Folks, I am not sure if this has been discussed before. If so, can you pls direct me to the relevant posting?
I would like to know about the standard practices to decide compensation for early stage employees. Consider this example: I am planning to hire a person at the CxO level. My company is about 15-20 people. Of these say 4-5 ppl are the Sr Mgmt. The Sr Mgmt have equity stake and the remaining employees as low level guys hired at market salary. Now if I have to add another person at the CXO level, are there any thumb rules for compensation? Say mkt salary for this guy is over 20L. How can I estimate a fair salary/stock package? Pls let me know in both cases – 1. the company has a valuation 2. The company has never been valued.
regards,
Vamsi.
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Krish: I think I see your point – that when a senior exec joins he can scale up the existing plan, so an existing valuation or projection may be off the mark. In that case, if the executive is able to plot in his value into the same business plan, you can reach a value based on a forward P/E of the existing plan+contribution and provide an appropriate stake.
I would say that a senior execs contribution is just about as imaginary as the projections on an excel sheet. Perhaps if they come with contacts the equation is slightly changed – a business owner I know has just hired a CxO level person who supposedly has contacts that can generate enormous revenues. The deal is simple – you get a fixed percentage of profits generated over the next five years, and from then on you get x% of the company where x is a pre-agreed number based on the revenues brought in. Period. You can create a deal like that – it’s visible and quite simple, but contingent on a) getting in business and b) ability to deliver. Both may not co-exist.
I’ve seen a lot of people burnt because they hired someone with “existing client relationships”. Sometimes people overrate their relationship with a client, and it turns out later that the client was a more attached to the brand the exec carried rather than the exec himself. I have personally been on the client side of this equation a number of times. If a startup gets into this kind of a deal, I’d say put a number down as a goal and adjust stock/salary to reaching that number instead.
But I see one thing – that a senior hire can significantly alter your business plan and you should add that in the compensation calculations – may simply be more stock options based on a certain goal, or a revenue/profit percentage, or it could be a higher stake upfront. I’m not sure about the last but the others would probably work well.
Deepak,
Hope I should elaborate my point to make it clearer…
Senior executives join a startup not believing on founders’ projections or future earnings, but their own take on it.
They look at the idea, the team, its skills and resources and join in if they are convinced that their own efforts, initiatives and experience could contribute value to the enterprise and complete the picture. Let’s say the CxO coming in with a good set of ready client relationships, meaning immediate revenues for a pre-revenue startup… Imagine the value? Can you compute it on PE terms? Would any projection could’ve foreseen it…?
For such people, compensation will not be a deciding factor. They are aware of the risk, opportunity cost of time spent and are open to early sacrifices that payoff in the longer term.
My point was that they agree for a % stake not on the basis of early stage valuations [ computed on the principles of valuations applied to late stage companies (like PE / Discounted value of future earnings / book value etc.) that could at best only be arbitrary if not imaginary ] . Instead, they would seek a % stake in the company that they help build, the gap they help bridge after convincing the founders of the value of their contribution. Incidentally my first comment to this thread illustrates the point.
Are we one…?
Krish,
Any business plan that the founder creates has an earning set in it in the futuer, and IMHO there is an implicit valuation metric that (of what I’ve seen) is a P/E multiple. If you won’t do P/E (or P/S) you can have no projections of value, can you? And if you don’t know what value you can build into your company, you probably can choose a random figure and give that as a percentage stake to your new hire. That works just as well.
I don’t think you can value a company on INVESTOR valuations like Dad putting in $10. You can hopefully put in a VC valuation. other than VCs putting any valuation based on what level someone invested earlier is a no-go – I did not recommend that, I expected it based on projections instead.
Coming to why outsiders would believe in projections – if they don’t believe in the projection, then either pay them full salary or don’t hire them. Why bother with option grants? Hopefully the startup is looking at someone who’s gung-ho on the predictions and can see the future value should they reach the targets. If that’s not true, this entire discussion is moot.
I agree that looking purely at percentages can give you the wrong impression – a book I’m reading now called “Traders, Guns and Money” has an anecdote of where the author, Satyajit Das, was helping a company select a fund manager. In one presentation, the manager provided data like we beat the index by 3%. Das asked him what the absolute return was, and he said “That doesn’t matter, we only concern ourselves with the index”. Das persisted, and the company’s honchos also asked the same question and the fund manager said, “We lost 45% but the index was down 48%”.
Absolute numbers matter too – it should be a large enough number to give a huge valuation at a p/e of 10 also. I’ve seen deals done at lesser and those done at much more, but 10 for a company that intends to eventually get valued on growth is a reasonable start.
Yet, companies like YouTube would have probably not have succeeded had they followed my approach, but youtube gave nearly 35% of their company to their employees, so it’s perhaps not comparable.
Deepak,
PE ratios, market cap etc., are applicable for growth stage companies that are *near the gate* (ripe for IPO, buyout etc.). For startups, it makes no sense until they clock substantial revenues and are in profits. If and when they get there, they are no longer startups. In effect, the question remains – other than a founder, why would any outsider believe in `projections’ at all and settle for option grants that have little or no value, now or in near future…?
It’s like the founder saying – my dad invested $10 for a 0.000001 % interest in my company, and by that count my company is valued at $ 1 billion on day one…!
For startups percentages don’t matter… it’s the absolute numbers that count. What if the startup has a Rs.500/- profit for year one and Rs.1000/- for year two – i.e.100% growth – will you give that a PE of 10…? How much sense does that multiple make…?
How about: Take your business plan and take the earnings projections at end of year 4. Multiply that by the p/e ratio you think is attainable – I would think 10 is conservative if your earnings are growing at 50% or higher projected further, but 10 is a number you probably want to stick with. This is the interim value of your company.
Now for a person earning 20 lakhs, let’s say he takes zero salary and only stock. For the four year period he should see at least 5-10x return on the opportunity cost, so you’re talking 5-10 cr. If the interim value of your company is 200 cr. ($50mm) you’re going to give him 2.5% to 5% of the company.
Now you’d say, who’s fool enough to take no salary for four years? Well, then put a salary into the business plan at a point when you CAN afford it, meaning where there are either revenues or venture funding to support a base salary. Then do the same calculation. Essentially your income after year 4 reduces to the extent of the salary paid out, and you have to ensure cash flow supports the salary.
If you’re giving him a lifestyle managed salary up front, the risk goes down and so do option grants, in a parabolic curve (more the salary up front, lower the risk, lower the grant). It’s not easy to quantify “risk” and it will forever be disagreed upon; in fact the whole Bhagavad Gita was an exercise in understanding different sides of risk.
So now the question is – Mr. CxO isn’t willing to take zero salary, but wants something. Throw a number: 5lakhs. Say you’ll double it if revenues/targets/something else reaches a figure you have in the plan, or higher. The 15 lakh opportunity cost he’s taking has to be compensated, plus additional risks in future years on salary and career and all that. Meaning, about 3-5cr. (out of air figure, you can use excel) which again can be appropriately matched with valuations.
FWIW, Anyone who wants more than sustenance salaries should get stocks options under 0.1% of the company – essentially saying we won’t take the risk of having you as a significant shareholder, if you don’t take any risk. I know it doesn’t work that way, but that’s my view.
I think that any salary lost in year 1, above sustenance levels, is money you can afford to lose. Above that, it’s much more serious risk because of compounding and some other factors. So compensate risk after 1 year much more than you do the first year…perhaps staggered and increasing option grants can help.