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.
Aim high, seek out key networking meetings, and pick yourself a winner.
By Jeff Bussgang
FORTUNE -- My first time jumping into the startup world was as a freshly minted Harvard MBA in 1995. As my classmates were rushing off to high-paying, high-powered jobs on Wall Street, I joined a Series A startup with 30 employees as a product manager, making $65,000 per year - lower than my pre-MBA salary at MOREApr 3, 2013 3:14 PM ET
Not every VC deal can be a hit. And that's when the real work begins.
By Fred Wilson
FORTUNE -- Early stage venture capital is a lot like baseball: If you get a hit one out of every three times, you are headed to the Hall of Fame. And if I look back over my career, and also over the track records of the firms and funds I have helped manage, MOREMar 28, 2013 2:34 PM ET
The three real keys to going public have nothing to do with $100 million in revenue.
By Glenn Solomon
FORTUNE -- As a junior banker at Goldman Sachs (GS) in the early 1990's, I was weaned on the conventional wisdom that growth companies were ready to go public when they reached $100 million in annualized revenue and had at least two quarters of profitability under their belts.
The "$100 million revenue" theory MOREFeb 25, 2013 11:06 AM ET
Startup crowdfunding is due to change drastically this year. Here's advice from Ronny Conway, Ben Horowitz, Kevin Rose, and others.
By Kurt Wagner, reporter
FORTUNE -- Investing successfully in startups takes more than a pocketful of cash. That's the message venture capitalists and securities regulators hope to transmit to those interested in equity-based crowdfunding, a new form of investing currently awaiting regulatory approval. Ordinary investors will soon have the opportunity to invest MOREFeb 25, 2013 10:30 AM ET
Big drugmakers are submitting to investors' short-sightedness instead of doing the right thing.
FORTUNE -- Earlier this year, drug giant Pfizer (PFE) announced plans to slash spending on research and development by a third. Its shares closed that day up more than 5%. Two days later rival Merck (MRK) went the other way, saying it would maintain existing R&D levels. Its shares fell by nearly 3%. Investors had sent Big Pharma MOREDan Primack - Nov 28, 2011 5:00 AM ET
The creators of a new measure claim it will spur 200,000 jobs, but the red tape it creates will hinder growth, not boost it.
By Gary Lauder, contributor
FORTUNE -- Few things upset me more than being lied to, so I am quite distressed that the proponents of the America Invents Act are getting away with characterizing this bill as promoting job growth. The Senate is scheduled to vote on the bill MORESep 2, 2011 11:12 AM ET
Discussions about startups often focus on founders or investors, but most people in the startup game are regular employees. So how do you find a startup job?
By David Beisel, contributor
"I want to work for a startup." It's a common statement, but a "startup" can be very different things. The primary dimension on which startups differ is stage: Two guys in a garage is definitely a startup. So is a 30-person MOREFeb 7, 2011 6:40 AM ET
Corporate competition is healthy, but it needn't always be antagonistic
By Mark Suster, contributor
Conventional wisdom in most companies is that "the competition is the enemy." It's the rallying cry to dig deeper, get more features out the door, issue press releases citing differences and attack the competition's weaknesses in sales presentations. I understand this instinct – it's tribal, like rooting for sports teams. And there are benefits to having something that MOREDec 28, 2010 8:35 AM ET
By Fred Wilson, contributor
Most people assume that price is what matters most in a financial transaction. When you are raising money, you want to get the money at the highest price (least dilution). When you are selling, you want to get the highest price for your company. But that is not always the case.
Price matters, but my experience says that it often does not matter the most. In many of MOREOct 25, 2010 10:55 AM ET
|Tesla repays federal loan nearly 10 years early|
|How police can find your deleted text messages|
|HP soars as Meg Whitman turnaround continues|
|Insanely durable smartphone ... from Caterpillar?|
|New Jersey's "Operation Swill" cracks down on alleged liquor substitution|