Article written by Kip McClanahan and Morgan Flager of Silverton Partners. This article originally appeared in the Austin Business Journal.
Compensation is a multi-dimensional challenge for founders and the first few executives in early-stage startups.
The most important principles to remember as issues present themselves are fairness — including the perception of fairness — and strong alignment between the key stakeholders in the company.
A startup management team, taken to a bit of an extreme, is like a special operations unit. There isn’t a ton of redundancy built into the system, the tolerance for failure is low and the cost of failure is high. To succeed, everyone has to be on point and everyone has to depend on the next person to do their job or the mission fails. If people don’t feel like they’re treated fairly, they aren’t going to be motivated and they won’t perform at the level required. The result will be that everyone fails. The perception of fairness is, simply, mission critical.
Another important factor to consider when coming up with pay is alignment — alignment between the founder and the rest of the early executives and employees, and alignment between the management and investors. As it relates to compensation, the healthiest organization is one where the CEO, founders and management team and equity investors are all aligned and focused on maximizing equity value instead of collecting current cash income or pursuing some other agenda.
What should you pay yourself?
One of the biggest questions relates to the startup’s founder and CEO: How much should he or she pay themselves?
Several successful investors have said that one of the most important things they look at before investing in a startup is how much the CEO or founder is getting paid. The assumption is, the lower the CEO salary, the more likely the company is to succeed. Whether that statement is correct is beyond the scope of this discussion, but the logic behind it is worth examining.
The salary of the CEO sets several important precedents.
First, it sets the tone for the rest of company, in terms of how much people are paid and how expenses are managed. If the culture is such that everyone is well-paid, new employees have no real incentive to take less now and play for a bigger equity event down the road — and that takes away a primary driver of innovation and a crucial element of why startups succeed against incumbents.
Second, in a more subtle way, the CEO’s salary is a strong signal behind the true motivation of the founding/executive team. In an organization where the CEO, founders and management team are aligned with its equity investors, everyone is focused on creating equity value and not collecting their monthly allowance. At the most basic level, a high salary sends the signal that the team isn’t “all in” on the equity opportunity. All dollars spent on the CEO’s salary are additional dollars of dilution that has to be endured, and smart investors know to pay close attention to how CEOs place their bets because it is one of the truest indicators of what they really believe. Do they hedge and take more current compensation, or do they believe in the long-term opportunity for the company?
So, does that mean CEOs should pay themselves nothing, live in a cardboard box and eat Ramen every night for as long as the company is around? Not by a long shot. The best advice I’ve heard is to pay yourself as little as you can where you can still live your life, do the things you need — not want — to do and enjoy yourself. In other words, enough to pay the bills. There is no universal, black and white answer because salary needs can vary widely. A 23-year old founder with a modest background and no mortgage and kids will have different cash needs than the 50-year-old with two kids in college.
Over time, as the company develops and hopefully succeeds, it is a fine practice for the CEO and the rest of the early executives to move closer to “market” salaries if they chose to. For example, after a company raises a Series A round, it’s typically to see seed-stage salaries adjusted upward a bit. Other adjustments typically come with later stage financings or, preferably, as the business reaches a break-even point. In all these cases, employees that wish to remain at a lower salary level should be rewarded with additional equity.
How to compensate the core team
Early, non-founder executives should be subject to the same compensation scrutiny as founders. In fact, one of the easiest ways to tell that an executive candidate may not be right for an early-stage startup is if they have a high cash requirement in their compensation package. While employees must earn enough to cover their living expenses, executives from larger, more mature companies may not easily make the transition to the scrappy, cash-is-king startup environment.
A good way to test how an executive is thinking is to offer them a choice between two different packages. For example, COO candidates might be offered a choice between a $100,000 base salary with 3 percent equity in the company or a $150,000 salary with 1 percent equity in the company. In most cases, you’d want to see the executive choose the lower cash, higher equity option. That’s in line with the company’s needs — minimizing cash burn and pumping up shareholder expectations.
Much like the CEO’s salary setting the tone for the rest of the company, the salary of the first non-founding executive sets the compensation context for the next set of executives. This is one reason to work especially hard to recruit early executives that believe in the long-term opportunity of the company and clearly value equity compensation above cash.
As companies mature further, the process of setting salaries becomes more formal — some would say institutionalized — and tends to gravitate more toward what are perceived to be market packages based on the position and the candidates’ experience.
Remember, with startups, prizes are not handed out at the beginning of the race. The time will come when you prove you’re a winner, and that’s determined by how you finish.
