attention to year-over-year data, but don't allow yourself to be handcuffed by it.

THE THREE ELEMENTS OF STARTUP COMPENSATION

There are three typical elements to executive compensation: base pay, incentive pay, and equity. You need to pay attention to all three, every year, for you and your executive team. As your company grows, you need to pay attention to all three for a larger and larger number of employees.

Base Pay

This is probably the easiest of the three areas, especially as your company gets bigger and more benchmark data are available. In the early days, especially before any outside financing or post-angel financing, you typically just want to hold the number as low as the team can physically and emotionally handle, under the principle of “sweat equity.” At Return Path, no one on the entire team (including me) made more than a $75,000 base salary for the first 9 to 10 months until we raised venture capital.

As you enter the revenue and growth stages, it's important to pay yourself and others a reasonable cash compensation package. Equity is awfully difficult to trade for groceries. (I've heard stories that would indicate the contrary, but they are limited to very small districts of San Francisco and Palo Alto from 1996 to 1998).

We use a few sources of benchmark data each year for our executive compensation process:

• Recruiting data—“market rates” are pretty easy to define if you're in-market.
• Published data from consulting firms like Mercer and Hay Group.
• Our own internal data from recruiting for comparable levels and positions.
• Internal comparables based on level and performance.
• The annual Venture Capital Executive Compensation Survey, conducted by Advanced-HR, Inc. and Opinion Impact and comparable public company data from 10K and 10K filings for senior positions.

A final note on this: you don't have to give senior executives pay increases every year. Maybe two out of every three years, but not every year. As one of our board members once told me, “It's not like someone making $200,000 year needs a cost-of-living increase. Sometimes someone who makes $150,000 is more insulted by the $5,000 increase than they are by skipping a year and then having a $10,000 increase.”

Incentive Pay

There are lots of theories of nonsales incentive compensation. And we've tried a lot of them, coming nearly full circle in the end. In the early days of the business, we had no incentive comp. We felt like all employees in a pure startup were working for passion and equity, and the lure of a bonus wouldn't move the needle on the quality or intensity of their work, which was already high.

Then, at some point, we needed to cut everyone's pay to stay alive, so we cut everyone's base compensation by 10 percent in exchange for a 15 percent target bonus based on overall company financial performance because it seemed like an all-for-one-and-one-for-all philosophy of fairness. Of course, that just irritated a bunch of people who then felt that they had no control over the company's revenue or costs. It didn't do much to incent or align work.

So then we kept everyone's bonus target, but we made each person's bonus based on a combination of company performance as well as individual metrics and milestones. This seemed like a good compromise. But the problem here was one of governance. It was never clear that everyone had the same level of “stretch” in their personal goals or that managers had the same level of toughness in grading—and after a complex spreadsheet circulated among the executive team at the end of each quarter, almost all employees miraculously earned somewhere between 95 and 100 percent of their target. That seemed like a huge amount of effort for no benefit. It also had the unintended consequence of throwing our team out of alignment by creating too many separate incentives, especially at senior levels.

Then we came full circle at some point and abolished the 15 percent bonus targets and just increased everyone's base by 10 percent, back to where they were, other than senior executives and salespeople. We decided it would just be more impactful to instill a discipline of managing people to stretch goals and firing underperformers than go through all of the rigmarole of any of the legacy bonus programs we'd run through.

The major exception to this rule is sales compensation. There might be misalignment between individual development goals or marketing goals or accounting goals and your company's goals as a whole. But there really isn't any way that sales goals—which consist, in essence, of driving revenue—can be misaligned with top-line company goals. Reward salespeople for individual performance. In this case, it won't lead to any misalignment.

My conclusion from all of this is that incentive compensation is tricky in startups where passion and equity are big drivers. The best use of incentive compensation I've seen is to drive alignment or individual sales performance.

Equity

Equity is a much more challenging and nuanced topic than base pay or incentive pay. Like base pay and incentive pay targets, outside benchmark data can be helpful, but, unlike base pay, each company's cap table and financing history is different and independent of its size, stage, sector, and number of employees. We give equity to 100 percent of our employees in the form of stock options. We want everyone to think like an owner of the company and act like an owner of the company as they make decisions about time, resources, and money. The best way to do that is to make them owners of the company!

The type of equity you and others in the company receive has a lot of components to it—and they're all negotiable. As CEO, you want to make sure that you have a good deal, but you also need to manage your employee base to have deals that are fair for both employees and the company, preferably without many (or any) exceptions to standard policies for you to manage or worry about.

For most of our company's life, we've had an option pool (inclusive of all employees) of around 20 percent of the company on a fully diluted basis. I've heard of companies with as little as 10 percent and as much as 25 percent. The more important number, though, is the percentage of the company in the option pool that is either unvested or ungranted, which defines how much equity your current employee base is earning every year and how much equity you have left to give. Again, circumstances vary from company to company, but we've always tried to have the employee population earning about 2 percent of the company's equity each year, and we've always tried to leave at least 2 percent of the company ungranted for future employees (more in the early years).

Sizing individual equity grants for employees is really tricky early on, and the size of the grant is related to the next two topics:

• Different types of equity grants
• The vesting terms associated with the grants

I've heard two rules of thumb over the years that sound completely at odds with one another: “give out equity with an eyedropper” and “make sure your best people earn as much equity as you can possibly stomach.” Usually, those two points aren't as far off from each other as they sound. In the really early days of a business, it's not uncommon to give senior hires as much as 2 percent of the company over time; even later, new senior hires still receive up to 0.5 percent. The biggest rule of thumb with equity, though, is that it's much easier to give than to take away, so you're better off starting with smaller grants and adding new ones over time.

There are several different forms that equity grants can take. I can describe some of the common ones here in brief terms—but be sure to consult an accountant or a lawyer for more specifics as they relate to your company's situation. If you just own founder's stock (regular old common stock) in your company, you don't need to worry about this—for now. Over time, assuming you take on investors, you'll probably receive incremental equity that can take other forms, and any employees who get equity will also take one of these other forms.

The most common forms of traditional stock options are ISOs (incentive stock options), which are available only to employees and likely have better tax treatment upon a gain than NQSOs (nonqualified stock options), which are the only kind of options you can grant to nonemployees like directors and advisers. Also, note that should you receive a big enough stock option grant in a given year, the IRS forces some of the options to be NQSOs.

Another important consideration is the vesting schedule associated with equity. The typical vesting schedule of a stock option grant, or even restricted stock (which usually has a claw-back provision, effectively the same as vesting) is a four-year evenly distributed vest with a one-year “cliff”: no stock vests until one year, then the stock vests monthly or quarterly after that. I've seen other terms, though, from performance vesting (stock vests on a particular hurdle being met like profitability or a specific revenue target), to three- or five-year terms, to backloaded vesting (i.e., not 25 percent per year for four years, but a pattern like 10 to 15 to 25 to 50 percent). You can do anything you want here, but keeping it fairly consistent across your employee base and having a rationale for it are important.

Some companies also include some kind of acceleration of vesting on the sale of the company or IPO. Years ago, in the throes of the Internet bubble, lots of companies gave all employees 100 percent acceleration on a “single trigger,” meaning if the company got acquired, all employees' shares would vest. This has fallen out of favor quite a bit in recent years as acquirers realized that having lots of the employees of an acquired company cash out and quit after they acquired the company was a bad idea. (As Brad Feld and Jason Mendelson point out in Venture Deals, smart investors push back on “single trigger” acceleration for exactly this reason.) Now, it's more common to occasionally see some minor acceleration of vesting (one year, two years) on a “single trigger” event if any; and occasionally full vesting on a “double trigger” of the sale of the company combined with getting fired or laid off in conjunction with the sale, but plenty of companies have no vesting acceleration provisions.

Note: There is one exception to the rule that you should generally avoid “single trigger” acceleration: your board of directors. Directors are always fired upon change of control, so their options should vest immediately.