The B Word

Warning: You are going to hate this post.

Why do start-ups have bonuses in their budgets? What's up with that?  Let's roll back a bit and figure out what we collectively start with.

First, you come to me with a plan. You believe this plan is extraordinary and the idea, product, or service is amazing.  It is the next Google.  Fine. Let's assume I believe all this and not only drink the Kool-Aid but eat the packaging, cups, and pitcher you served it in.  I'm in. You are funded, baby, let's rock.

You've told me in year 1, 500k of revenue but year 2, Katy bar that damn door, good golly Miss Molly, it is 10x in revenue over year 1.  Amazing! So, why are you asking for a bonus if you met these objectives that you set out.

According to Dictionary.com, ‘bonus’ means ‘something given or paid over and above what is due or expected’. Said differently, it’s compensation for extraordinary performance.

By definition, what is “expected” or “due” of venture-backed companies is “extraordinary” growth. The whole idea of taking venture capital and putting it to use is to grow an enterprise well beyond any natural rates of growth. Accordingly, the basic compensation that a management team earns should be to compensate them for that extraordinary growth. Ordinary growth, even good growth, is less than what is due.  And growth, just so we are clear is not always measured in raw revenue so this isn't about a revenue to pay

Enter variable compensation.  This I love doing.  Give me a set of milestones and objectives you think can be done. Let's give you compensation and equity for doing that. Let's even let you share (equity) in the extraordinary growth of the company as you define it.  When you go above and beyond those targets, you can share and share big in my view.

Practically speaking, if the Hockey stick you tell me can happen is $5,000,000 in year two, excellent, let's comp you so you can avoid worrying too much about the home bills (thank you, Austin Hill) and the rest of it in equity and variable compensation when you go way above and beyond. You get a good/big piece when all the shareholders win.

When I point this out to start-ups, pre-revenue companies, etc, lots of people phreak.  

My advice when you are structuring your compensation packages is make them scream you believe. Think about it.  If you take no salary and all stock, you damn sure believe. The other end of that spectrum is all comp, "market rate" pay and bonuses for doing the job.  You will be somewhere on this spectrum one size doesn't fit all.

To me, it's about how much you believe. That was the B word: Believe.  Do you believe?

Okay, flame away but before you do, please read this again, slowly.  There is a larger point about you being committed and believing in the gig; not me making you go on food stamps.  Every situation is different but the beliefs have still gotta be there.

Comments

[You Mon Tsang]

Do you do the same for your LPs? Charge a pay-the-home-bills, drive-a-12-year-old-Toyota fee?

[rick segal]

You Mon,

I cant tell you what other VCs but here at our firm, we get a fixed fee and only make additional compensation after the LPs have gotten paid back those fees, interest, etc. Then we get a piece (the carry).

Also, speaking for our firm, each partner including me, has millions of our own dollars invested into the firm. We write a check right along side the other LPs.

Thanks for stopping by.

R

[mark]

Hey Rick,

I mostly agree with your points here. And for any serious operator its all about the equity. But I offer some arguments for why comp (in whatever form) is important:

1.)Unlike VCs, operators have no diversification. 100% of our holding are in one startup - the one were trying to build. You know the success rate for any one venture. We need to be compensated for the risk.

2.) The most senior operators (the ones you want in your companies) have all lived the starvation in their early years. Now that they have families and responsibilities, cash is more important than it once was. Equity is still by far the most important piece. But there has to be an overall balance to the comp mix.

3.) By definition, startups must deliver extraordinary performance - as you wrote. The growth and rates of return we deliver - even when we just hit our plan, not exceed it - are far above what a F500 management team (thats bonused up the ying yang) must deliver.

You raise a complicated and important debate. Adding my 2 cents to it...

Mark

[rick segal]

Hey Mark,

Thanks for the comments. Some observations on you comments.

1. I probably should have focused this on founders vs. start-ups since you are making the argument that says when I hire somebody into a start-up they should be compensated for the risk. I hear you but my view holds that if you believe you are signing up for a billion dollar exit, or whatever the kool-aid is, you should be given a piece of the pie that rewards you for the risk. If you are about the cash comp, then yes, you are hired help and the company buys what they can afford. Different rules somewhat.

2. Same commentary different twist. Start-ups, by their nature, are usually a group of people signed up to take the risk. A senior operator being brought into the mix needs to believe as much as anybody else, but I get your point. My point, tho, remains about belief.

3. Yup and it is probably unfair. A start-up is more than just comp, Id observe. Its about beliefs, passion, vision, art of the deal, etc, etc.

Thanks for coming by, drop by the office one of these days!

R

[Damon Cali]

I dont buy it. If 10x growth was due and expected, valuations would be an order of magnitude higher than they are. Exceptional growth is deemed possible and hoped for - which is quite a leap from expected.

It seems reasonable to give the companies that perform at the top end of the curve bonuses at the top end of the curve because they have outpaced the expectations implicit in the valuation they received.

[Martin Edic (Techrigy)]

Im in a start-up, self-funded so we dont have a lot of extra cash. I joined the founders at the point where the product was marketable (Im the marketing guy) and took a salary about half of what Id make in the normal economy (whatever that is these days!) plus equity. Ive since turned down a job that paid double what I earn now. A couple of things. First, I took that hit salary-wise because I saw a company and product that was going to be a homerun- not might be, going to be. Thats the belief level were talking about here. I also saw perfectly logical exits in the not too distant future at prices that would easily wash any salary differences plus a lot more. I also have the luxury (or misfortune, it works both ways) of being single and no kids so I can take risks.
If you look at it this way, Im an investor in the same way that a VC is. I assessed the opportunity, the people, the product and the market and made my decision to put some skin in the game.
Finally, we are close to cash flow positive after only ten months of sales. Once you reach this point you have a choice: invest in more people to grow faster or up your comp or some combination of both. Well face that choice when we either raise an A round or reach positive cash flow. I suspect Im going to want more sales reps...

[Martin Edic (Techrigy)]

Regarding the bonuses at 10x returns comment. Im sorry but your bonus is the increase in valuation of the company based on your efforts. This is not a situation where youre an employee in an established company. VCs invest in growth and our job is to grow our companies, acting as owners. Were going for the big end game not a check once a year.

[J. Shirley]

Heres how I see it...

Entrepreneurship is not for the paycheck. Anybody who says it is may certainly be a founder; but an entrepreneur they are not.

Some artists paint, others thrive on the creation of companies and products. The act of creating. This is why the weekend my second kid was born, I spent the downtime building a product that -I- wanted to build.

If youre in it for the act of receiving a bonus check, you are after the exit and not the art. I believe that if youre so fixated on the exit you need incentive to get there, youre likely missing other opportunities along the way and certainly missing key features on your product.

It doesnt mean that every founder is an entrepreneur. Martin, posting above me, makes a great point that the end game is very important and you absolutely must be paying attention to that but I honestly dont believe that it is the enrepreneurs job to do that.

The entrepreneur is there to build a fantastic product that gets a solid userbase. Let the other people deal with exit strategy.

Thats my own strategy, I just need to find the other people.

[Oryx Orange]

Amen to that J. Shirley, but Ive found that the more mouths you have to feed, the more of that other crap you have to deal with, like it or not (and I dont). Either that, or you just need endless patience, and that is not a trait with which I (or most entrepreneurs, I suspect) am blessed. Ah, to be 20 again knowing what I know now...

[You Mon Tsang]

Rick: I dont disagree with your idea and I think it can work well in certain situations.

But I doubt if your management fee is pay-the-home-bills low, despite you and your partners investments. Dont discount the entrepreneurs invesrment. He or she has also invested deeply with time, lost salary during the initial startup phase, and probably undermarket compensation for the life of the company.

Just think about it and do you believe enough to do the same for your LPs. Just like the founder, if you are successful, the fee/salary is an insignificant part of total comp.

[rick segal]

You Mon,

Actually, without violating confidential stuff, it is model close to what you are saying. I have 7 figures invested in my fund. If I take my pay and multiply it times the years I get fees, it is slightly more than what I am paying into the fund.

The big pay off, as you said, are the exits which makes the salary an insignificant amount of my total comp over the life of the fund.

It isnt exactly the same but I do feel that I am getting paid on the upside and not just living on the fees. Its not just a job as I am an investor as well.

I appreciate the point you are making and thank you again for coming by the blog.

R

[Damon Cali]

Martin, You missed my point. All Im saying is that VCs do not *expect* that their portfolio companies will rack up massive returns. They *hope* they will, knowing that the real performance will be all over the map. If they really expected that sort of performance, they would have pay you MUCH more than they do for your equity. (and whos running this ship anyhow?)

Thus, a company making 1000% annual growth is crushing it, not merely meeting expectations. In that situation, the entrepreneurs can rightfully claim to have generated extraordinary performance, and a bonus of some sort may be in order by Ricks own definition.

You can argue that bonuses a waste of cash, create misaligned interests, or that there are better ways to compensate people, but the expectations argument is a loser.

[rick segal]

Damon,

Two points. If you come in and tell me 1000% growth and you hit that, you and I should have had a discussion about what happens when that happens. There is no misaligned interests at all.

Which brings me to my second point: Variable comp. I have zero problems with paying for the 1000% growth. My issue is a structure that says bonus at 300%, 500%, etc. That was my point. Factor in a variable comp structure that allows you to work hard and get rewarded for the efforts.

R

[Damon]

Rick,

I believe we have a case of violent agreement. Bonuses, especially cash bonuses, should be reserved for exceptional performance, not middling performance (in the context of a VC investment!). I got hung up on your 10x number, which seems quite good to me.

How do you feel about equity bonuses? Does it change anything if its not cash?

[rick segal]

Damon,

I love equity vs. cash. Always a smile on my face when somebody wants stock vs. cash.

R

[Oryx Orange]

My view, Rick, is that all the starry-eyed dreamers that parade through your office with the next Google have justifiably influenced your views on this matter, but that, for the few real Google-level entrepreneurs there are out there, they must not only believe but also show that it is them giving you the opportunity, not the other way around. In other words, even by the time they come in to see you, they must be running their businesses as if they were existing successful revenue-generating businesses, which, to me, has always meant minimizing risk and making sure that my loved ones and lifestyle are well taken care of.

[rick segal]

Oryx,
Ah if were to be true. For a start-up, it is impossible to run the business as if. Remember: Start-Up. Coming to me as a $5MM run rate company? Salaries, profits, etc, etc, etc, yup I can see your point.

Start-Ups, I believe, have to get where you are talking about first which is a different risk profile.

P.S. I enjoyed Tottenham when I was there as well.

[Oryx Orange]

Tottenham, huh? Perhaps if we were there at the same time, I may have even served you a pint...

[Pat Moore]

Peter Thiel at TechCrunch50:

He said the #1 predictor of whether or not an investment was a success or failure was the CEO salary. He drew the line at $120K. More than that and the company was like to fail.

The simple reason he offered was that the CEO salary caps everyone else’s salary.

From my and my wife’s personal experience, every start-up that we worked at (except one*) where the CEO had a great comp package — the company failed. Everyone was looking at scoring their next bonus — not making the company better. The other result was that because the compensation given to the big wigs there was less money available for the engineers to make things happen.

There are also malusus ( http://www.nakedcapitalism.com/2008/11/ubs-revamping-bonus-plan-will-try-to.html )

more comments on my blog (http://www.sworddance.com/blog/2008/11/20/compensation-in-the-startup-world/ )

[Sandy Ward]

Rick Pat Moore,

When a startup CEO believes in a company (ie: takes just a base salary so he doesnt have to worry about bills at home) it definitely helps setup the company for success.

Having bonuses can divert the company from the real long term goals; but this is only natural. It is only human nature If you know signing a bad deal is going to get you at $25K bonus it is hard to stay no to the bad deal.

Great post Rick!

[varun mathur]

I think the problem of executives focused on incremental success to bag their own bonus as opposed to being more dependent on the final outcome of the company is prevalent across the board. Look at GM. What if its CEO was given a bare min. salary to pay the bills with the majority of his earnings dependent on the company's energy efficiency strategy ?

The base premise in the post is interesting. When people are more desperate, when they can sniff failure, they are more likely to work harder and smarter and thus succeed. So putting startup founders/ceos in that position can be justified by that. But, why shouldn't the same yardstick be applied for every employee then, as if EVERYONE feared failure, then the odds of success would be even higher, wouldn't it ? :P