Partner Compensation in a Start-Up

post # 249 — November 27, 2006 — a Managing post

A reader wrote in to ask:

“What’s the best way to structure a compensation system for partners in a small startup firm? I have recently launched my own consulting practice with another partner. We also have a third minority owner (1%) and we expect to hire between 3-5 associates this year. We might even bring in a third partner if things go well. Should it be simply a division of retained earnings by ownership share? A formula that builds in factors such as total sales, revenue managed, etc? Obviously, fairness and trust among the partners is critical.”

It would seem from previous comments on this blog during the year that some of you might have been through this, or are in the business of advising start-ups . (I am not.)

But here are some of my thoughts to get your juices flowing:

(i) I always like “look ahead” systems, not “look back” systems. In other words, let’s discuss how we are going to allocate next year’s profits. Once we’ve agreed on that, and each have our shares, we can move together during the year aligned in our interests, focusing on making the whole enterprise successful. If that proves to be a little unbalanced, then we’ll tackle it at year end when we plan the division for the year after that. However, if we have a system whereby you’re always looking back – trying to allocate funds based on performance that has already taken place – you’ll always be fighting over differing interpretations of history.

(ii) Stay away from formulas based on origination or anything else. In a start-up there are just too many things that need to get done to allocate incomes on a few measures.

(iii) Recognize that, even in a tiny partnership, it’s possible to invent a system that has different categories of splitting available cash. For example, you could begin by saying “tranche” number one of any end-of-year cash is to be split by ownership shares, while tranche number two is to be split on some other “performance” basis. The weighting between these two might vary over time. Initially, to encourage a focus on overall success, you could say “Let’s allocate 80% to reward for ownership — which gets everyone focusing on the firmwide result — allocating only, say, 20% to be divided to the basis of performance. As the years go by and you add more people, you will then have choice as to the weighting between the reward for ownership and the reward for performance.

(iv) In general, I like systems where everybody shares in the overall performance (relatively fixed shares, adjusted only infrequently), but that can only be sustained if your ‘system’ is good at addressing performance issues, so that you tackle performance problems by talking to each other during the year, not trying to invent crazy formulae. So, how well can you and your partners talk with each other? Are you the type of people who are comfortable addressing issues during the year and commenting if you thi k the burdens are not being equally shared? If so, you won’t need the comp system to do it for you.

(v) What you REALLY have to ask yourself is: do I want to be partners with this person? With these people? Am I prepared to trust that we can work it out? IF yes, then any scheme will get you through the first couple of years, and you can re-examine it later. If the answer is no, then no comp scheme will cover up that lack of trust.

OK everybody else — jump in. What advice do YOU have to give about structuring partnership compensation in a start-up?