Updated June 2, 2021
The Many Challenges of Second Stage Compensation
If you’re a second stage company, there is a high probability that your compensation program is broken.
There are lots of complicated areas in strategy and management, but I think compensation has to take the crown. On top of the usual issues that show up in strategy – prioritization, coordination, planning for the future, resource allocation – compensation is intensely personal and intensely important to the ability of the business to create value and stay competitive.
Pay people too much, and you rob the business of resources it needs elsewhere. Pay people too little, and you won’t get the productivity you need and want, and you may lose key employees, too.
As some of my other posts show, management gets much more complicated as a second stage business. Let’s look at what goes on with compensation in startup versus second stage businesses so that we can get some sense of how to solve these challenges.
Start Up Compensation
As a startup, compensation is relatively simple. The rationale for pay is a combination of intuition, personal opinion, emotion and limited budget. Don’t underestimate the ability of emotion and a limited budget to hide compensation problems. Job descriptions are usually pretty broad and flexible, and the team is small so that evaluation can be done based on personal experience. Changes are either ad hoc corrections “we really need to do something about Jane’s salary – she’s not making enough for what she does for us”, or automatic each year.
The Growing Business
Complexity creeps in – usually unnoticed – to the compensation “ecosystem” as a business grows. As people are hired, job descriptions need to become more specific. But the situation is fluid enough that duties often shift as the company adapts to new positions, or as it continues to change and develop new needs. As roles become more specific, the pay differentiation among those roles needs to get more specific, too. Yet there is more budget available, so there’s more flexibility, and rules can be bent if intuition or emotion drive them to be.
The Difference a Timeline Makes
Surprisingly, the overall reward “horizon” of the business – whether people get rewarded for their value in the long-term, medium-term, or short-term – actually shortens as the business grows. As a startup, because budgets are limited, everyone knows that the payoff comes in the long-term. People hired during the shift to second stage, though, usually don’t have the same risk profile and expect to be rewarded more in the short- and medium-term. This shift of horizon presents a big challenge for most startup leaders because their reward model over-emphasizes long-term reward.
The Compensation Black Box
How do most second stage business leaders deal with all of this complexity and confusion? They create a compensation “black box” that makes compensation decisions, but doesn’t show how they are made. The black box is how the leader combines loose performance data and gut feeling into subjective assessments about how people are performing and how they should be rewarded. This process is usually managed by the founder of the business, who has a high degree of credibility and power in the company. As a result, the black box is usually able to hold the (broken) compensation program together even though it no longer works for the business.
The Challenges the Black Box Creates
The black box has two problems:
First it lets the business off the hook in deciding how value is created and what should be rewarded.
Second it confuses people about why and how they are being rewarded. A typical comment about a black box program (this one is an actual quote): “There have been years when I did a great job, and I get a tiny bonus. And then there are years when I don’t really contribute much, and I get a huge bonus. I think [the founder] has a sense of who should get what, but I have no idea how he makes the decision.”
Where does the black box need to evolve to? What does compensation need to look like as you grow and become a second stage business?
Your Strategic Compensation Program
The compensation program needs to have clear rationale for how and why people will be rewarded. There are eight compensation drivers that a leader can choose from to develop that rationale. Four of them are:
Compensation needs to be aligned with strategy – for example, if the strategy calls for going into new markets, then the compensation program needs to reward activity along that path.
The program itself needs to be multi-dimensional – in what is evaluated and what rewards are given.
There needs to be a distinct pay for performance component, and the way that works needs to be defined at the start (i.e., explain at the start of the year how performance will be assessed over the coming year, not ex post facto when the year is over).
And, pay changes should not be ad hoc or automatic – they should be planned and connected to an explicit purpose.
With everything that is going on in a compensation program, it’s likely yours is broken. And compensation programs are a challenge to fix. But the long-term cost of not fixing them is far worse.
When you decide to fix your compensation program (you have decided to, right?), please, please, please, go slowly, expect it to take a lot of work, stay at it, involve your staff and get help from someone with expertise and experience. For further guidance, reach out to me at dave@phimation.com.