How to Structure Executive Compensation
As I spend more time with founders, CEOs, and investors, I’m reminded again and again of how poorly executive compensation tends to be structured. Jason M. Lemkin’s half-decade-old post on how to structure a VP of Sales’s compensation has aged well, but it’s specific to that role, and while another of his posts discusses incentive compensation for non-sales executives, it’s comparatively light on details. Here’s a framework for structuring executive compensation across every function.
On-target earnings (“OTE”) is the total cash to be paid during a single fiscal year if the employee hits his or her plan goals exactly (i.e., 100% of plan). For example, $100k of base salary and $100k of target incentive compensation (“IC”) yields a $200k OTE.
It’s that simple: A + B = C. It’s hard to screw up. And yet, I frequently encounter IC plans that include (for example) a 10% bonus once plan goals are achieved. That means the OTE is $220k, not $200k; you’re fooling yourself (and probably not accounting for the additional 10% expense in your financial plan) if you think otherwise.
The easiest way to set each executive’s OTE is to consult benchmarks. If you have professional investors, they should be able to provide you with data from their portfolio companies. If you don’t have professional investors, give an executive recruiter a call—most are happy to help.
Base/variable split (“B/V split”) refers to how OTE is apportioned between base salary and target IC. For example, $140k of base salary and $60k of target IC is a 70/30 B/V split. At the extremes, a 100/0 B/V split means no alignment between compensation and results and a 0/100 B/V split means total alignment between the two.
Obviously, these extremes are rarely seen; no executive should be all base salary, and only CEOs that can comfortably forgo base salary should be all IC. So what’s an appropriate B/V split for each executive?
- VP of Sales: 50/50
- CEO: 60/40
- All others: 70/30
Yes, I do mean all others: marketing, customer success, product, engineering, finance, human resources. All of them. Anything less than 30% of OTE simply isn’t meaningful enough to produce the alignment between compensation and results to which you should aspire.
In an early stage company, where you may be paying some or all of these positions a below-market OTE, it’s okay to apportion more of the cash compensation to base salary—so long as future increases are to target IC until the ideal B/V split is achieved. Similarly, if you hire an executive at or above top of market, you should apportion more of the cash compensation to target IC—the “I’ll pay you top dollar only for top results” arrangement.
The only exception to the above is the VP of Sales position, for which I’d never deviate from a 50/50 B/V split.
For which results should an executive be compensated? My answer is, “The ones for which the executive is personally responsible.” That means new logos for sales, pipeline generation for marketing, net revenue retention for customer success, and so on. Of course, it isn’t quite that simple; for example, marketing may be contributing to customer retention and expansion, too. My point is simply to identify the exact (and measurable) results you want each executive to deliver, and tie compensation to them.
Product, engineering, finance, and human resources executives frequently find their IC tied to achievement of sales goals. I get the appeal of this approach — growth matters more than anything — but doesn’t it oversimplify, and do a disservice to, their contributions and those of their teams? Maybe limit the achievement of sales goals to 50% of their target IC. For the other 50%, here are a few ideas:
- Product/engineering: Product qualified leads; feature adoption
- Finance: Collections (days sales outstanding); vendor expense reduction
- Human resources: Time to hire; one-year survival rate
The measurement period is the timeframe for which the target IC applies. I’m a firm believer in the measurement period for executives being the fiscal year, rather than quarterly or monthly. You want (and I argue, need) executives to be aligned to (and comfortable with) behaviors that deliver results over a period of time longer than a quarter or month.
Having a shorter measurement period can be disastrous for alignment between compensation and results. Imagine a company with customers up for renewal as follows: $2 million in Q1, $3 million in Q2, $1 million in Q3, and $4 million in Q4. The plan goal is to achieve 110% net revenue retention. As of September 30, the company has retained $6.6 million in revenue (exactly 110% of the Q1–Q3 cohort). What percentage of target IC should the VP of Customer Success have earned at this point?
The company retained exactly how much revenue was planned in each of the first three quarters, so the executive should receive all of his or her target IC for that period of time: 75%. Makes sense, right? But the goal was 110% net revenue retention for the fiscal year. The company could bomb Q4, leaving the company reeling, and the VP of Customer Success would still walk away with most of his or her OTE for the year.
By making the measurement period the fiscal year, you achieve more than aligning compensation and results: you best align compensation and value creation, which is what investors care about most.
Most private equity investors and public companies tie payout frequency to measurement period, e.g., annual measurement periods mean earned IC is paid in a lump sum 45–60 days following the end of the fiscal year. If an executive leaves before the payout date, he or she doesn’t receive any IC for the year. Frankly, I think this approach is a bit draconian.
I recommend the following payout frequencies:
- VP of Sales: Monthly
- CEO: Annually
- All others: Quarterly
Actual payout should occur within thirty days of the conclusion of the month, quarter, or year, as appropriate.
Calculating earned IC when the payout frequency differs from the measurement period is straightforward. In the previous example, the company retained $6.6 million of an $11 million plan target, or 60%, through September 30. The VP of Customer Success should cumulatively be paid 60% of his or her target IC by the end of October.
Decelerators & Floors; Accelerators & Caps
What should happen if plan goals aren’t achieved? Should the payout rate be reduced and/or should there be a floor that must be cleared before any IC can be earned? Similarly, what happens if plan goals are exceeded? Should the payout rate increase and/or should there be a cap on how much IC can be earned during the measurement period?
This is my preferred approach for executives:
- Less than 100% of plan achieved: 0.85x multiplier
- Achievement of plan: 15% of target IC
- Beyond 100% of plan achieved: 1.25x multiplier
This makes a statement about the importance of hitting the plan (to the tune of 15% of target IC) without setting an arbitrary floor at which no IC is earned. It also offers a generous incentive for outperformance. To illustrate the impact of this approach, consider a $200k OTE executive with a 50/50 B/V split. His or her earnings would be:
- At 80% of plan achieved: $168,000 (84% of OTE)
- At 100% of plan: $200,000 (100% of OTE)
- At 120% of plan: $225,000 (113% of OTE)
If you want your executive team aligned with the company’s goals, be intentional about how you structure their compensation. It’s the best way to ensure that the company gets what it needs at the right price.
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