By Eric Paley
FORTUNE -- Venture-backed startups are incredibly ambitious. A startup team comes together to try to create something highly improbable and well beyond what can reasonably be expected given the scarce resources at hand. Once financed, everyone at the startup should have a reasonable salary, but the real compensation for achieving the improbable is equity.
Inevitably, I get into a discussion with my companies about bonus packages. The idea being that startups are cash constrained and should limit the guaranteed salary costs, but that if the company is achieving goals, it should reward its employees with non-guaranteed compensation for a job well done.
The logic is compelling, but faulty. Bonuses are toxic at startups.
Outside of sales rep commissions, I don't think startups should be giving employee or management bonuses in the early years -- or at least not before the company has very well understood financial performance. The problem is that bonuses don't match well with the audacious ambition of the startup and aren't fair to the company or its employees.
Inevitably, startups don't quite live up to their goals. Using revenue metrics because they are simple, consider the startup that has $3 million in previous year revenue and is hoping to 4X that this coming year to $12 million. Instead it does $9 million in sales. The team bonus is based on hitting or exceeding the goals. The team has worked really hard and, by all means, has done strong work growing the business. Yet it's fallen short of the goal. Unfortunately, somewhere over the course of the year, the team members start to assume that they will get the bonus. After all, the team tripled the business and worked really hard to do it. Yet the bonus was clearly for meeting or exceeding the goals.
What should the company do now? Disappoint their hard-working team by not giving a bonus or give the bonus and suggest that the goals are soft goals and the team will get paid as long as there is general progress and the team works hard. Add to the scenario that at $12 million in revenue the company would be positive cash flow for the first time and have cash to pay a bonus and at $9 million the company loses $1 million and will need to raise more capital and suffer additional dilution to cover the loss and potentially the bonus. It's easy to imagine employees leaving the company and saying that the goals are crazy -- "we tripled the business and didn't even get our bonuses."
Most companies just pay out the bonus anyway. Did that make the employees happy? Not really. They expected it. Did the bonus help set the ambitious goals for the next year? Not really. Paying the bonus below the goal suggested that the goals don't really matter, which undermines the idea that the bonus is a form of motivation that leads to retention.
Worse yet, bonuses are not effective at recruiting employees. Most people that I know are a bit skeptical of bonuses before they join a company. They have no idea how ambitious the goals are or how likely they are to achieve the target bonus. On top of that, there is an ego element tied to salary that is absent in bonuses. All other things being equal, most people would rather join a company offering $100,000 a year in salary than make $90,000 a year with a potential target bonus of $20,000. That isn't so much an issue of risk aversion, but more of self assurance that they are worth $100,000 salary combined with the unknown of how likely they are to get any bonus at all.
Bonuses also create a culture of sandbagging and therefore are a bad motivation tool. Instead of wanting to achieve incredibly ambitious goals, employees start to consider whether the goal is likely and whether they will achieve their bonuses if they accept an ambitious goal. By arguing for lower goals, employees are optimizing for getting a bonus while actually working counter to the interests of the company.
Why are large companies different? At large companies goals are not as ambitious (10% growth vs. 200% growth) and employees typically don't have the equity potential that they have at startups. Most importantly, financial goals are much better understood and typically achievable. Startups forecast based on what's possible. Large companies forecast based on what's probable. It's easier to bonus employees on the latter than the former.
So bonuses aren't a good recruiting tool. Or a good retention tool. Or a good motivation tool. For these reasons, bonuses damage culture and focus the team on the wrong objectives.
What compensation tool is effective for recruiting, retaining, and motivating employees at a startup? Equity. Pay employees a fair salary for the stage of the company and keep everyone aligned to the extraordinary equity potential of huge growth. If the company achieves a 4X plan, the company's equity has appreciated more than if it achieves a 3X plan. When employees don't quite achieve plan, they understand that the equity hasn't appreciated as much, but they are still rewarded for the forward progress with assumed appreciation of their stock. Employees have no financial incentive to sandbag because trying to achieve ambitious goals is how they maximize the equity reward.
Best of all, equity has the potential of paying out orders of magnitude higher than any potential bonus.
Proposed limits on banker bonuses would cause the slow death of what continues to be - despite overregulation and higher taxes - a very profitable industry for Europe.
By Cyrus Sanati
FORTUNE -- The European Union and Switzerland would be wise to rethink recently proposed policies restricting bonus payouts. The new rules, which cap bonuses for banking employees in the EU and for all employees of publicly-traded companies in Switzerland, could MOREMar 5, 2013 11:31 AM ET
New York City bean counters would like you to believe that Wall Street bonuses have plummeted since 2006. In fact, the reality is much different, at least for those who are left in the industry.
By Cyrus Sanati
FORTUNE -- Wall Street compensation may look shoddy compared to the boom years, but it's really not as bad as the numbers suggest. Estimates released Tuesday by New York State show bonus payouts MOREFeb 28, 2013 8:34 AM ET
With one year left, Goldman Sachs looks like it will come up woefully short of producing a big payout for its CEO and other executives.
FORTUNE -- Lloyd Blankfein may soon have to walk away from a $10 million payday.
Two years ago, Goldman Sachs set up a special bonus plan for its CEO and four other top executives that would produce an eight figure payout should the firm hit specific profit MOREStephen Gandel, senior editor - Feb 12, 2013 1:57 PM ET
Wall Street's bad bonus year did not extend to Citigroup's c-suite.
FORTUNE -- Vikram Pandit is officially no longer Citi's $1 man. Whether he should be a $15 million one is the question.
Yesterday, the bank disclosed that it paid its CEO nearly $14.9 million in cash and options in 2011. That was up from a dollar the year before. Back in 2009, Pandit said he would take a salary of $1 until MOREStephen Gandel, senior editor - Mar 9, 2012 4:58 PM ET
Here's a tear-jerker: Goldman Sachs' better-than-expected first quarter won't mean a bigger bonus pool.
Goldman's (GS) per capita compensation expense fell 11% from a year ago in the quarter ended March 31, even as the firm's revenue and profits handily beat analysts' expectations. Scrimping on pay isn't exactly what Wall Street is known for, as the raises being handed out at J.P. Morganattest. So what gives?
The answer is that Goldman's revenue, MOREColin Barr - Apr 19, 2011 9:23 AM ET
Who says there's no wage growth in the United States?
Bankers at J.P. Morgan, the investment banking unit of JPMorgan Chase (JPM), are in line for a 34% raise this year, if the bank keeps paying at its torrid first-quarter clip.
The investment bank set aside $3.3 billion for compensating its 26,494 workers in the first quarter. That's equivalent to $124,330 for the quarter and projects to $497,320 for the year.
That compares MOREColin Barr - Apr 13, 2011 8:36 AM ET
Give Transocean this: It never runs out of ways to make itself look shabby.
The Swiss-based oil driller tried to clean up a major public relations mess, announcing Tuesday that its five top execs will give back a fraction of the bonuses they undeservingly received for last year. Transocean (RIG) put the fool in April Fool's Day last week by awarding the five $898,282 in bonuses in recognition of the "best year in safety MOREColin Barr - Apr 6, 2011 5:49 AM ET
The oil driller committed the corporate public relations blunder of the year, then followed up with an empty apology. What will it do for an encore?
Making full use of its April 1 filing date, Transocean's (RIG) proxy statement deemed 2010 the "best year in safety performance in our company's history," by certain statistical measures. In a small oversight, those stats ignored the 11 deaths caused last April when the company's MOREColin Barr - Apr 4, 2011 1:48 PM ET
In the you don't see this every day department, executives at ING are giving back their bonuses.
ING (ING) CEO Jan Hommen sounded his hasty retreat in an op-ed piece Tuesday in a Dutch newspaper, after his 1.25 million-euro ($1.8 million) payout came under attack in the public and in Dutch parliament.
Two other top execs at ING, which has repaid only half of a 10 billion-euro financial crisis bailout, will give back their MOREColin Barr - Mar 22, 2011 10:50 AM ET
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