Would you pay a high achiever more than yourself?

Recently I was asked to review an offer letter for a senior director of business development. The CEO was concerned that he was offering far too much in the form of incentive compensation, with bonuses that could greatly exceed the base salary if all the bonus items were achieved.  I asked the CEO to imagine what the company would look like if all those bonus-expensive items were completely achieved in one year.

Upon reflection, he stated that revenues could double the following year, and that the company’s reputation among larger customers would be so greatly enhanced that the company could become the leader in its niche.  My obvious retort: “Then why not offer this candidate the moon if he can achieve this?”  The offer was sent and the CEO was much happier, dreaming of the possibilities, not the incremental cost.

I love to point out that my top several sales people were making more than anyone else in the company, including their boss.  These outstanding achievers worked for salaries below those of their engineering peers, and had to put it all on the line every day to earn their keep, let alone excel.

The best way to encourage alignment between your managers and the company’s goals is to create a bonus plan for each, with its payments made based upon the key performance indicators established for them and for their areas of responsibility, all in turn based upon the tactics and strategies contained in the company’s strategic plan.

[Email readers, continue here…]    It is amazing how few company CEOs grasp the concept that executives and managers should be compensated not just for doing their named job, but for exceeding expectations while advancing the corporate goals.  To align everyone in the organization in exactly the same direction is a task, one that is a powerful driver for growth.  People should be compensated well for such outstanding contributions.

What is the general rule for such a bonus plan? Provide no more than five key performance indicators derived from the strategic plan and fitted to the specific job of the manager.  Set time-based goals for each.  Provide bonus opportunities that add to approximately 50% of the base salary if all are achieved within the year.  Meet and measure progress truthfully each quarter.  Perhaps pay a portion of the bonus upon completion of these meetings.  Do not make the usual mistake of ignoring or passing on the progress of any of these items by just paying a part of the bonus at yearend because no-one carefully reviewed progress, or because circumstances changed and the bonus item could not be completed as written.

Incentives are powerful tools when used well and reviewed often.  They are a major part of a good manager’s work and should be treated as such by the CEO and all senior managers.

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Careful about equity and options in early stage businesses

This post is longer than usual.  For those negotiating equity allocations it covers some of the most complex issues to address in the process.  I just couldn’t reduce it to far fewer words…  Dave

Here is the warning: The execution of partnership equity allocations and of a good incentive program using equity is often mismanaged, damaging the corporate capitalization structure and even affecting the outcome of subsequent investment into the company.

Here’s an example: First, a brand-new enterprise is often formed from the efforts of several “partners”, each with an expertise valued by the others.  Equity is divided between the founders and the business begun.  Although this insight does not address this point of ignition, we should note in passing that things always change over time, and formerly strong founder-contributors can become a drag upon a business or lose interest if the enterprise is not quickly successful.

To protect against this, there must be some document in place from the beginning that clearly states the expectation of each founder as to contribution of time and resources to the enterprise.  The document should also contain clear buy-sell clauses, forcing any sale of shares to first be offered to the corporate treasury, then to the other founders in proportion to their holdings, and then if no interest, to outside investors.  It should contain a mandatory sale clause in the event of separation of a founder, so that a major owner who is passive in the enterprise cannot easily vote against measures other active founders endorse.

 And then there are options:  [Email readers, continue here…]   Stock options or phantom stock are the tools of early stage businesses used to attract great talent when there is not enough cash to pay market rates.  There are some rules.  First you must create a stock option plan using your attorney, which must be registered in many states as a security offering. (The fee for registration is well under $100, so this is not an issue.)  Options are usually best with “C” corporations, but granting options for either LLC’s or “S” corporations are not a real problem.

Most early stage companies make the mistake of making option grants to new hires at all levels that are too aggressive and distort the capital structure of the company to a degree that damages future professional investment.  Let me try to advance a few rules of thumb to help guide you here.  An option plan should carve out an addition of about 15% of the “fully diluted” shares.  If there are 85,000 shares issued to the founders, then a plan calling for 15,000 shares in a pool reserved for future hires is appropriate, making the fully diluted shares 100,000.  The board must approve the plan including this number, and shareholders must approve the plan as well.  Each grant to new or existing employees must be approved by the board before issue.

How about the price per share? The price per share for option grants is also an important consideration.  IRS rule 409a specifically calls for an appraisal of the value of the corporation’s stock current to within a year of any grants of options, although there is an exclusion for early stage businesses in which expert members of the organization or board may make such an appraisal if they qualify according to the exemption.  If there is only one class of stock, the same as the founders, and the appraisal of the single class of shares yields, say $2.00 a share, then options must be priced at that amount.  In other words, you cannot create bargain options at below “market rates.”  If you have a preferred class of stock with special protections, that class of shares will be valued at a price higher than the founder common shares, allowing stock options to carry a lower price per share than preferred investors may have paid.  This is important because high quality candidates should be induced to consider coming aboard at lower than market salaries using the tool of “cheap” options, properly priced.

How many options are appropriate for a grant? What percentage of the total company shares should be reserved for what specific job titles?  Inducing a new CEO to come aboard usually means creation of a stock option package of 5-8%. That size of grant would take much or most of the option pool.  A vice president, or CxO candidate, typically is offered between 1% and 1.5%.  Director level employees are typically granted ½%.  All other grants usually are much lower, allowing for the typical 15% pool to last for quite a while in most companies.

We will cover board members and advisory board members at a later time.

Options typically are earned over time, which we call vesting.  If a grant of 10,000 shares is made on January First, typically there is a four-year vesting period in which the employee earns the right to exercise (buy) 1/48th of the shares each month.  Many plans also call for a one year “cliff” in which an employee who is separated from the company before a year is unable to exercise even the shares which would have been vested at that point.

Any other important considerations? There is an important consideration that will become an issue with sophisticated candidates for VP and above.  We call these “trigger” provisions, in which selected options negotiated for a select group of senior managers, fully vest to 100% upon any change of control.  This provision allows these select individuals to perhaps profit handsomely in an acquisition by being able to exercise their options in full at the time of sale.  The negative side of this is that the buyer may not want to so enrich these managers that they may not be willing to come aboard the buyer’s organization, even if the existing options are replaced with options from the buyer company.

If all of this seems a bit overwhelming, we have just scratched the surface of option plans and incentive compensation.  This is an area of expertise that a CEO is required to quickly learn and carefully manage with the help of the corporate attorney and the board.

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Fire fast, not last.

Here is one that takes a real leap for a younger manager or CEO to believe.  After hiring someone with all the attendant enthusiasm followed by the training and learning curve, if an employee shows signs of weakness in the job or problems dealing with contemporaries, it is the natural tendency for most of us to go first into coaching mode, and reset the observation clock to see if our excellent coaching does the job.

A month or so later, when no apparent change has been noticed, we may move from coaching to a polite warning and maybe even the dreaded note-to-file.  Another month, and the probability of a decision to separate becomes obvious and the move initiated.  Lawyers will tell you that this progressive chain of moves is good for the company, protecting against lawsuits by a disgruntled former employee.

Then there is the ninety-day clock to consider.  In most states, employees gain rights after the ninetieth day on the job that make it more difficult to fire an underperforming employee without careful documentation of reasons for concern.

[Email readers, continue here…]  But – before or after that ninety day line – surprisingly, in post-exit interviews after emotions have dissipated, most former employees (who were handled respectfully during the separation process) and most managers will agree that the move should have been made sooner.  The former employee will often state that he or she was at least somewhat unhappy in the job, knowing that the fit was not as good as it should be. The manager will most often admit that he or she did not move aggressively, following best judgment in coaching the employee toward separation much earlier.

Firing fast in most every case is best for everyone, as opposed to long, drawn out sessions and stressful employee periods of waiting for a verdict in between sessions.  It does sound counter-intuitive. But I would believe the post-exit interviews.  Why not conduct your own survey of fellow executives and managers and see what they think.  If they agree, you should re-calibrate your expectations and act sooner, with the important caveat that employees must always be treated with respect.  Remember that there are many times when documentation to file is a required protection for the company against possible lawsuits, especially by protected classes of employees.

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Hire as if your survival depends upon it.

Aside from visionary management, this is your most important job.

Many of us go through the motions of hiring to fill a position, trying to use our intuition and skills to find the best candidate for the job.  Sometimes we use consultants or recruiters; often we use internal talent to fill most positions.

And over the years, we students of business success have learned that there is a science to the hiring process that continues through the life of an employee’s tenure with the company.  Bradford Smart captured this succinctly in his book, Topgrading. His thesis is that “A” players amount only to the top ten percent of the talent pool at any given time, and that your job is to find, recruit and retain only “A” players to make a successful business.  It is hard to argue with that.

What is hard to find, is the rare CEO that makes the process of hiring top recruits such a priority that he or she spends personal time deeply involved in the specification, resumé review, interview and selection of top employees.  Most of us are “far too busy” to do all of that.  And yet, aside from managing the vision of the enterprise, the most important job of a CEO is to find, recruit and make productive “A” players for the team.

[Email readers, continue here…]  As an investor and board member for numerous companies, it is increasingly easy for me to quickly evaluate the quality of senior team members in an organization as I probe for strengths and weaknesses in the enterprise.  Teams where the CEO is comfortable enough to delegate to “A” players and manage the strategies for growth stand out as rare and powerful.  Conversely, it takes very little for a CEO to derail what could be a great team and company, by ignoring the details involved in finding the right talent for each senior position, and by failing to communicate the strategies and empower the team to execute.

A successful hire is not just the responsibility of the recruiter and manager to whom the recruit will report.  Many companies require that finalist candidates be interviewed by company contemporaries, good employees who fill similar level positions. Some even encourage interviews with those the candidate would manage.  Agreement among the interviewers becomes an empowering experience for those conducting the interviews and agreeing to the decision to hire, and paves the way for a quicker assimilation of the new employee into the organization whose cohorts are already prepared to receive and encourage the new hire.  This is not an inexpensive process when considering the cost in time and productivity of the interviewers.  But finding “A” players is not an easy job, requiring a stretch of resources at each stage of the process.

Weeks ago in these posts, we explored strategic planning within the enterprise. We spoke of developing strategies and tactics that are measurable for each department.  Now is a good time to complete that chain by suggesting that paying significant incentive compensation to the people empowered to execute those strategies and tactics is critical to the success of the plan as well as to the organization.  Aligning everyone toward the same goal and using the practice of rewarding for achievement of milestones defined by the tactics from planning, makes for a great business, managed by a leader who understands the process.

What makes a great leader great?  Of course, it’s great execution by great employees acting as a unit in the best interests of the enterprise.  No-one can do this alone.  No CEO can do this with “B” players or less.

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Are you mentally equipped to depend upon others?

I guarantee that there comes a time when growing businesses outgrow the original span of control of the entrepreneur.  It is a critical period, and is a test of the entrepreneur’s desire and ability to delegate.

And I found from experience – after investing in many other entrepreneurial businesses over the years – that this stage typically occurs first at about twenty employees or $3 million in net revenues (or gross profit) for most any kind of company.   In future weeks, we will dissect this $3 million-dollar phenomenon separately.

But for now, let me digress to the story of my first hiring decision for my first company, years ago.  Way back then, I was managing a small and growing phonograph record manufacturing business (yes, back in original hay day of vinyl records) using independent contractors for both content and production.  I built this business through my high school and college years. Soon after graduating from college, I was making a good living and enjoying growth and freedom managing the enterprise.

It occurred to me that I had come to a fork in my career.  I could continue with the status quo, making a good living, or I could reinvest much of my profit into my first hire, an assistant that would free me from the day-to-day management tasks, allowing me to recruit more business (content) and build a real enterprise.  This was a tough decision at that time.  Comfort, or risk-it-all?

[Email readers, continue here…] On a Friday evening, I got into my car and drove from my office in the Los Angeles area all the way from Los Angeles to Ensenada, Mexico, checking into a remote beach hotel.  Early the next morning I found a large rock at the shoreline, climbed it, and sat there for hours contemplating my future. Hire for growth, or grow slowly and comfortably?  Well, the decision was what you expected.

I did hire my first employee, leveraging her organizational skills to grow quickly enough to continue hiring as growth accelerated.  The company reached over fifty employees at the point where I sold my interest and moved into the computer programming business at what turned out to be just the right time.  But I’ll not forget the overwhelming weight of that early decision, compared to the many much more expensive decisions made in subsequent years.  I was for the first-time dependent upon the work of others.  And I had made a successful hiring decision, lucky for me.

As years passed, more hiring insights became clear as I made mistakes and had successes, and watched other entrepreneurs struggle with similar choices and opportunities.  Let me share some of those insights during the coming weeks as we focus upon “depending upon others.” Stay tuned, please.

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Are you or your business “time bankrupt?”

Time bankruptcy results from the deliberate over-commitment of core resources.

You’d know the symptoms, if not the name.  You’re fighting to put out the fires from customer complaints, or incomplete work, or are suffering from an inability to focus upon new development or new customers before cleaning up the mess inside your organization.

I created the term “time bankruptcy” almost thirty years ago when the computer software business was young, and I was a software developer building a young company based upon quality first.  Asked to speak at software industry events, I found my voice and immediate audience understanding as I described variants of these problems to my audience. The insight became clearer as I was hired again and again to pick up the pieces of failed programming efforts by other software companies in this then young industry.

Here is one example:  You take on a new customer, customize programs or services as needed, and install perhaps an 80% completed system, product or service. The customer pays for all or at least 90% of the bill, perhaps holding back a retainer awaiting completion.

[Email readers, continue here…]  Burning through the payment and needing more to cover fixed overhead, you do the same partial task for the next 80% customer, moving on to the third.  About that time, the first would call asking for completion, firmly but politely.  The fourth installation was interrupted as the first customer suggested that he would stop giving glowing recommendations for you, insisting upon a completion date, while the second customer interrupted with its first call for completion.  By the fifth or sixth (who keeps count for these stories?), the first threatens suit, the second becomes demanding and the third makes that expected call for a completion date.  So, you stop work on the newest product or installation to complete unfinished work.  Revenues dry up while overhead continues to burn though your pockets.  It’s a classic case of time bankruptcy.  You have deliberately overcommitted your prime or core resources (in this case personal time) leading to a loss of income and reputation that you cannot easily recover.

The same story could be constructed for any company selecting a limited number of test customers for a new product. Select too many, and pay too little attention to each.  Commit all your core resources to solving the resulting problem, and new work stops.  Time bankruptcy. Not a pretty sight, and completely avoidable.

Be aware of this trap.  No-one but yourself can be blamed for allowing core resources to be overcommitted, even if by subordinates.  That’s because you now know the term and the impact of such an error in judgment, and understand that the simple but important remedy is to slow the commitment of those most critical resources to the front lines.

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There’s no second chance to create first quality.

Let me illustrate this insight with a personal story.  As my enterprise computer software company which produced innovative lodging systems for hotels and resorts grew quickly, we found ourselves straining to keep up with the hiring and training of good customer support representatives, a critical part of the equation then and still so today in the 24-hour environment of hotel front desk operations.

If a front desk clerk called support at 11.00 PM in the evening, it usually meant that there were guests lined up waiting to check in, anxious to pass beyond this necessary but inconvenient bottleneck between a tiring plane ride and a comfortable bed.  The result would be very frustrated clerks facing angry guests if the wait was too long.  It was simply not acceptable to be backed up in customer service, forcing either a ten-minute wait or a call back from support.

It took several months to hire and train enough new support reps to keep up with the rapid growth of our company.  But the problem was solved, and response times returned to “immediate” for at least this class of customer call.  There was no wait, and the quality of response was rated as “excellent” by callers later surveyed.

[Email readers, continue here…]  But “There’s the rub” (the snag) wrote Shakespeare in Hamlet. It took two long years for the company to fully recover its lost reputation after the actual problem was fixed to the satisfaction of all.  Aided by salespeople from competitors and long memories from unhappy customers, the myth of continued quality problems in customer support bounced around the industry for those years, until finally good press, great experiences and an effective  marketing campaign together overwhelmed bad memories to put this issue to bed.

If the problems had been in product stability and customer service together at the same moment, there might not have been enough time and resources to recover.  There are plenty of young companies that died trying to recover from such a combination.

Your reputation hinges upon delivering a quality product at the moment of release, and maintaining product quality throughout its life.  The smaller the company, the more is at stake.  There are fewer resources and much less of a reserve of good will among the customer base to absorb a problem release – or in the example above, inability to fill the void in customer service created by rapid growth.

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Haste makes waste; but to lag is to sag.

Let’s examine the relationship between time, quality and competitiveness. If you are getting the impression from these many insights that complex relationships cause simple problems, you are right.

We have heard the “haste makes waste” ditty since childhood.  There is little need to reinforce the obvious.  On a larger scale, there are epoch stories of giant companies eating massive losses in a recall of product, often based upon limited testing before release.

A marginal example was the Intel release of the Pentium Pro and new Pentium II processor to rave reviews – until a math professor found an obscure error in the chip’s code that made a rare floating-point calculation error.  Posting that finding on the Internet, quickly Intel found itself defending against fears by others using the processor for math work that the processor could not be relied upon.  Intel rushed to fix the bug and offered to replace the processor to anyone requesting such a replacement.  At a cost of millions and a reputational hit, Intel recovered.  The lesson here is a bit obscure, since it is not clear whether the kind of testing then common in processor design would have surfaced the error.  It is quite clear that such an error would be found immediately today based upon changes in testing procedures made by all processor manufacturers after that event.

The waste from haste in this example was in not pre-thinking of enough testing scenarios for a new product.  There is always a trade-off between cost for testing, time to market and risk of problems.

[Email readers, continue here…] Perhaps better examples to point to are easy to find in the toy industry, where recalls because of small parts that could be swallowed by infants or lead-based paint or flammable components make the news on a regular basis.

And the other side of this coin, “To lag is to sag”, addresses the two issues of loss to the competition because of delays in release of a new product, and burning of fixed overhead while products are redesigned.

It becomes obvious then that there must be a balance somewhere between rushed release and too much rigor in pre-release planning and testing.  Perhaps that balance can be measured in estimating what a company could endure in lost overhead and hits to reputation before becoming crippled and unable to recover.  With that measure based upon pure estimates, the balance point changes between companies, with the largest, most profitable companies able to suffer the most risk as to resources, and the smallest suffering by far the most when measuring reputation.

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Wasted time is money lost.

There is a relationship between time and money that is more complex than most managers think.  Fixed overhead for salaries, rent, equipment leases and more make up the majority of the “burn rate” (monthly expenses) for most companies.  Since this number is budgeted and pre-authorized, managers tend to focus upon other things such as sales, marketing and product development issues.

There is an art to efficient management of a process, whether that is the process of bringing a product to market from R&D to production or developing a new product’s launch program.  What most managers miss is that every month cut from the time it takes to perform such tasks cuts the cost by the value of a month’s worth of fixed overhead or burn.  Although young companies rarely measure profitability this repeatedly, more mature companies usually can bring from five to ten percent of revenues to the bottom line in the form of net profit.  Ignoring cost of product for a moment to make a point,  saving a month’s fixed overhead by making processes more efficient, could easily double profits for the year.

That relationship between fixed overhead and production time is as critical as any other factor in success of a young company.  Many of the start-ups my various angel funds have financed died a slow death, not because of poor concept but because of poor execution, wasting fixed overhead and draining the financial resources from the company coffers.

[Email readers, continue here…] In the technology sector where I most often play, extended unplanned software development cycles account for the majority of these corporate failures.  We often accept that development schedules for young companies are almost always too optimistic.  But we investors often allow too little slack in our estimates as well.  The great majority of young companies developing complex products such as semiconductor-based products, new software-based systems and technologies based upon new processes greatly underestimate the time needed to bring the product to marketable condition.  So the CEO comes back “to the well”, asking for more money from the investors to complete the project.  It is not a strong bargaining position for the CEO to ask for money to complete a product promised for completion with the previous round of funding.  And professional investors often penalize the company with lower-priced down rounds or expensive loans as a result.

I have one story that remains as vivid in my mind as when it happened several years ago.  Helping the founder create a company and build a much-needed product in an industry I knew very well, I served as chairman for the newly formed company, and along with my several rounds of early investment, led rounds of other angel investors in what I knew as a successful opportunity to fill a need in an industry I understood.

The company grew to be well known in this limited niche and was operating at slightly above breakeven, when the Board and CEO decided to seek venture investment from what we hoped would be a first tier VC firm in Silicon Valley.  And we were able to secure that investment along with a partner from that firm joining our board.  It did not take long for the partner to become impatient with the relatively small size of the opportunity.  Dreaming of a company many times the size, he led the board to approve a complete reversal of course, even stating that the company should ignore the existing market niche completely and redesign the product for the broad Fortune 500 corporate market.  Every one of us on the board expressed our concern that the time to make these product changes and position for the new, broader market, would eat away all of the company’s capital.  Promising the full weight of his VC firm’s resources, the board voted to make the change against the best judgment of those of us who knew the original market niche so well and thought that there was growth to spare in that niche alone.

So the company turned the ship, slowly it seemed, as R&D worked to develop an appropriate product using the base of the original design.  Time slipped; fixed overhead continued.  And exactly as you’d expect, there came the time when the company ran out of money as it ignored its original market.  Surprise.  Since the company slipped in its R&D schedule, the partners of the VC firm voted to not add new money to the company for the project.  Not long after, the company was sold in a “fire sale” amounting to slightly less than the debt on the books. All investors, including the VC firm, lost everything.  Do you remember a previous insight, that “the last money in has the first say”?  That is what happened within the dynamic of the board, and the result is that the board was completely at the mercy of the “last money” VC to save the company in the end.  Yes, there were other issues such as a protracted patent rights fight that drained cash, but the largest problem, inefficient use of R&D time burning fixed overhead, led to the demise of the company.  Lots of good jobs were lost and many investors including myself were left with the question. “Why did the company abandon a profitable market, even if it could not generate $100 million a year in revenues?”

We will revisit the relationship between time and money again in future insights.

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Greatly exceed early customer expectations.

First customers are critical. Greatly exceed expectations at all costs.

There is so much history behind this insight, and so many stories that illustrate this point.  Your first customers for any product or service form your reference base, the important group of allies that your marketing and sales people rely upon when attempting to create buzz and make a mass market for a new product.  If you’ve been involved in the launch stage of any product in the past, you should recognize the overwhelming feeling of panic when initial customers make first contact with complaints about quality, functionality, speed of service or other critical part of the new release.

The best advice I can give is to allocate all of your resources to supporting the roll-out of a new product, at least for a short period.  Respond immediately to every question and complaint.  Capture every compliment and ask if you can use it for marketing purposes.  If the product or service is especially complex or expensive, send someone from sales or marketing or even R&D to the customer location at the moment of first use.

Of course most of us have limited resources for such overwhelming support of a new offering. So, make the first release a limited one, sized so you can support it with existing resources, even if that means releasing it to only three carefully chosen customers at first.

[Email readers, continue here…]    And I am serious about the “…at all costs” admonition in this insight.  If you must provide a free backup unit, personal on-site service for a month, your personal cell phone number for the customer CEO, or any number of unexpected offers of superior service and accountability to those first customers, do just that.  Make your customer a partner in the process.   Send flowers to the staff in the department using the product for the first time if appropriate.  Call the customer CEO and thank him for helping launch a product so very important to your success.

The result of doing this right will be to blunt criticism, reinforce compliments and provide a solid user base to build upon.  And the alternative is a lost opportunity to shine, perhaps a first wave of negative public reviews that post and report across the Internet, and a loss of reputation and goodwill that will take years to overcome.

I don’t know about you, but I would much prefer to spend dollars reinforcing a great first customer’s experience than fighting fires in the marketplace after seeing negative reviews.  Make sure your entire staff buys into this mantra. “These first customers are critical.  You are personally empowered to do everything possible to exceed their expectations.”

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