Breaking Down Start-up Compensation

What I wish I knew 5 years ago

The below is not financial or legal advice.

The CEO role

Your jobs as a start-up CEO are to:

• Set the vision

• Hire and incentivise well

• Build a strong culture

This post doubles down on the incentivise well part, and details the compensation component of start-ups and my framework for evaluating it from an employee perspective.

Why compensate?

Compensation is one of the key mechanisms to incentivise people to do good work for you. There are others that are often more impactful such as mission or learning, but compensation still plays a substantial role in building a great company, so it’s worth deep diving.

Note here how compensation is there to incentivise people to do good work for you, not just to continue to work for you and not join your rivals.

I reiterate, poor comp design leads to underperformance amongst high performers.

As such, the objective of a compensation discussion is not to win, but to go through a discovery process to reach a point where all parties are happy. In this case all parties are:

• Employer / Investors

• Employee

• Other employees

It is pivotal that all 3 of these parties are happy with the outcome; if this situation cannot be created, then there is likely to be a flaw in one of the benchmarks for compensation assessment or a difference in how the employee, employer or team perceive their value.

What is fair

There are a few benchmarks to evaluate what fair is:

• Market benchmarks

• Individual impact assessment

• Firm benchmarks relative to other employees

I recommend a view of a balance of all three.

Market benchmarks

Market benchmarks give an indication of the alternative options that an employee has, as well as the cost of replacing them in an open market. Here the core factors I would assess are:

• Experience level

• Geography (I’d also proceed with caution with geography in a world of greater remote work and easier access to foreign employment opportunities)

• Role type

Some individuals use things like company stage when assessing the compensation framework. Having seen this across multiple start-ups, I believe that doing so is a driver of churn and underperformance in start-up teams. Company stage will likely lead to a different overall cash/equity balance as potential equity upside is higher, but I’m not sure it’s a good idea to reduce overall compensation for earlier stage companies.

In general, given how start-up outcomes are pretty binary, and top performers more than make up for their value, it makes sense to try to be at the top end of compensation bands to attract the top talent.

Individual impact assessment

Individual impact assessment gives an indication of where this employee may be more valuable relative to their peer set, and also an indication of the potential value lost from losing said employee. If other employees also recognise the value that a relevant employee brings then putting more weight on this makes sense. As start-up outcomes are so binary, they rely on superstar employees, as such, a more bespoke assessment of impact makes sense. From my experience working in start-ups but also managing an angel portfolio and from years of management consultancy, there really is a substantial difference between good and great employee, I’d argue this multiple is closer to 5x. In Netflix’s culture deck, they argue that in procedural work the best are 2x greater than average, in creative/inventive work the best are 10x better. The core determinents of 10x employees is both hiring the best, but also incentivisng them well through a thorough compensation strategy and culture. As such, I’d say that it is more important to weigh up individual impact over benchmarks when it comes to start-up compensation.

Firm Benchmarks

Firm benchmarks are a crucial determinant to building culture. People behave according to what you do not what you say. They act according to what you reward not what you tell them. If a firm overcompensates for the wrong behaviour, that behaviour will be replicated. Certain things like loyalty are valuable to a point, but performance drives growth and growth ensures all else.

In the Invest like the best podcast, Doug Leone says:

“If you stick everyone’s compensation on a wall, they should all feel comfortable with that”.

Companies like Buffer and Even healthcare have taken this one step further by just making compensation frameworks public.

If there is a disparity between views of market benchmarks, then this should be rectified as openly as possible to see where the disparity is. Similarly it’s important to assess an employees individual impact as objectively as possible, and try to reach consensus. There are a series of mechanisms like 360 reviews where you also get a sense check from fellow employees about an employee, but the main thing to aim for in a process like this is that they are compensated in a way that the team would deem fair.

If there is a discrepancy in how the employee vs employer vs other employees view a person’s performance, and this discrepancy is not resolved, it is good to find more objective metrics for an employee to be judged on, and if not to part ways – not doing so could lead to resentment or a change in culture which will stagnate the productivity of fellow employees. The more objectively this is mapped out the more likely you can get to a good end state.

I must reiterate that compensation should not just be seen as a mechanism to ensure that an employee stays, but instead one of a few methods for ensuring that team members are enthused enough to grind towards company objectives.

Personalising compensation

The most important thing to assess when compensating an employee is what would best incentivise them. Some people like a high salary and are motivated by the need for a high salary. Others need very little salary and would prefer to have a lot of ownership in the thing that they are building. Other’s would prefer a company that invests in their development so would be better incentivised by the investment of more senior time on coaching. Understanding what people actually want is the best driver to getting compensation right.

How to assess an offer as an employee

This next section runs through the key factors in start-up compensation and a method to compare them to potential outcomes.

The objective of this section is to allow an employee to calculate a net adjusted compensation for a startup and compare it to alternatives.

Comparable selection is incredibly important to this process to ensure that you benchmark correctly. My view is that you should compare the offer to the best alternative that you would be willing to do and capable of landing. This is distinct from the next best role you could do as if you are not willing to do it then it makes no sense as a comparable.

Three components to compensation:

• Cash

  • Base Salary

  • Bonus

  • Commissions

• Equity

• Other

  • Token pool

  • Perks

• Adjustment Working hours/lifestyle

( Base salary + Bonus(-50%) + Other comp.(-50%) + Equity(*1.5) + Perks – tax deduction) / Lifestyle adjustment

Base Salary in general will be slightly lower at a start-up than a large corporate, or investment fund. As a start-up hits later stages and raises more money, base salaries generally improve to be on par with the market, but with that potential equity upside usually decreases. As you grow in your time at a start-up, your role likely grows too and your base salary should grow with that.

At early stages base salaries are generally kept low as people tend to be more minded to optimise for equity during these stages – this is driven by the fact that these individuals are usually the type to want to reap the upside of their work and are usually more risk taking than those who join later stage startups. In support of a desire amongst the startup and team to avoid dilution of their equity at early stages of the business, employees will often be willing to accept the minimal amount they need to live as an early base salary. As there is generally an expectation in these situations that base salary will be baselined to market as the start-up grows, I’d argue that it’s better for an employee to sacrifice salary for equity at early stages as the salary pool will likely grow, where potential additional equity will diminish substantially, particularly if the start-up does well.

Bonuses at start-ups, I’ve seen either no bonuses or bonuses to be a smaller proportion (e.g. 20% of base salary). In general the joy of scaling and value accrual in the equity owned is enough of a driver to incentivise work. With scale as equity upside reduces, the start-up raises then bonuses may be used to provide further incentive to team members. These however will be substantially different to those seen in private equity, banking or other comparable fields.

In general, as start-ups are more likely to face changing funding situations, bonuses are also less guaranteed and so when assessing an offer it’s worth discounting for the risk of a substantially lower or no bonus.

Discount 50% and then discount taxes

Commission related bonueses are more guaranteed so require less adjustment.

Equity is arguably the best incentive mechanism that start-ups can use to incentivise talent for multiple reasons as it:

• Ties upside to performance via the success of the company

• Is a team incentive rather than individual so increases collaboration

• Scales with time and good performance to continually motivates as long as performance stays good

When most equity is offered, it is vested over a time period, with a minimum service period before the first tranche is secured (known as the cliff).

The most standard terms I have seen are:

• 4-year vest, 1-year cliff vesting monthly: you get 1/4^th of your allotted equity after 1 year of service, and then 1/48^th for every month you serve thereafter up to 4 years.

• 3-year vest, vesting annually: you get 1/3^rd of your allotted equity after every 12 months of service

• Amazon vest: 1/20^th after 12 months of service, 3/20^ths 12-months thereafter, 4/20^ths every 6 months for the final 2 years

There are two kinds of equity provided:

• Options

• Restricted Stock Units (RSUs)

Whereas RSUs are actual grants of company given to you for employment at said company; Options give you the right, but not the obligation, to buy shares of the company’s stock at a predetermined “exercise” price. The date you receive the options is known as the “grant date,” and the predetermined price is the “strike price.” The idea is that as the company grows and increases in value, the market price will exceed your strike price, giving you the opportunity to buy shares at a discount.

As such when calculating the value of the options that you are being given at today’s value, you should remove the exercise price from the value of the options today.

I view equity options as you basically being “lent” a certain amount of money to buy equity in a start-up given 4 years’ worth of equity in advance. If the company does well then you are in effect being lent that money interest free. And if it does not then you can jump ship slightly earlier without any loss.

For this reason the calculation I do is the (amount of equity given * 1.1^ vesting period), in effect to account for the value of the interest a year you’d pay if you were to borrow that amount.

The valuation you should use should be best adjusted to what you think the start-up is worth today. For example, during the bubble period of 2021 when everyone was raising at sky high valuations it would have been fair to adjust the value of your equity down to what you feel an appropriate value is. Similarly with most start-ups now market 50-60% below their 2021 valuations, if the start-up has not raised it may be wise to track back it’s valuation slightly. Bear in mind that if the options have an high exercise cost this may well imply that the equity you’re being offered is not worth very much.

Some people like to multiply the equity by the potential amount that it would be worth after a 4-year stint at a startup (assuming 2 rounds of funding each at double the prior valuation). I’d advise against this, I generally view the last round of financing to be the estimated fair value of the equity, if anything investor protections would suggest that the valuation provided is overvalued.

As an employee at one of these start-ups you’re investing your career capital into it, and as such you should only join a start-up that you either think:

• you will learn tonnes from being part of

• will perform exceptionally well

(Ideally both).

Equity equation: (Real Equity Value - Exercise Cost) *(1.1^Vesting period)

In any case, given how variable VC term sheets can be, it’s worth asking for a breakdown of estimated upside for yourself depending on value created.

Other compensation

There are two kinds of other compensation I’m familiar with, token compensation and commissions. Token compensation is a web3 concept, and in my view should be benchmarked to equity – so to say that you receive tokens out of the team pool proportional to your equity ownership in the company relative to the team. Tokens are also locked up for a time period and often vested depending on how long you work at the company post token launch.

I’d discount these by the probability that they will be received: I usually estimate 50% to be conservative

Perks

I view perks to be anything that provides you with tangible value that is not formally seen as compensation. These include dinners where you would otherwise spend on dinner, team retreats etc.

Especially early on in a career, these can add up fast. As a consultant my spending was substantially lower than it was post that role as I no longer had dinner covered for working late most evenings. Similarly, team retreats or health insurance add tangible value that is not formally seen as compensation so should be accounted for.

Taxes

It’s not what you earn it’s what you keep.

Note here in particular that salary, bonuses and commissions are taxed as income tax, whereas with equity you are generally taxed on the initial equity actual value (often quite low) and then the capital gain that your equity receives (which is often lower than income tax).

Lifestyle adjustment

Different jobs require different levels of commitment, and different start-ups have different working norms. If you’re committing more hours to a role, you should for sure adjust for that. Review the learn, earn, time to learn more about this.

Adjust relative to proportional increase in hours worked

A note on documentation

One of the biggest mistakes I made early in my start-up employee journey was not being direct enough in asking for documentation of promised equity. It benefits neither the employee or employer to withhold or delay documentation and not giving employees very clear written agreements and documentation suggests a severe lack of competency amongst start-up leadership, which is a definite indicator of the potential of the start-up. Deprioritising processes like these substantially affects team member motivation, and given a CEOs job is primarily around hiring and incentivising well, as well as building a good culture, ensuring comfort in this area should be a CEOs top priority. Remember, idle or less productive start-up employees are worse than having no employee at all due to effects on other members of the team and the culture.

Another area of caution would be around future growth promises. Good start-ups will make you an offer and if you grow with the role will top you up to ensure you fit within the right baseline. I would highly discourage you from joining any start-up that makes future promises.

On salary, it’s much more common practice to make sure that employees are paid more in line with the market post a fundraise so in writing guarantees of payment after a round is slightly less of a red flag, however, these things may be delayed substantially depending on the market or a myriad of other factors so it is worth proceeding with caution here. The reason it can make sense to take a deal for a future salary increase at an upcoming next round is that you will get access to your equity at what you would expect to be a lower valuation.