Startups should keep employee upside in equity.

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.

Eric Paley (@epaley) is managing partner at Founder Collective. This post originally appeared on his blog.