Bonus Plans for Startups
We are setting up a bonus plan for my startup and making it cash only, as my employees do not want stock. Do you have any bonus structures you can suggest that will help promote rapid growth since we are not using traditional stock options?
First, I rarely would offer a cash bonus plan if the startup is not yet break even, but perhaps you are already there. Second, I would want to understand why your employees do not want stock, as having employees share in enterprise value creation is the best bonus program of all. Perhaps there is no exit planned for the future (in which case stock is of limited value) or the employees simply do not see any long term value in the business (which is a more fundamental problem).
If you do want to create a cash plan, I am partial to sharing a preset amount of quarterly revenue beyond the previous revenue “high water mark.” I take this idea from Tim Connors, our December Expert Webinar guest, so we can ask him more about it soon.
If you want something less complicated than what I am about to describe, you can have a simple bonus program based upon a defined scale of performance versus budgeted projections, or just a straight commission scale. If you use either of these traditional approaches, I urge you to make the scale progressive, so that the incentives escalate non-linearly based upon extraordinary performance.
In the plan Tim and I set up together, we paid out bonuses to eligible employees and contractors after the end of each fiscal quarter. We computed the pool based upon the following three factors.
First: “Net Collected Revenue,” which means revenue which is both collected and recognized under the Company’s accounting practices, using its standard accounting practices consistently applied, minus all reductions in revenue, including for returns, defects, chargebacks, and the like. You need to figure out what metric matters most to your company and what accounting practices matter. I am a fanatic about revenue being collected, which will be obvious to anyone who has watched the classes. Never pay bonuses for promised revenue not yet in the bank account.
Always ensure you have checks on the system. In the classes, I frequently tell stories of how employees motivated solely by sales have destroyed their company by selling below cost. You need to ensure the metric you measure is a healthy one, not a vanity (or cancerous) one, and that you have prevented abusive behavior and obvious gaming of the system.
Second: “High Water Mark,” which means the highest amount of Net Collected Revenue from any previous quarter during the life of the bonus plan. A High Water Mark is simply the highest amount you have collected before. The goal is to go beyond your previous record. Some businesses are highly seasonal, in which case you may instead look to define the High Water Mark in a quarterly adjusted fashion, or use the previous year’s same quarter numbers.
Third: “Quarterly Bonus Pool,” which means a set of amount of Net Collected Revenue for a fiscal quarter above High Water Mark. I have used 15-25% in the past, but anything can work. You should be pragmatic about your margins and the real value created by increased sales.
The board and CEO typically figure out how to allocate the bonus pool, but I suggest everyone in the company participate. Engineers, for example, suddenly become less interested in how technically “cool” their code is and obsessed instead with whether their developments result in actual revenue, which is an important shift in engineering culture.
Let’s run an example scenario. Your company has US$200,000 of Net Collected Revenue for the quarter ending June 30, 2020, with a previous High Water Mark of US$100,000. If you use a 25% bonus amount, US$25,000 shall be paid as the Quarterly Bonus Pool (25% times the increase in value beyond the old quarterly High Water Mark). Your company then has US$180,000 of Net Collected Revenue for the quarter ending September 30, 2020. The High Water Mark remains US$200,000 and no bonus is paid for this quarter. You missed the quarter, so no bonuses. Your company then has $320,000 in Net Collected Revenue for the quarter ending December 31, 2020. The Quarterly Bonus Pool will be US$30,000 (25% of US$120,000, which is US$320,000 minus the previous High Water Mark of US$200,000).
The goal this program is to share some of the revenue growth with the employees so everyone is motivated to exceed past performance. Because the pool is based upon collected revenue, you pay on a lagging basis for real, documented growth, using actual funds in the bank account.
I have seen dozens of creative bonus programs. The best share these core principles: what behavior truly drives company value (which may vary based upon the individual), how do we measure that value, and how can we allocate that value rationally between employee and company. Let me know if you have any favorite program structures.
See also: 3.102: Common Stock and Options