There are two main components of a compensation policy: salaries and equity. An equation with only two variables? Should be pretty simple, right? Well, not when you are talking about something as symbolic as money. Before all, let’s remind the three core principles of any good compensation policy: 1: Being as objective as possible: this ensures fairness and acknowledges a basic truth: people talk. The goal is to ensure fairness, real and perceived (more or less the same package for the same position, all things being equal). 2: Cash is for a short/mid term reward when equity is a long term alignment. 3: Compensation needs to be adapted to market practices (especially, to local practices). That being said, let’s dig dive and look at the best practices of compensation policy for startups. Starting with wages.
The main trade-off regarding wages is the split between fixed and variable salaries.
The rule of thumb is to give 20% of the fixed salary in variable. In the US it is on average 50–60% and can go up to 100% in certain companies.
Establishing the fixed salary
The best way to establish the base salary is to look at a benchmark of comparables companies. The first year or so, you can attract great people with a salary below the market cap if you give high enough equity package.
Buffer, being a distributed team across the world, had to make sure they were competitive with the local market practices and keeping a fair formula for all their employees.
They ended up with this salary formula, which has the benefit of making the variables readable and objective (let alone the experience which is discretionary): Role * Experience * Loyalty * Choice
Role, being composed of the 4 following variables”
Experience: they weight the role base with experience multipliers:
Loyalty: raise of 5% every year for everyone
Risk choice: they offer every member the choice of having an extra $10k to the salary or get roughly 30% more stock options;
Here is an illustration of their formula for an advanced engineer, living in Cape Town, who chooses more equity: $60,662 x 1.20 + $9,000 + $0 = $81,794
Quick note: contrary to the economic theory, salaries are not directly correlated with the actual marginal productivity of the employees. Firstly, for a very good reason: it is very hard to determine the real marginal productivity. For instance, sometimes when someone who seemed a low performer leave a company, the overall productivity decreases. A living organism has very complex mechanisms with many feedback loops.
Secondly, because there is a tacit agreement in the job market: the cost of living needs to be taken into consideration. And generally speaking, the older you are, the higher is your lifestyle, which end up with a premium for age. So the correlation, all things being equal, tends to be more between age and salary than marginal productivity and salary.
That doesn’t make a talent management policy useless: people need a framework, and the better you do it the closer you will link performance and remuneration. For instance, you can manage the gap for young people and older people between their actual marginal productivity and their compensation with variable compensation (rewarding productivity). Also, this divergence is not always a problem. It is important that companies ensure the actual needs of their employees: it matters for economic reasons in the long term (satisfaction, retention, attractivity, etc.) but also because companies should answer to broader rules of fairness and social justice.
Establishing the variable salary
The composition of the bonus is a bit tougher to establish.
First of all, you have to decide whether you cap it or uncap it. When most of the objectives are personal and/or the variable formula is directly link to the generation of EBITDA, the best solution is often to uncap the bonus. Sometimes you’d like to control the OPEX, no matter what growth you generate.
Secondly, you need to figure out how often you pay the variable. The more often you pay it, the more attractive it is (the reward is never far away). You can even pay retroactive rewards in case of catch up (eg: 90% of the objective of Q1 but 130% in Q2), especially if you chose to cap the bonus.
Thirdly, and maybe more important, you need to find a good and precise formula for the attribution of the bonus for each one of the employee. It is always a good idea to have around half the comp depending on a collective outcome (eg: for the company scale, reaching a certain level of gross margin and/or EBITDA ; for a team, managing to develop a new feature or to develop and launch a new inbound strategy) and the other half as a specific functional goal (eg: acquisition of 10000 new users).
Beware of not falling in the trap of trying to make everything quantifiable. Some tasks/activities are qualitative and the bonus attribution needs to be relevant. As long as the decision-making process is transparent and fair, this is not a problem. It that case, it is always a nice idea to identify and explain precisely the expectations and the things that will be used to assess the performance.
A good variable policy is a management lever to link individual contributions to the overall strategy of the company.
Salaries should be updated as often as needed
Fred Wilson says: “Figure out what “market salaries” are for all the positions in your company and always be sure you are paying “market” or ideally above market for your employees. And review your team’s compensation regularly and give out raises regularly. This stuff matters a lot. Most everyone is financially motivated at some level and if you don’t show an interest in your team’s compensation, they won’t share an interest in yours (which is tied to the success of your company).”
Nextflix, has made their compensation philosophy famous thanks to their amazing culture deck (slides 95–111): pay top of market, because one outstanding employee gets more done and costs less than two adequate employees.
They have three tests, which they use at the time of hiring and every following years, since market practices needs to always be updated to be effective:
Test 1: What could this person get elsewhere?Underlying principle 1: pay them more than anyone else likely would
Test 2: What would we pay for replacement?Underlying principle: Pay them as much as we would pay to keep them if they had higher offer
Test 3: What would we pay to keep that person?Underlying pay them as much as a replacement would cost
What about founders salaries for VC-backed startups?
Establishing the salaries of founders is never easy. Their profiles are very eclectic and for founders, the real incentive should be equity, not salary. The general principle is the following: being able to earn more money in the long run if the company is successful thanks to equity, but having a discount in the present time, compared to what they could be earning in an established company. Consequently, the salary will be below market practices for a given profile of founders, so the needs of the founders have to be taken into consideration. As Fred Wilson wrote, “people can’t use options to pay their rent/mortgage, send their kids to school, and go on a summer vacation with the family.” Indeed, salaries won’t be the same between a young founder, a CEO that sold his company and founders having children and living in a big city. Also, you have to balance the total revenue stream and the actual cost of living (eg: in France there are many founders that are benefiting from the unemployment office).
Bottom line, for founders, salaries should never be a source of additional stress and respect the general principle that equity should be the main driver of their incentive. Market practices in France: in the seed stage founders are paid (annual gross salary) between €0 and €80k (more or less a Gaussian distribution centered in €50k), in series A between €60k and €100k (more or less a Gaussian distribution centered in €70k).
That’s all for the moment! You should have a good overview of how to design your compensation policy. In the next article, we discuss how to determine what level of equity should be offered to a given candidate. Stay tuned!