Compensation Strategies


Daniel Yates
20-minute read

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Organizations and compensation

It’s important to manage both the structure of your organization and the compensation of your employees. Both are complex topics, and the two are highly intertwined, a fact that is often overlooked. We explore these together and conclude with a set of simple processes to implement to better manage both.

Organizations

Organizational shape

Every organization has a shape. It’s determined by the number of employees at each seniority level. You can visualize it with a bar chart or org chart:


Different types of work are best served by different org structures. Here are some examples:

Let’s walk through each of the three examples above. In the case of the contract attorneys, work can only be performed by highly trained lawyers, so seniority levels tend to be high. At the same time each attorney operates mostly autonomously, so a single manager can oversee many attorneys. And because their operational support requirements are limited, they require few lower level administrators.
In the case of customer service reps, work is repetitive and prescribed, so the org can be scaled with limited management and lower paid workers. Finally software development is a complex, interdependent pursuit, and requires higher ratios of managers to developers. At the same time software organizations can thrive with a mixture of highly paid engineers leading teams of less expensive on-shore or off-shore developers, allowing for large teams further down the compensation ladder.

Organizational Flow

In addition to a shape, an organization has a “flow,” driven by new hires, terminations, promotions and raises. Managing it allows you to control costs and maintain morale. If left untended, this flow can reshape an organization in unproductive ways. Below is an example of a well-structured org that has grown top-heavy through promotion:

Why does this happen? The most common reason is that you’ve got a number of excellent people on your team who are in the earlier stages of their careers, and they expect to see significant promotions as they continue to deliver for the business and mature their skills. In fact, and here’s the real challenge, they know that if you don’t give them promotions and raises, they can run off to some other high flying, big name company and get that higher salary that they’re demanding.
So what do you do?
Well first, here are the problems that arise if you just do nothing and accommodate a high promotion rate with no other actions.

1. Breaking the budget or not hitting your staffing levels

The simplest problem is that you find yourself unable to stay within budget at the headcount numbers that you’d like to have. You either end up over budget‚—by a lot—or you give up on your staffing plan and end up settling for fewer employees to get the same work done.

This tends to be an insidious problem, because it’s really good at masquerading as a solution, rather than a problem. Your team will inevitably tell you “I can get more done with this elite team of super stars than I could if we had an army of lesser people!” Maybe. Only if you had poorly designed your org in the first place, with a ratio of too many inexperienced staff members to too few senior staff members. What is more common is that this argument always maintains, no matter how senior and how “elite” your team becomes. Why? Because the alternative is making tough choices about senior people who you know and like. More on that in a minute.

2. Too many cooks

When you promote too many people to senior levels, you end up with an excess of senior managers and mid-level managers. This leads to all sorts of problems. In the worst case, you end up splitting important roles among multiple people, breaking the Ben Horowitz “one person in the box” rule and sowing all sorts of confusion and inefficiency. In other cases it leads to unnecessary division of labor amongst leaders who end up creating work to justify their senior roles and satisfy their desire to make strategic decisions.

In one enterprise software organization, the promotion of mid-level managers actually negatively impacted the system architecture. The company was building on a multi-tenant micro-services architecture. In the career ladders of the engineering org it specifically spelled out that engineering managers should be able to lead the development of their own micro-service. What happened when too many people were promoted to engineering manager? Too many micro-services were developed. What should have been 8-10 micro-services turned into a miasma of 50 micro-micro-services, all highly dependent on each other and nearly impossible to test and validate.

Keeping super stars while managing your org structure

There are only two ways to support rapid individual career growth while managing a well-structured org.

1. Run a hyper-growth business

If your business is growing faster than the internal promotion+raise rate of your employees at every level of the business, in every department, then you don’t have this problem. So when companies like Snapchat and Uber grow like crazy, this isn’t on the issue list. They worry exclusively about recruiting and training (see [link:TRAINING], and [link:RECRUITING]).
However, even hyper-growth businesses have portions of their business that don’t scale that fast, because they don’t need to. And for the record, that’s a good thing, because that’s how you make money—by bringing in revenue faster than you escalate costs.

2. Manage out senior people

When employee growth outstrips plans for org growth, there is only one way to release the pressure: manage out higher level staff to make room for fast-rising junior performers. This seems anathema to successful business building. Why would you ask your most senior, talented employees to leave? The answer is spelled out above, in terms of the problems if you don’t.
Here’s the basic math, again in visual form:

So how do you do this? You set expectations with your teams from the beginning. You explain how you’re building a high performance org where people rise quickly and are rewarded for their excellence. And if they stall out, you will be supportive in helping them transition somewhere else. Importantly, the org doesn’t let go of people just because they’ve risen in the ranks—there is always a place for them as long as they keep rising.
Are there other orgs that do this? Yes. Most famously, the top-notch consulting firms like McKinsey and the best investment banks like Goldman Sachs do this. Revered for their ability to attract and retain talent, they have been able to hire the very best in large part because they promise extraordinary career potential in the form of high salaries, and the possibility to skyrocket within the org. And the reason McKinsey and Goldman aren’t overloaded with senior partners is because they practice what is preached above. There is a significant winnowing factor at each level of promotion within the org, and if you don’t progress to the next ladder within a set amount of time, the pressure mounts for you to seek employment elsewhere. McKinsey and other high end consulting firms keep a placement office to help with this transition.

The other way: “low flow” orgs

There is of course another way to cope with this problem. And that is to hire an employee base that is satisfied with a lower rate of career growth. Often, growth-oriented leadership teams treat this as anathema. That’s a mistake. The fact is nearly all orgs benefit from having divisions staffed with employees who are not pounding the table for a double-digit raise every twelve months. Example orgs on the lower end of the compensation scale include: customer service, accounting, procurement, physical operations, technical integration services, low ASP sales forces, etc. And you can have low-growth orgs on the high end as well. In fact, a mature executive management team at the very top should be one such group—well compensated but not expecting above market salary increases.

 

Knowing when you can and should design an org to be lower growth will set expectations properly for your team, and enable you to keep morale high from the beginning.

Implementation

When your company goes through its annual budgeting process, spending targets should be allocated per department. This is a good time to require development or updating of org charts from each department, normalized to compensation bands set by HR. These diagrams facilitate conversation and often clarify gaps in planning (“oh right, we do need some more managers if we’re going to hire 15 more salespeople!”).
[Worksheet: diagramming your org shape for annual budgeting]
These worksheets, and tracking metrics tied to them, then become a critical tool in compensation adjustment (promotion + raise) cycles. Here’s how you do it:

 

  • HR is the keeper of this info
    • Also brings to the table compensation bands (informed by 3rd party research)
  • Have an org chart per department with key metrics:
    • Visual of the org chart
    • Totals: $ budget, #employees, average salary, average branching factor
    • Per level: % of employees (and $), compa ratio
  • For each promotion + raise cycle:
    • Report on the change in each of the aforementioned metrics
    • Report on change in salary ($, %) per level

Compensation

The manner in which you compensate your employees impacts many things. These can include employee motivation and retention, recruiting competitiveness, company culture, budget flexibility, and of course shareholder value. The primary components of employee compensation are (1) fixed and (2) variable cash and (3) equity compensation. How you structure each, and how you allocate across them affects your employees and company.

Overall compensation

The first question to answer is where will your company stand relative to your industry’s benchmark: at the average, above or below? Some early stage startups attempt to pay as little as possible. Others strive to share upside equitably. And many larger tech companies have chosen explicitly to pay above market, in pursuit of high performing employees. How do you decide what the right answer is for your company?

Establishing your benchmark

First, you need to actually know what benchmark is. For companies with more than a hundred employees, there are relatively good services that offer this data. Turn to the Radford Survey, ERI or other similar providers to get quality benchmark information. If you can afford the full subscription, great. If not, getting your hands on that data even once, even if it’s slightly out of date, is hugely helpful.
For smaller companies, AdvancedHR with their OptionImpact offering has great data on private company compensation. ALternatively, you can turn to your investor networks, such as fellow VC portfolio companies to get up-to-date information on market comparables in the region you work in.
[PROJECT: get employee compensation benchmark data that we can post (Option Impact is likely source)]

Paying above benchmark

Many companies make the argument for paying above market: you need to pay more to compete for the best talent, and the cost is outweighed by the benefit. Netflix committed to this, famously, in their ”culture deck,” which includes a section titled “Pay Top of Market”, with the rationale: “One outstanding employee gets more done and costs less than two adequate employees.”
At face value it seems reasonable to assume that paying higher salaries will increase the talent of your employee base. But this is based on a homo economicus view of human behavior, which views people as purely rational, value optimizing machines. This is a limited view.
First, for most very talented people all of their job options are meaningfully high paying, and consequently other considerations—quality of work, peers, mission of company, culture—can outweigh even a double-digit percentage difference in compensation. This implication goes both ways:

  1. Top of market comp will often not be enough to get top talent. You have to look to culture, peer quality, and other factors to really capture the best employees (In Netflix’s defense, they do all of these things).
  2. Many employees offered top of market comp may have joined anyway with lower comp. If, for example, for every five top hires you make only one is swayed by the extra compensation, then you are paying 5 times the premium for that one hire than you think.

Second, there is an important motivational side effect to paying more than other companies: employees can no longer tell if their motivation comes from their passion for the job, or the cash. This is a real problem. In behavioral science speak, you shift intrinsic motivation (“I’m so proud of our achievements!”) to extrinsic motivation (“I work here because I get huge checks”). And the science shows that intrinsic motivation wins every day. This is the secret behind the advice “Follow your passion.” You only work your ass off if you’re passionate.

Paying at or below benchmark

The alternative, paying at or below benchmark, has its own pros and cons. The benefit of course is that if you can keep employee quality and motivation constant, you can stretch your incredibly valuable cash further. And your employees won’t be at risk of having their intrinsic motivation stripped from them. The problem is that you have to have a pretty great reason for someone terrific to join you and take equal or less cash.

 

How do you justify paying at or below market? You have to make people believe. In you, your team, the likelihood of outsized success, your mission, the culture, the organizational structure, whatever it is that is relevant to your organization and that you and your team can sell. You put that front and center in your recruiting process, on your website, in your employees’ minds, and you work and work and work at it.
For specifics on doing this well, see Chapters on Recruiting, and Culture.

Compensation composition

Companies can have very different philosophies on how to break up compensation. We provide a discussions of the pros and cons of these different approaches, and then include case studies and industry benchmarks.

Equity:

Nearly every high tech/high growth company issues equity incentive compensation to their employees in the form of stock options or restricted stock units. But that’s where the similarities stop. Some companies give equity to almost everyone in the company, others to only a select few.

  • Some people don’t give a shit about it
  • At lower levels it can be sort of like a free raffle ticket
  • At larger levels it gets people to act like owners
  • Can be a branding thing: “everyone is an owner”

 

Equity documents:

  • Budgeting your total spend
  • Survey of equity terms (acceleration, cliffs, forfeiture policy, etc)

Cash:

  • What people will budget their lives around.
  • Go to low and it’s a non-starter for non-founders.

Bonus:

  • Really depends on the nature of your bonus payout. Pay ~100% people treat it like base. Large variance and it can be written off.  
  • Bonuses create extrinsic motivation problems, and distance between manager and employee
    • Stigma can create problems
  • Best suited for objectively measurable outcomes for individuals
  • Corporate bonus can be useful to flex compensation, but people treat it like raffle ticket
  • Annual bonuses can drive retention, but can also drive up attrition right after bonus time.
  • Others think that they drive performance.

 

  • Pay more or less than average, and now vs dream (equity) and how performance tied
    • Total high vs low
      • Benchmarking and the above/below market question
    • Now vs dream:
      • Normal rationale: lowers cash burn, and it aligns incentives more
      • Norms of ratios for various companies
      • Important: calculate what your cash costs you in equity to make that trade
        • Allowing employees to choose
      • Also: equity exposes you to company performance: can overpay, or underpay
      • Culture of equality versus value
    • Flexibility/performance tie
  • Budgeting
    • Cash budgets: existing + hiring + raises + promotions
    • Equity budget: rules of thumb
    • Multi-year plans: adapting to org growth changes
  • Structuring your equity grants
    • Lot to say. Need to flesh out.
  • Structuring your cash
    • Lot to say. Need to flesh out.
  • Individualizing offers versus standardizing
    • Complexity of tracking all the deals versus leaving money on the table
    • Banding as a compromise
  • Commissions

Equity

Base Cash

Raises and promotions

Variable Cash

Flexibility of compensation

Comp in changing growth environments

Organizational compensation considerations:

  • Flexibility of
  • Up and out vs stable
  • Flat vs hierarchical
  • Impact of org growth vs shrinking

 

Most conversation is about individual compensation.
Designing the compensation for your company is both delicate and important.

Components of rational compensation strategy

Design

Implementation




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