Compensating Your Executive Team on a Shoestring

You have this great idea that will be an absolute killer in the marketplace. No other company is working on it, yet if you asked the practitioners in the fields, it is something that will revolutionize the business. If you can get the product to market, it will sell itself. You'll make a killing if you're successful. You just have to find the right talent to develop the product, test it and get it into production. The problem is that talent costs money. The really good talent is already working for other, bigger companies where the compensation package handsomely rewards them. (Unfortunately, no one has yet figured out how to compensate employees without some form of money. Ahh, there is the next new company idea!)

If you work it right, you can recruit the right talent, compensate them for their contribution and compete with the industry giants. It is all in how you package the deal. Here's what you need to make success affordable.

Recognize that there are three major elements to compensation that are within your arsenal: base salary, annual bonuses and long term compensation. Each one of these components triggers different types of behaviors that are deep inside your future employees' psyche. You just have to figure out how to use them to your advantage.

Base Salary

Base salary is the component of pay that most people focus on first. It represents a fixed cost and an ongoing obligation. Once you set it, it rarely goes down so you have to work this one carefully. Recognize that base pay can end up being the smallest component of compensating your executive team. Recognize also what base salary does for the executive. It represents cash necessary to pay for standard of living obligations to pay for the mortgage, food, cars, college education for the kids, and keeping up appearances. It needs to be just large enough to permit the executive to maintain their sense of worth to themselves and their spouse.

In start-up companies base compensation is lower than in companies that are further along the growth curve. If you are recruiting out of larger, more mature companies, base salary will be larger than you can afford. You need to be competitive here, but that does not mean that you have to break the bank. Competitive is within 10-20% lower than their current base salary. In some situations, it can be even less if the other components can trigger their entrepreneurial spirit. The actual level of base salary should be comparable to like positions in similar start-up companies that are in the same industry, geographical location and past performance, if any. Tie the level of base salaries to the level of responsibility of the executive and their direct impact on your business plan. Those that directly affect the success of the company should get paid more.

Compensate them so they maintain a reasonable standard of living and no more. After all, you're selling not just a job but an opportunity for greatness. You don't get much in return for the cost of a base salary other than their obligation to show up. Don't give away the store.

Annual Bonuses

The purpose of an annual bonus is to motivate short term behavior. Annual bonuses clarify and sharpen the executive's attention to doing everything possible so you can continue on your road to success. Usually an annual bonus is paid in cash, or it can be deferred. In either case, it isn't much different than base salary because it is a cost. The major difference is that if performance expectations are not met, it won't involve any outlay of cash. The downside is that if you don't meet the objectives, the company may not be in business long enough to see the day when you can pay it out. You want to pay it out.

Design bonuses around attainable objectives. In start-companies where product development, production and customers are the key criteria of making sure that you have long term success, bonuses should be tied to these critical milestones. In companies that enjoy cash flow and income, the measurements are positive cash flow and net profits. If your company is not that far along the growth cycle, then you need to set your objectives in terms of critical dates and key developmental milestones.

If you need to conserve cash, you can provide a deferred bonus. This can be mandatory or at the executive's discretion. Most likely you will want to make it mandatory. Deferring bonuses does not alleviate you from setting the cash aside, but it does allow you to retain the cash in the business. Talk to your accountant to decide how best to negotiate this area. When push comes to shove, you will be required to pay it, but you can extend the date that you have to write the check.

Bonuses in start up companies are smaller than in your larger, more mature cousins They are established as a percent of base salary. Depending on the level of responsibilities of the executive, the percent of base salary for meeting objectives ranges from 20% to 100% of base salary. It is less if you fall short. About half of the start-up companies pay no bonuses at all, so don't feel that you are obligated to pay a bonus. Remember that a bonus is just one arrow in your quiver. Don't use it unless your target is clear.

Long Term Compensation

Long term compensation is where you can really work wonders and trigger that entrepreneurial spirit in your executive team. In this component of pay, you can tie their hands to the long term success of the company and satisfy their desire to retire on a beach in the French Riviera, or some equally exotic place. The best part of long term compensation is that you can achieve astounding leverage for the dollars it may cost you.

Long term compensation is usually in the form of company stock. If you are company that is plans on an initial public offering, it will be a certificate that will convert to real stock when the offering is made. If you are a private company, a phantom stock plan will probably be required.

Long term compensation helps to retain executives and focus their behavior on managing the business for the future (long term) killing that you will make in the market. In larger companies it is formula driven, based on a shareholder return objective, such as return on investment, return on sales, return on cash employed. In a start-up company, however, you may not have a return to measure. This leaves you with developing an objective measure based on the milestones that you need to achieve. For example, you would grant shares of stock based on meeting the required dates in your business plan. Each time you reach a milestone, you would grant additional shares. In addition, you will set a vesting schedule for 3-5 years in the future such that the company has sufficient time to achieve growth and profitability.

Of all the elements of compensation, long term compensation is an area where you want to be generous. In comparison to a low base salary and annual bonus, long term compensation should be high. Typically, the value of the grant (the expected net cash value of the stock) will be equal to 1.3 times the base salary up to 22 times base salary, with a median of 4 times base salary.

If you are planning on an initial public offering, the grant of certificates of stock will give you the leverage you need and allow growth in the market value to reward your executives. Although stock compensation is not without cost to the company, it is currently by far the most inexpensive way to reward your executive for the effort they have expended. It will make up for lower than normal base and bonus compensation.

If you plan on remaining private, the opportunity for the market to pay for the executive's compensation is limited to a phantom share plan. In this type of plan, you allocate phantom shares in the same fashion that you would if the shares are publicly traded. The only downside is that the shares represent cash and must be accrued on the financial statement. On the flip side, phantom shares do not represent real ownership (i. e., voting rights) and grow in value only if the company grows in value. In this manner, it is still a low risk way to compensate executives while at the same time motivating long term behavior. If phantom shares are your only option, structure a vesting schedule such that the payout is gradual and 3-5 years into the future. For example, one successful way is to grant phantom shares that vest only a one fourth of each grant four years after the grant. This gives you the breathing room needed to grow the company and ties executives to the company for a long time. If they leave, they forfeit their unvested shares.

Start-up companies should tie the award of stock with the following caveats. They should vest based on the expected achievement of the milestones or other objectives established, and the granting of stock should be accelerated if the milestones or other objectives are met ahead of time. Plan to allocate up to twenty percent of the company stock to your executive team. This will typically permit sufficient ownership to capture their heart, mind and soul. Getting a successful start-up company off the ground will demand it. Get it by giving it to them.

Benefits and Perquisites

Finally, you could give executive cars and country clubs and other perks of the position. You don't need to and these can be rewards that you retain for later. Benefits are normally minimal, and should be offered only to protect executives for life's unexpected events. The leverage of these additions to a compensation package are low on the scale of importance. Do only what is necessary.

Summary

As a start-up company you don't need to match the compensation packages of the mature companies. You can attract, motivate and retain them with something better: the excitement of the challenge and the opportunity to achieve long term personal and financial success. For the right talent, that may be more that they can get from the mega-corporation across town.

Relationship Between Pay and Stages of Company Growth

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