You’ve decided to start a company. Your business plan is based on sound strategy and thorough market research. Your background and training have prepared you for the challenge. Now you must assemble the quality management team that venture investors demand. So you begin the search for a topflight engineer to head product development and a seasoned manager to handle marketing, sales, and distribution.
Introduction
Attracting these executives is easier said than done. You’ve networked your way to just the marketing candidate you need: a vice president with the right industry experience and an aggressive business outlook. But she makes $100,000 a year in a secure job at a large company. You can’t possibly commit that much cash, even if you do raise outside capital. How do you structure a compensation package that will lure her away? How much cash is reasonable? How much and what type of stock should the package include? Is there any way to match the array of benefits—retirement plans, child-care assistance, savings programs—her current employer provides? In short, what kind of compensation and benefits program will attract, motivate, and retain this marketing vice president and other key executives while not jeopardizing the fragile finances of your startup business?
Selecting appropriate compensation and benefits policies is a critical challenge for companies of all sizes. But never are the challenges more difficult—or the stakes higher—than when a company first takes shape. Startups must strike a delicate balance. Unrealistically low levels of cash compensation weaken their ability to attract quality managers. Unrealistically high levels of cash compensation can turn off potential investors and, in extreme cases, threaten the solvency of the business. How to proceed?
First, be realistic about the limitations. There is simply no way that a company just developing a prototype or shipping product for less than a year or generating its first black ink after several money-losing years of building the business can match the current salaries and benefits offered by established competitors. At the same time, there are real advantages to being small. Without an entrenched personnel bureaucracy and long-standing compensation policies, it is easier to tailor salaries and benefits to individual needs. Creativity and flexibility are at a premium.
Second, be thorough and systematic about analyzing the options. Compensation and benefits plans can be expensive to design, install, administer, and terminate. A program that is inappropriate or badly conceived can be a very costly mistake. Startups should evaluate compensation and benefits alternatives from four distinct perspectives.
How do they affect cash flow? Survival is the first order of business for a new company. Even if you have raised an initial round of equity financing, there is seldom enough working capital to go around. Research and development, facilities and equipment, and marketing costs all make priority claims on resources. Cash compensation must be a lower priority. Despite this awkward tension (the desperate need to attract first-rate talent without having the cash to pay them market rates), marshaling resources for pressing business needs must remain paramount.
What are the tax implications? Compensation and benefits choices have major tax consequences for a startup company and its executives; startups can use the tax code to maximum advantage in compensation decisions. Certain approaches, like setting aside assets to secure deferred compensation liabilities, require that executives declare the income immediately and the company deduct it as a current expense. Other approaches, like leaving deferred compensation liabilities unsecured, allow executives to declare the income later while the company takes a future deduction. Many executives value the option of deferring taxable income more than the security of immediate cash. And since most startups have few, if any, profits to shield from taxes, deferring deductions may appeal to them as well.
What is the accounting impact? Most companies on their way to an initial public offering or a sellout to a larger company must register particular earning patterns. Different compensation programs affect the income statement in very different ways. One service company in the startup stage adopted an insurance-backed salary plan for its key executives. The plan bolstered the company’s short-term cash flow by deferring salary payments (it also deferred taxable income for those executives). But it would have meant heavy charges to book earnings over the deferral period—charges that might have interfered with the company’s plans to go public. So management backed out of the program at the eleventh hour.
What is the competition doing? No startup is an island, especially when vying for talented executives. Companies must factor regional and industry trends into their compensation and benefits calculations. One newly established law firm decided not to offer new associates a 401(k) plan. (This program allows employees to contribute pretax dollars into a savings fund that also grows tax-free. Many employers match a portion of their employees’ contributions.) The firm quickly discovered that it could not attract top candidates without the plan; it had become a staple of the profession in that geographic market. So it established a 401(k) and assumed the administrative costs, but it saved money by not including a matching provision right away.
Events at a Boston software company illustrate the potential for flexibility in startup compensation. The company’s three founders had worked together at a previous employer. They had sufficient personal resources to contribute assets and cash to the new company in exchange for founders’ stock. They decided to forgo cash compensation altogether for the first year.
Critical to the company’s success were five software engineers who would write code for the first product. It did not make sense for the company to raise venture capital to pay the engineers their market-value salaries. Yet their talents were essential if the company were to deliver the software on time.
The obvious solution: supplement cash compensation with stock. But two problems arose. The five prospects had unreasonably high expectations about how much stock they should receive. Each demanded 5% to 10% of the company, which, if granted, would have meant transferring excessive ownership to them. Moreover, while they were equal in experience and ability and therefore worth equal salaries, each had different cash requirements to meet their obligations and maintain a reasonable life-style. One of the engineers was single and had few debts; he was happy to go cash-poor and bank on the company’s growth. One of his colleagues, however, had a wife and young child at home and needed the security of a sizable paycheck.
The founders devised a solution to meet the needs of the company and its prospective employees. They consulted other software startups and documented that second-tier employees typically received 1% to 3% ownership stakes. After some negotiation, they settled on a maximum of 2% for each of the five engineers. Then they agreed on a formula by which these employees could trade cash for stock during their first three years. For every $1,000 in cash an engineer received over a base figure, he or she forfeited a fixed number of shares. The result: all five engineers signed on, the company stayed within its cash constraints, and the founders gave up a more appropriate 7% of the company’s equity.
Cash vs. Stock
Equity is the great compensation equalizer in startup companies—the bridge between an executive’s market value and the company’s cash constraints. And there are endless variations on the equity theme: restricted shares, incentive stock options, nonqualified options, stock appreciation rights (SARs), phantom stock, and the list goes on. This dizzying array of choices notwithstanding, startup companies face three basic questions. Does it make sense to grant key executives an equity interest? If so, should the company use restricted stock, options, or some combination of both? If not, does it make sense to reward executives based on the company’s appreciating share value or to devise formulas based on different criteria?
Let’s consider these questions one at a time. Some company founders are unwilling to part with much ownership at inception. And with good reason. Venture capitalists or other outside investors will demand a healthy share of equity in return for a capital infusion. Founders rightly worry about diluting their control before obtaining venture funds.
Alternatives in this situation include SARs and phantom shares—programs that allow key employees to benefit from the company’s increasing value without transferring voting power to them. No shares actually trade hands; the company compensates its executives to reflect the appreciation of its stock. Many executives prefer these programs to outright equity ownership because they don’t have to invest their own money. They receive the financial benefits of owning stock without the risk of buying shares. In return, of course, they forfeit the rights and privileges of ownership. These programs can get complicated, however, and they require thorough accounting reviews. Reporting rules for artificial stock plans are very restrictive and sometimes create substantial charges against earnings.
Some founders take the other extreme. In the interest of saving cash, they award bits of equity at every turn. This can create real problems. When it comes to issuing stock, startups should always be careful not to sell the store before they fill the shelves. That is, they should award shares to key executives and second-tier employees in a way that protects the long-term company interest. And these awards should take place only after the company has fully distributed stock to the founders.
The choice of whether to issue actual or phantom shares should also be consistent with the company’s strategy. If the goal is to realize the “big payoff” within three to five years through an initial public offering or outright sale of the company, then stock may be the best route. You can motivate employees to work hard and build the company’s value since they can readily envision big personal rewards down the road.
The founder of a temporary employment agency used this approach to attract and motivate key executives. He planned from the start to sell the business once it reached critical mass, and let his key executives know his game plan. He also allowed them to buy shares at a discount. When he sold the business a few years later for $10 million, certain executives, each of whom had been allowed to buy up to 4% of the company, received as much as $400,000. The lure of cashing out quickly was a great motivator for this company’s top executives.
For companies that plan to grow more slowly over the first three to five years, resist acquisition offers, and maintain private ownership, the stock alternative may not be optimal. Granting shares in a company that may never be sold or publicly traded is a bit like giving away play money. Worthless paper can actually be a demotivator for employees.
In such cases, it may make sense to create an artificial market for stock. Companies can choose among various book-value plans, under which they offer to buy back shares issued to employees according to a pricing formula. Such plans establish a measurement mechanism based on company performance—like book value, earnings, return on assets or equity—that determines the company’s per-share value. As with phantom shares and SARs, book-value plans require a thorough accounting review.
If a company does decide to issue shares, the next question is how to do it. Restricted stock is one alternative. Restricted shares most often require that an executive remain with the company for a specified time period or forfeit the equity, thus creating “golden handcuffs” to promote long-term service. The executive otherwise enjoys all the rights of other shareholders, except for the right to sell any stock still subject to restriction.
Stock options are another choice, and they generally come in two forms: incentive stock options (ISOs) and nonqualified stock options (NSOs). As with restricted shares, stock options can create golden handcuffs. Most options, whether ISOs or NSOs, involve a vesting schedule. Executives may receive options on 1,000 shares of stock, but only 25% of the options vest (i.e., executives can exercise them) in any one year. If an executive leaves the company, he or she loses the unexercised options. Startups often prefer ISOs since they give executives a timing advantage with respect to taxes. Executives pay no taxes on any capital gains until they sell or exchange the stock, and then only if they realize a profit over the exercise price. ISOs, however, give the company no tax deductions—which is not a major drawback for startups that don’t expect to earn big profits for several years. Of course, if companies generate taxable income before their executives exercise their options, lack of a deduction is a definite negative.
ISOs have other drawbacks. Tax laws impose stiff technical requirements on how much stock can be subject to options, the maximum exercise period, who can receive options, and how long stock must be held before it can be sold. Moreover, the exercise price of an ISO cannot be lower than the fair market value of the stock on the date the option is granted. (Shares need not be publicly traded for them to have a fair market value. Private companies estimate the market value of their stock.)
For these and other reasons, companies usually issue NSOs as well as ISOs. NSOs can be issued at a discount to current market value. They can be issued to directors and consultants (who cannot receive ISOs) as well as to company employees. And they have different tax consequences for the issuing company, which can deduct the spread between the exercise price and the market price of the shares when the options are exercised.
NSOs can also play a role in deferred compensation programs. More and more startups are following the lead of larger companies by allowing executives to defer cash compensation with stock options. They grant NSOs at a below-market exercise price that reflects the amount of salary deferred. Unlike standard deferral plans, where cash is paid out on some unalterable future date (thus triggering automatic tax liabilities), the option approach gives executives control over when and how they will be taxed on their deferred salary. The company, meanwhile, can deduct the spread when its executives exercise their options.
One small but growing high-tech company used a combination of stock techniques to achieve several compensation goals simultaneously. It issued NSOs with an exercise price equal to fair market value (most NSOs are issued at a discount). All the options were exercisable immediately (most options have a vesting schedule). Finally, the company placed restrictions on the resale of stock purchased with options.
This program allowed for maximum flexibility. Executives with excess cash could exercise all their options right away; executives with less cash, or who wanted to wait for signs of the company’s progress, could wait months or years to exercise. The plan provided the company with tax deductions on any options exercised in the future (assuming the fair market value at exercise exceeded the stock’s fair market value when the company granted the options) and avoided any charges to book earnings in the process. And the resale restrictions created golden handcuffs without forcing executives to wait to buy their shares.
The Benefits Challenge
No startup can match the cradle-to-grave benefits offered by employers like IBM or General Motors, although young companies may have to attract executives from these giant companies. It is also true, however, that the executives most attracted to startup opportunities may be people for whom standard benefit packages are relatively unimportant. Startup companies have special opportunities for creativity and customization with employee benefits. The goal should not be to come as close to what IBM offers without going broke, but to devise low-cost, innovative programs that meet the needs of a small employee corps.
Of course, certain basic needs must be met. Group life insurance is important, although coverage levels should start small and increase as the company gets stronger. Group medical is also essential, although there are many ways to limit its cost. Setting higher-than-average deductibles lowers employer premiums (the deductibles can be adjusted downward as financial stability improves). Self-insuring smaller claims also conserves cash. One young company saved 25% on its health-insurance premiums by self-insuring the first $500 of each claim and paying a third party to administer the coverage.
The list of traditional employee benefits doesn’t have to stop here—but it probably should. Most companies should not adopt long-term disability coverage, dental plans, child-care assistance, even retirement plans, until they are well beyond the startup phase. This is a difficult reality for many founders to accept, especially those who have broken from larger companies with generous benefit programs. But any program has costs—and costs of any kind are a critical worry for a new company trying to move from the red into the black. Indeed, one startup in the business of developing and operating progressive child-care centers wisely decided to wait for greater financial stability before offering its own employees child-care benefits.
Many young companies underestimate the money and time it takes just to administer benefit programs, let alone fund them. Employee benefits do not run on automatic pilot. While the vice president of marketing watches marketing, the CFO keeps tabs on finances, and the CEO snuffs out the fires that always threaten to engulf a young company, who is left to mind the personnel store? If a substantial benefits program is in place, someone has to handle the day-to-day administrative details and update the program as the accounting and tax rules change. The best strategy is to keep benefits modest at first and make them more comprehensive as the company moves toward profitability.
Which is not to suggest that the only answer to benefits is setting strict limits. Other creative policies may not only cost less but they also may better suit the interests and needs of executive recruits. Take company-supplied lunches. One startup computer company thought it was important to create a “think-tank” atmosphere. So it set up writing boards in the cafeteria, provided all employees with daily lunches from various ethnic restaurants, and encouraged spirited noontime discussions.
Certainly, Thai food is no substitute for a generous pension. But benefits that promote a creative and energetic office environment may matter more to employees than savings plans whose impact may not be felt for decades. One startup learned this lesson after it polled its employees. It was prepared to offer an attractive—and costly—401(k) program until a survey disclosed that employees preferred a much different benefit: employer-paid membership at a local health club. The company gladly obliged.
Conclusion
Deciding on compensation policies for startup companies means making tough choices. There is an inevitable temptation, as a company shows its first signs of growth and financial stability, to enlarge salaries and benefits toward market levels. You should resist these temptations. As your company heads toward maturity, so can your compensation and benefits programs. But the wisest approach is to go slowly, to make enhancements incrementally, and to be aware at all times of the cash flow, taxation, and accounting implications of the choices you face.
