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Executive Compensation

What are average compensation packages for executive positions in start-ups?

This article comes from Peter Kennedy of WTR Consulting Group [pkennedy@wtrbeth.com].

First of all, there is no traditional average for the amount of stock given to a new executive in a very small Internet start-up. If you knew what was given to every new executive in every new start-up, you would have every imaginable amount from 50% or more to a small fraction of the company equity. The key question to answer is: how much are you willing to give up, and in fact risk, now, and how much might you give up later? Your answer depends on a lot of factors, including the following:

• What are the chances of future success (with and without a key player)?
• How many other key executives may I need to recruit later?
• How widely do I want to share ownership and under what circumstances? (The faster you grow, the less you need to retain as a percentage of the total equity).
• How much risk is the new executive willing to take on? (The more risk, the greater should be the potential reward).
• When do you plan to go public and under what circumstances?

Secondly, there are some good general rules of thumb to follow in structuring an executive compensation plan. The best thing to keep in mind up front is that the interests of the owner and the interests of the hired executive tend to diverge on a number of fronts, including the following:

• The amount of risk assumed,
• The time horizon for a return on investment, and
• The ability to re-deploy assets.

The owner/entrepreneur is usually willing to take a great deal of risk while the executive/manager is generally much more risk averse. The owner is going for all or nothing, while the executive is less willing to make a wild bet.

The owner usually has a fairly long time horizon and is willing to be patient about eventual success. The executive is generally working with an annual time horizon is much more impatient for success. Compensation can not wait for several years, since the executive is investing human capital, and has entered into a contract to exchange services for compensation.

The owner may ultimately exit out of an investment and re-deploy assets in another venture. The executive's investment of human capital is more difficult to re-deploy. The executive is trying to build a career, and must seek another opportunity that seeks the kind of experience and qualifications gained from the last venture. This can take time.

With that in mind, an executive compensation plan that is able to cause the interests of the owner and the executive to converge is generally more successful than one that tends to reinforce these different interests. In general, that means some meaningful ownership interest, contingent on performance, ought to be a part of the executive's compensation package. How much? In general, some now, and perhaps more later, all tied to actual results.

One way to approach this is to have a better understanding of the marketplace for the executive's qualifications and experience. What are other's willing to pay for the skill set, the reputation, the experience, the track record, the education, etc? Put another way, where would your ideally qualified executive most likely be working? And where would this executive go after working for you?

Starting with an amount of money that represents the estimated present value of total direct and indirect compensation over a fixed period of time (say five years), the question becomes how to allocate that compensation in two ways:

1. Over time
2. Over different elements of compensation

Thinking about a 5-year time horizon initially, does it make the most sense to allocate the compensation as equal amounts over the time period, as declining amounts, or as increasing amounts? I would suggest the latter.

As to different elements of compensation (described further below), the basic question is how much to allocate to fixed compensation, and how much to allocate to variable compensation. Base salary and most benefits are fixed compensation, annual and longer term incentives, including stock options, are variable compensation. Again, the answer for start ups should be obvious: put as much as possible into variable compensation initially. The following examples should illustrate the ideal principle, which can only serve as a starting point for negotiation, but which at least gives the owner a philosophical and financial basis for an opening offer.

The numbers are not necessarily representative, although they shouldn't be too far off for a small start up. Please note the following in the example:

• Base salary only goes up about 2% a year.
• Bonus represents 30% of base salary in year 1, rising to 70% in year 5
• Stock represents 20% of base salary in year 1, rising to 100% in year 5
• Variable pay amounts assume outstanding year to year performance; high growth and high profit
• Benefits and perquisite costs remain relatively flat over time
• Variable pay represents an increasing share of total compensation over time.
• Total compensation increases substantially over time.

As background for this example, a definition of the different elements of executive compensation follows.

The typical executive compensation program is structured to include the following components:

• Base salary,
• Short term (annual) incentive payments,
• Long term (2-5 years) incentive payments,
• Stock options (10 year option term),
• Supplemental benefit plans, and
• Perquisites.

Base salary is the amount that an executive receives generally irrespective of the performance of the company at any particular point in time. In most cases, executive base salaries are more closely related to the size and scope of a company's operations, to type of company ownership, and to industry, than to considerations having to do with recent company or individual performance. Base salary is generally increased from year to year at a relatively steady pace that corresponds closely to average increases for all employees for that year (typically 4%-7%). This excludes promotional increases, competitive adjustments, or incentive payments. There is some relationship with general inflationary trends, although only over longer periods of time.

Annual incentive payments are typically based on tactical objectives measured on a year to year basis. The objectives can relate to company or individual performance. As a company moves into a more competitive environment, the variability of annual incentive payment amounts is likely to increase.

The characteristics described for short term incentives would also generally apply to long term incentives, except long term incentives are often based on goals identified as "strategic." Ostensibly, the intention is to focus the executive's attention on long term planning and results. Because long term incentive payments incorporate longer periods of performance measurement, their variability is likely to be greater than short term payments.

Stock options are granted to executives from time to time as a reward for performance or as a means of aligning executive and shareholder interests. Where company cash flow and capital resources are limited, typically in an early stage of growth, stock options are often used as a substitute for higher cash compensation. The amount of options provided is rarely based on the meeting of specific performance objectives, although this practice is increasing. The value of the options relates only to the growth in the value of company stock and not to any specific performance by the executive. The value of stock options is not currently accounted for on the income statement, representing only a dilution of shareholder equity, instead of a direct expense that reduces net income for accounting purposes. However, FASB Statement 123, "Accounting for Stock-Based Compensation," which was adopted in October of 1995, encourages companies to adopt a new method of accounting which would reflect the estimated fair value based on a selected option pricing model and would have the effect of reducing net income and earnings per share, either directly in the financial statements where the approach is adopted, or in the very least, in pro forma disclosures in the footnotes to financial statements, where companies continue to rely on APB Opinion 25 for stock option accounting.

Supplemental benefits are those benefits provided to executives that are in addition to the benefits provided for rank and file employees of the company. These are typically provided in the retirement area to make up for limitations imposed by the Internal Revenue Service on highly compensated employees on the benefits that are otherwise available to all employees under the general retirement plan benefit formula.

Perquisites have traditionally been available to executives to assist them with the performance of their job duties and to convey the rank and status of their office, particularly with respect to the outside contacts the executive must cultivate. In recent years, where perquisites do not have a strong business rationale, they have often been abandoned.

[Peter Kennedy, WTR Consulting, pkennedy@wtrbeth.com]

Q2 What are good resources for determining compensation for both technical and executive positions? [Ariel Glassman, glassmaa@nsainc.com]

In general compensation strategies get very complicated very quickly, so be prepared for some real head scratching. There are no easy answers. Another thing to keep in mind is the impact on your personal exit strategy: if you plan on selling the company, you don't want to have given most of it away early on. [Hans Tallis, Hans_Tallis@ers.com]. Depending on the type of salary information you are looking for, check out the following resources:

General Salary Information:

• The Bureau of Labor Statistics, http://stats.bls.gov/ has lots of information on salary statistics. You can find the average/high/low for System Analysts in a particular region. Do a search on the position name and the city/state you want. Information is in PDF and ASCII. [Miles Fawcett, miles@iapps.com]
• The Software Publishers Association (based in DC) publishes annual salary surveys that include technical and managerial positions. [Neil Harris, neil@simultronics.com]
• Some statistics from a 1997 executive compensation survey (for California): http://www.hronline.org/research/hiex.HTM
• Order form for 1997 National Executive Compensation Study, http://maea.org/survey.htm

Executive Compensation:

• For a services business with approx. $1 million in revenues, you can expect to pay a CTO about $120-150K salary, plus options on 2-5% of the company, plus an eventual bonus of 20-40% of salary. A COO would cost approximately $140-180K, plus options of 5-10% of the company, or more, plus a bonus of 20-50%. [A VC investor]
• Don't commit too much of an ownership interest up front, before you really know how well a newcomer would do. Leverage your offer of a somewhat lower base salary with a high target bonus tied to the results you are expecting, so that the individual can earn significantly more in cash compensation if performance expectations are met. Allow for a range of possible bonus payments tied to a range of possible growth and net income results. [A compensation consultant]
• Stick with 3% equity if that's what you're comfortable with, and offer a warrant or other options to purchase more shares at a good price based on the person's meeting performance goals. Have that person then take 24-48 hours to define the goals he/she will meet. Put a deadline on getting a response to you. Make sure he/she provides summary estimates for what it will cost in time and money (aside from salary) to meet the goals. Take at least 24 hours after you get the response to reshape it to your liking. If his/her goals are too far off the mark, go back and redefine the goals. Then, meet in person to make the final offer. Frame it in terms of goals, not money. Stick to the 3% plus options format. Finally, have one more person on your side of the table than your "target" does when you make the offer, and if possible, have one of your investors as the extra person on your side. The rest is easy. Hire if the person says "yes", or walk if the person says "no" or nothing, and don't look back. [Cliff Brody, Kidz Own America]
• The following attorneys may be able to make some suggestions:
  • Mark Wishner, Michaels Wishner & Bonner, 202-223-5000, mwishner@mwblegal.com
  • John Sullivan, Venable Baetjer & Howard, 703-760-1655, jlsullivan@venable.com
  • Ned Martin, Piper & Marbury, 202-861-6315, emartin@pipermar.com

Technical Positions:

• A book called "Graphic Artists Guild Handbook: Pricing and Ethical Guidelines" (ISBN:0-932102-08-5) is an excellent resource for design staff and general cost guidelines. There latest edition covers web development professionals. [Miles Fawcett, miles@iapps.com]
• The Hay Group http://www.haygroup.com/ (in Philadelphia) is a world leader in compensation consulting. They have a pretty good book out, "People, Performance & Pay" (Free Press). It emphasizes that for a compensation scheme to achieve effects you need to regularly advertise, monitor and encourage it. They also run seminars and do consulting.
• Type "compensation consult" into your favorite web search tool to find other online resources.

Q3 What kind of exit strategy compensation do I need to consider? [Pam Maloney, pmaloney@inner-vista.com]

Don't worry about someone's exit strategy. I heard a very interesting story the other day: a very hot new company had found the perfect CFO, and struck the perfect deal, including a package laden with options. However, at the final negotiation the prospect asked for a severance package. "We don't do those," the company said. That was it. Keep in mind, unlike some area companies, this one had set the reward return high to compensate for the risk involved. [Esther Smith, esmith@morino.org]

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