Sunday, October 9, 2011

Aligning Interests

I advise about 20 startups on and off on an ongoing basis. This is not one of my favorite stories.

One of the startups I advise went through a leadership change last year; revenue was flat, the year ended with a 17% loss, the product team had left, and the plans to replace them involved offshoring, which greatly weakened product- and people-oriented exit scenario.

A few of the key people had left because their options were underwater and it was no longer a fun or fulfilling place to be. The CEO had argued that nobody cared about employee options anyway, and they didn't even understand what they were. They had become, effectively, a joke.

Unaligned Incentives
After the change at the top I understood the ease of holding that position: the CEO had worked out a compensation deal with the board that paid management substantial cash bonuses based on the level of the exit, which was solid inoculation from the options--preferences mess, while leaving the employees and founders eating the dust of worthless options, depending on exit level.

On top of a relatively high salary padded with bonuses, it was clear the interests between shareholders, management, and employees were no longer aligned; there was no incentive left in the incentive stock option plan (ISOP).

The Pay Window
@JLM, a commenter over at AVC.com, says this regularly, and I think it's a good ethic: if anyone goes to the pay window, everyone goes to the pay window.

The intention for an incentive stock option plan is to align the interests of shareholders, management, and  employees, so all are pulling in the same direction toward the same goal.

When you go to sell your company, you're compensated based on the value of your converted stock options, which you earn through a meritocracy, typically based on role and impact.

In this case, the cash payouts were problematic because it aligned the interests of the CEO with a single class of shareholder--preferred. Employees and founders could be cut out of the exit entirely.

Not to mention the tax implications; cash is taxed as personal income (40% in this case), while stock options are taxed at the lower long-term capital gains rate (15%). Further, if you intend to donate any stock--and you should--you are not taxed at all on that stock, plus you get the full benefit of deductions. It's like found money.

Problems with Cash Incentives
But cash incentives and bonuses can be bad for a company's overall performance and can create perverse  incentives and outcomes. If you pay a bonus based on net profit, then the incentive is to maximize annual net, which can lead to keeping salaries uncompetitively low, firing higher salaried people, cutting corners on product, lower revenues.

If you pay a bonus based on gross revenue, you can get behaviors like shipping bricks: yes, a hard drive company literally shipped bricks instead of hard drives just to get its booked quarterly gross revenue up. I guess it never occurred to them that someone would open a box.

If instead, people have great healthcare, a good salary, and options that are not underwater because of poor pricing and/or liquidation preferences, and you create a buckets of several targets with long term success as the goal, you create the right incentives and behavior that aligns well with that.

My Bad
I was not immune to this; in the thick of things at my last company I negotiated a two-tranche Series B round where Tranche 2 was based on shipping product by a certain date. I had 5 months and no team for that product, so what did I do?

I outsourced locally at corporate rates, and blew through a ton of capital while delivering a substandard product. I had largely bootstrapped the company prior to that, but made the mistake of trying to hit the target so the capital coming in was cheaper.

Well, we hit the goal, but the effect was in fact much, much more costly than any equity I saved by hitting it. And that was the end of my tenure there (yeah, it's going in the book). There were some other circumstances that led to that, but it was all stuff I should have dealt with differently.

Cash is King
Finally, any time you take cash out of the company, you're removing tools for reinvestment and growth. Bonuses aren't a terrible tool, but they can create perverse incentives that don't align well with the progress of the company.

Be very careful about taking cash out of the company to provide incentives; if you need to use cash to motivate people, you're simply not doing it right.

Lesson?

So, back to basics: run a lean machine. That doesn't mean skimp on healthcare or comp, but be smart and build a team of committed, talented, motivated people aligned with your vision, goals, and interests.

When you take on investors, make sure they are aligned with your ultimate goals, and if they aren't, don't take them on. When you recruit board members, make sure they agree with your ethics, goals, and principles, and understand the importance of aligning employees with management with investors.

Use an incentive stock option plan honestly, and protect your employees options interest all along the way.

And if anyone goes to the pay window, everyone goes to the pay window.

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