Deciding to bring on an executive to run your startup is a big decision.
Hiring an executive is an exciting, high-stakes event that can bring fresh ideas or new perspectives and create a lot of questions, especially when it comes to compensation.
Getting compensation right is critical for attracting (and keeping) the right talent for your startup. For senior executives, compensation can provide a big carrot, used to encourage and motivate certain behaviors. But when done wrong, it can put a significant burden on your cash flow.
While that may sound simple, compensation can be a complex topic. How should you approach executive pay?
Many factors figure into determining what to pay your executives. It’s important to think carefully about what sort of behavior and development you’re encouraging.
Typically, executive compensation is a mix of fixed (base) salary and variable incentives. The details hinge largely on:
When deciding how to pay your startup’s execs, start with a clear strategy for what you’d like the incentive structure to accomplish. Think carefully about what you are incentivizing. What are you driving the executive team to do, and over what time frame?
Beyond your CEO’s base salary, which should be enough to cover their reasonable personal needs, the variable pay aspect can be used to motivate the CEO to drive long-term growth. The variable component can be paid out through a mix of bonuses, profit-sharing, or even an ownership stake in the company through various equity instruments.
Also, consider how the company intends to pay the variable component. Is it a sizable annual cash payment? Is it paid out in increments over three years? Is there no cash at all, and it’s delivered in the form of stock options?
Whatever you decide, make sure the executives are motivated to work toward the long-term good of the company.
Where possible, use a formulaic approach driven by multiple metrics to eliminate ambiguity and grey areas.
Profit and revenue growth are commonly used metrics. But other social or non-financial metrics are sometimes also considered. Some companies even use environmental, social, or governmental metrics, especially for public utilities and companies focused on social causes.
Creating a compensation scheme from the ground up can be a challenging undertaking. Fortunately, it’s not necessary to reinvent the wheel. Because public companies are required to publish executive pay and incentives, information is readily available.
Align your strategy with other companies in your sector and make adjustments up or down depending on your startup’s specific situation.
However, be careful about only relying on the market to determine your compensation. You don’t want the executive team to only be there for the paycheck and bonus. They will perform better within the organization longer-term if they identify with the mission and objectives of the firm.
Set target numbers for the executive team to hit. This is typically done with a payout curve starting when the company reaches 50% achievement of the target and topping out at 150% achievement.
Clear metrics and detailed tracking are key for setting targets, and adjusting compensation based on profitability performance. For instance, Harvard Business Review states that CEOs receive 50% of their pay in the form of bonuses.
As an example of a specific goal: Achieve a target of 20% increased profitability, year-over-year.
If an executive, or the leadership team, achieves 10%, the goal of 20%, or above (at least 25%, per se) — bonus compensation would be set based on the increase.
Important note: Clarity is, again, important. For instance, how you improve profitability must fit in with your other goals. (E.g. Executives shouldn’t try to save costs on the product, at the cost of quality.)
Imagine bringing in a new executive because your startup is going through a rough patch. For example, your company is focused on survival or attempting an aggressive new strategy.
Instead of boosting revenue or net income, the CEO will need to focus on implementing the new strategy successfully or generating Free Cash Flow, and reducing expenses.
Finding a way to work those measures into the variable compensation calculation will drive the right behavior.
Beyond finding the right mix of variable and fixed compensation, you have flexibility in how you pay your variable compensation.
Will your executive receive the variable portion immediately (i.e., semi-annually or annually)? Or will it be deferred to a future period? Compensation deferred to a future period is often delivered as equity through options or other types of shares.
The payout time frame can depend on the length of your business cycles and whether or not your startup is going through a major transition. Companies in transition tend toward a shorter payout term.
Cash bonuses often encourage executives to think like managers and not act like owners. Again, it depends on the size and maturity of the company, but also the industry.
Generally speaking, equity stakes in the business encourage executives to think more about what’s good for the business’s long-term health..
However, equity is not without flaws, as the final value of the compensation can depend heavily on the market as a whole (especially for public companies). Think about what happens in the event of an economic recession or a large-scale recovery. It’s a significant, unpredictable factor over which the executive has no control.
Which portion of the CEO’s goals can be met individually? Which are dependent on the organization working together and performing as a whole?
It’s not uncommon to have both.
Compensation can be a sensitive topic at any level. It’s easy to get wrong and can have a big impact on your company. But it’s also one that’s critical to the healthy development of your organization.
Founder’s CPA understands how complex the needs of a startup can be and is ready to help you determine the proper executive compensation approach.
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