Compensation Posts

From The Human Equation:

“Seven dimensions that seem to characterize most if not all of the systems that produce profits through people.

  1. Employment security.
  2. Selective hiring of new personnel [especially screening for attributes that cannot be taught such as attitude and cultural fit.]
  3. Self-managed teams and decentralization of decision making as the basic principles of organizational design.
  4. Comparatively high compensation contingent on organizational performance.
  5. Extensive training.
  6. Reduced status distinctions and barriers, including dress, language, office arrangements, and wage differences across levels.
  7. Extensive sharing of financial and performance information throughout the organization.”

The author is Jeffrey Pfeffer, a professor at Stanford. He also co-wrote Hidden Value, which we covered in We don’t pay you to work here.

Implementing the whole system

Extreme Programming works well when you implement all of its practices. Most of the practices by themselves have too many flaws to be very effective. Each practice by itself may even have more disadvantages than advantages.

But all of the practices together work well. Why? For each practice, there are other practices that obviate its flaws. Wheels by themselves just roll a bit and fall over. But when you connect them to a car, the entire system can get you from Boston to San Francisco.

The practices in The Human Equation also work well when you implement them all. You can’t offer extensive training if you plan to lay people off when times are tough. That’s just a good way to waste money on training. You can’t offer employment security if you don’t hire new employees very selectively and if you don’t terminate the ones that aren’t effective.

If you’re searching for a magic incentive system to get high performance from your team, there isn’t one. If you’re willing to do the hard work of implementing a set of simple organizational practices, The Human Equation and Hidden Value have some suggestions.

“A raise is only a raise for thirty days; after that, it’s just your salary.”

– David Russo, VP of Human Resources at SAS Institute

This is one of my favorite quotes from the book Hidden Value. It explains why money by itself doesn’t motivate high performance. Money by itself can only motivate the quest for more money. A raise is only a raise for thirty days; after that, it’s just your salary.

We are motivated to perform when our work expresses who we are, when the business’ goals are intrinsically meaningful to us, and we feel that we are valued as people, not simply as economic agents.

But, even in startups, financial incentives and HR practices often treat us like economic agents:

“Consider the implicit values conveyed in the modern management practices adopted by many companies. Most firms today emphasize, among other things, the employee’s responsibility for being career resilient, employment at will and no-fault dismissal, pay for performance, downsizing to cut costs, and maximizing shareholder value above all else. What is the message any sentient employee takes from these practices? Pursue what is best for you, not the firm or the customer, adopt a free-agent mentality, and do not invest any more in the firm than it is willing to invest in you. The underlying values are crystal clear, even if they are never expressed in a formal way. In this sense, arguments by managers that value statements are irrelevant or inappropriate miss the point: All organizations have values; the only question is how explicit they are about them.

“And what happens when employees behave in accordance with these values? First, a rational employee is not likely to exert much effort in activities beyond what he or she is explicitly rewarded for. A ‘show me the money’ mood prevails. Second, a smart employee will be constantly alert for new and better job opportunities in other organizations—loyalty is for fools. Third, unless cooperation is explicitly monitored and rewarded, teamwork is viewed as optional… To resolve some of these problems, management’s job is to design ever more sophisticated control and incentive systems to ensure that the necessary teamwork occurs and that the loss of intellectual capital is minimized.”

The problem isn’t that money is a weak motivator. The problem is that money is a terribly strong motivator. By itself, money motivates the wrong people to do the wrong things in the quest for more money.

This is why Zappos pays employees to leave. This is why Tandem Computers didn’t tell employees their salaries until after they started working. In other words: we don’t pay you to work here—we pay you so you can work here.

Organizing around values, not value

The authors, Charles A. O’Reilly III and Jeffrey Pfeffer, both from Stanford’s Graduate School of Business, studied how eight companies, from Men’s Wearhouse to Cisco, ignore the pernicious assumption that compensation should be the foundation for management systems:

“First, each of these companies has a clear, well-articulated set of values that are widely shared and act as the foundation for the management practices that… provide a basis for the company’s competitive success. [e.g. Southwest's "Work should be fun… it can be play… enjoy it."]

“Second, each of these organizations has a remarkable degree of alignment and consistency in the people-centered practices that express its core values. [e.g. Southwest: "We hire happy people."]

“Finally, the senior managers in these firms, not just the founders or the CEO, are leaders whose primary role is to ensure that the values are maintained and constantly made real to all of the people who work in the organization… The senior managers in each of these companies see their roles not as managing the day-to-day business or even as making decisions about grand strategy but as setting and reinforcing the vision, values, and culture of the organization. Dennis Bakke at AES [a $2B company] claims that he made only two decisions in 1998, one of which was not to write a book on the company.”

Extraordinary results with ordinary people

The book’s subtitle is “How great companies achieve extraordinary results with ordinary people.”

Every rational company in the world is trying to hire the best people in the world. And all but one of them will fail at this task. There can only be one company with the best people. Hiring the best is a failing strategy.

Organizations must be designed to thrive with ordinary people. If businesses can thrive with the capabilities of ordinary people, they can also thrive with extraordinary people. Practices like Extreme Programming, that were designed for programmers with ordinary skills, work even better with extraordinary programmers.

Read Hidden Value for specific recruiting, training, information-sharing, and rewards practices that aim to exploit the capabilities of ordinary and extraordinary people alike.

“If people come for money, they will leave for money.”

James Treybig, CEO of Tandem Computers

We’ve been answering this question a lot lately:

“I have a job offer at a startup, am I getting a good deal?”

This isn’t a comprehensive answer—just some questions we would ask if we had an offer.

If you don’t understand your offer, get a lawyer. But—right or wrong—most people don’t hire lawyers to review their offer letter.

Table of Contents

The Offer (answers follow)

  1. Can you give me the offer in writing?
  2. How does my compensation compare to my peers in the company?
  3. What are my options worth?
  4. What percentage of the company do my options represent on a fully diluted basis?
  5. Can I exercise my unvested options early?

The Company (see Part 2)

  1. How much money do you have in the bank right now? How long will it last?
  2. What was the company’s post-money valuation in the last round?
  3. What are the investor’s preferences?
  4. Who is on the board and whom do they represent?
  5. Would I hire the CEO and board to increase the value of my options?

1. Can you give me the offer in writing?

The only good answers to this question are,

“Yes, an offer is on the way.”

and

“Let’s work out the major points and we’ll give you a written offer. We don’t want to start things off on the wrong foot with an offer that is way off the mark.”

2. How does my compensation compare to my peers in the company?

Some companies pay more, some companies pay less, but an offer is fair if your compensation is in line with you peers’.

Your total compensation consists of salary, options, vesting, cliff, acceleration, bonuses, and severance. And a peer is someone who (1) joined the company at roughly the same time as you did (e.g. halfway between the Series A and Series B) and (2) has roughly the same title you do.

Most employees have a 4-year vesting schedule with a 1-year cliff, no acceleration, no bonuses, and no severance. The exceptions are for Vice-Presidents and higher (and founders).

By the way, your cliff may be longer than the company’s runway, but c’est la vie.

3. What are my options worth?

First you have to know how many options you have and how they vest. Let’s say you have 1000 options and they vest over 4 years. So you get 250 options a year for 4 years.

Now you have to guess what an acquirer would pay for your shares. Let’s call this the acquisition share price. Setting the acquisition share price to the preferred share price of the last round is a good start—let’s say it was $1/share.

Now multiply your options (1000) by the acquisition share price ($1) to calculate the acquisition value of your options: $1000. Since the options vest over 4 years, the annualized acquisition value is $250/year. And while the acquisition value of your options might be $1000 today, you’re naturally hoping that the company’s acquisition share price increases over time.

If the company has gained a lot of value since the last round, you might set the acquisition share price higher than the preferred share price. If the company has not has not done well since the last round, you might set it lower. Either way, you will have to ask the company for the preferred share price in the last round. Or if someone has offered to buy the company for $50M since the last round, I might use $50M to calculate an acquisition share price.

Finally, you will have to pay for your options—they’re not free. Options have a strike price—that’s what you pay for your options. Sometimes it’s much lower than the acquisition share price and can be ignored. Sometimes it’s high and can’t be ignored—high strike prices are becoming more common due to high-valuation rounds (Facebook), founder cash-outs, and high 409A valuations.

4. What percentage of the company do my options represent on a fully diluted basis?

Most people think this number is important—it’s not. You care about the value of your options, not your percentage of the company. Your percentage will decline over time but the value of your options will hopefully increase.

Focus on the how many options you have and the acquisition share price (see question 3 above). Terms like percentage ownership and valuation can fool you.

5. Can I exercise my unvested options early?

This is for advanced Venture Hackers only. Don’t do this without an accountant and/or lawyer.

Exercise your options early if you want to start the clock on capital gains tax eligibility for your stock. Startup pros usually exercise their options early to lower the expected value of the taxes on their stock. In certain cases, you will pay less taxes in an acquisition or IPO if you exercise your options early.

Use an accountant or lawyer. Don’t sue us if this blows up in your face.

This post continues in Part 2.

Related: Other folks who have tackled the topic of “questions to ask before you join a startup”: David Beisel, Dharmesh Shah, and Guy Kawasaki.

Here are more frequently asked questions about advisors. See Part 1 for the rest. If you have more questions, email us at ask@venturehacks.com.

Frequently Asked Questions

General (from Part 1)

  1. What do advisors do?
  2. Should I put together a board of advisors?
  3. How do I get good advice?
  4. How do I apply advice?
  5. How do I find advisors?
  6. How can I tell if an advisor is any good?

Compensation (answers follow)

  1. What should I pay advisors?
  2. What are advisory shares?
  3. Why should I pay advisors?
  4. When do advisors get terminated?
  5. Should I give advisory shares to my investors?

Compensation

7. What should I pay advisors?

Nothing—get them to pay you. Ask advisors to invest. You get money, save stock, and amplify the advisor’s social proof in the process. But lots of good advisors can’t or won’t invest, so…

7.5 What should I pay advisors if they won’t invest?

Advisors are not paid by the hour—they’re paid for results. They’re not paid for their inputs—they’re paid for their outputs. If an advisor can uncork a million dollars of your company’s latent value with 15 minutes of conversation or a single introduction, you should pay him appropriately.

There are roughly two types of advisors—we’ll call them the normal advisor and the super advisor.

Normal advisors

The normal advisor gets 0.1%-0.25% of a company’s post-Series A stock. Normal advisors do something important for the company and aren’t expected to do much beyond that. For example, they introduce the company to a key customer or investor.

Normal advisors are also assembled by naive entrepreneurs who think the mere presence of an advisory board will create social proof and help them raise money. But investors don’t take these mock advisory boards seriously.

Super advisors

The super advisor can get as much stock as a board member: 1%-2% of a company’s post-Series A stock. Super advisors help make your company happen. They know all your prospective customers intimately. Or they raise your money for you. Or they bring you a handful of great employees. They can even add more value than an independent board member because they don’t have to deal with corporate governance.

If you find a super advisor, you want to incent him as much as possible and push him to help make the company happen. They can be much more effective than 5 or 10 normal advisors.

Most super advisors are unique and Y Combinator is a great example. YC takes about 6% of a company in return for $15K-$20K. Although most of their companies can survive with the small investment, the money is effectively meaningless—it’s an artifice. Most of their companies would probably give 6% of their shares to YC for free, just to participate in the program.

YC acts like a super advisor, not an investor—and YC makes their companies happen by helping develop the company’s product, introducing them to investors, and branding their companies.

Advisor compensation

Whether you’re hiring a normal advisor or super advisor:

  • Advisory shares are usually issued as common stock options.
  • The options typically vest monthly over 1-2 years with 100% single-trigger acceleration and no cliff. Although the advisor is on a vesting schedule, you should expect them to add most of their value up-front—that’s normal.
  • Many advisors want options they can exercise immediately—that’s fine.
  • If your company hasn’t raised a Series A, increase the advisor’s equity by roughly 30%-50% to account for dilution from seed investors, Series A investors, option pools, swimming pools, and the like.

Finally, there is a beauty to paying in equity rather than an equivalent amount of cash. If you pay for a service in cash and you want that service again, you have to pay again. If you pay in equity, you pay once and keep getting served ad infinitum. Equity is the gift that keeps on giving. Your shareholders own you, but you also own them.

8. What are advisory shares?

Advisory shares are normal common stock. There is no legal concept of ‘advisory shares’. The Supreme Court has never heard a case regarding advisory shares. Chief Justice Roberts doesn’t give a shit about advisory shares.

9. Why should I pay advisors?

“Make sure that, for the people that count to you, you count to them.”

Warren Buffett

If someone helps your company succeed, it is only fair to share that success with them. If you want to do repeat business with people, you need to treat them right the first time around.

Equity also keeps advisors on the hook: you can go back to them again and again for help. If they were helpful once, they can probably be helpful again. And people with a financial interest in your future tend to return your calls.

Equity also incents advisors to keep working for you in the background whether or not you ask them to. They’ll bring you leads for customers, employees, and investors.

If you’re an advisor, don’t do it for the money. The opportunity cost is probably too high. You want to get paid so (1) you can own a little piece of the company in case it happens to be the next Google and (2) so the company signals that it values your time and contribution.

10. When do advisors get terminated?

Advisors can get terminated when they don’t add value at the level they originally agreed to. They can also get terminated if the company is “reset”, e.g.

  • You hired a video game expert because you were building a video game but now you’re building a photo sharing site. The company has left the line of business where the advisor added value.
  • A naive entrepreneur hires the wrong business advisor and a major new investor asks the entrepreneur to clean up the dead wood.
  • The company is acquired, recapitalized, or otherwise restructured and the advisors are no longer useful or desired.

11. Should I give advisory shares to my investors?

“Board members and (good) investors are always de facto advisors.”

Paul Graham

Angels or seed investors may ask for advisory shares. They might argue that they will be more helpful than the other investors, so they should get advisory shares.

But every investor thinks he will add more value than the other investors. We would like to propose a shareholder’s code of conduct: if you think you’re doing too much, you’re probably just doing your share.

So, how do you decide whether you should give advisory shares to an investor?

First, determine how many shares you would give him if he were just an advisor. Then subtract the number of shares he is buying with his investment. If the balance is significant, say, more than 50% of the shares he is buying, give him the balance in advisory shares. If the balance is under 25%, the additional shares won’t really matter to the investor and they aren’t worth the trouble of trying to justify the advisory shares to the other investors.

(This is why you never give advisory shares to venture capitalists nor do they ask for them: the balance for VCs is zero since they are buying so much of the company anyway.)

If the balance is not significant, you should just say no:

“All of our investors will be advising the company. That’s what good investors do. If I gave you advisory shares, I would have to give them to all the investors. And that wouldn’t make any sense—our valuation already takes the investor’s value-add into account.”

But if the balance is significant, you need an argument that makes sense to the other investors or they will also ask for advisory shares and lower your effective valuation:

“We want to hire him as an advisor. Fortunately, we don’t have to give him all the shares for free because he’s also going to invest as much as he can.”

You have to be able to convince the other investors—that’s the test. Or you can just “burn the boats at the shore” and give the advisory shares to the investor with the agreement that he will invest a minimum amount in the financing.