David Maister - Professional Business, Professional Life
David’s ResourcesAbout David
NEW! Browse my materials by topic of interest:StrategyManagingClient RelationsCareersGeneral

Passion, People and Principles

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?


Ann Bares said:

I really appreciate this reader’s question and the thoughts you have posted in response. I am in the business of helping emerging and small companies on compensation issues and I find it a challenging area to navigate, without a lot of data or “best principles” to offer guidance.

I strongly second your preference for “look ahead” rather than “look back” systems (i). Then everyone involved is free to move forward and act based on a shared understanding of the “rules”, rather than being forced to negotiate them after the fact.

I also appreciate your thoughts on establishing an agreed-upon approach to allocating available cash (different “tranches”), and distinguishing between what earns based on ownership and what one earns based on contribution or performance. The tricky thing, at least in my experience, is defining and getting agreement on what is meant by performance and how it is measured. In response to your comment in (ii) about using “origination” to allocate income, I find that it is difficult to avoid business development (what I believe you mean by origination) as part of the income equation. The business owners I have worked with in these circumstances typically feel very strongly about motivating and rewarding the hard work of business development as a critical component of their initial compensation approach.

Finally, I echo your sentiments about ensuring that a good share of the income allocation — or compensation — approach focuses on collective performance, to reinforce the spirit of shared destiny that is so important in the early days of an organization.

Thanks again for a helpful and thought provoking post. I look forward to seeing the comments of other readers.

posted on November 28, 2006

David Kirk said:

I wish I could post about best practice, but I can provide some practical examples to back up David M’s points. I’m going to start at the end. Actually, I’m going to end there too.

David’s point 5 was “Do I want to work with these people?” and it sounds obvious. It is, and it’s also key. Deciding who gets what, when and how with a service business is always difficult because there are so many factors to consider. Not having the trust within the group makes it that much more difficult. Instead of focussing on what is equitable, what is sensible, what will motivate and reward fairly, the question becomes “How do I not get screwed over?”. Unfortunately, I suppose there is a risk of some members even asking “How do I squeeze this for all it’s worth?”.

I’m also not saying that sort this out and the rest is easy, but in my case it helped significantly. Our group had reservations about a couple of the members. We went nowhere with trying to agree a remuneration structure. Wives and girlfriends stopped talking to each other, phone calls stopped being returned. Thankfully, and I forget how, we eventually decided to part company with the two question marks. The discussions were resolved over a weekend.

We’re still friendly with the two, just not business partners. There wasn’t the trust or agreed values going into it.

If you’re interested, our approach was forward looking based on capital contribution in the first year and planned activities. There were still arguments at the year-end, but quickly resolved.

posted on November 29, 2006

Rob said:

I think you always separate compensation into salary and profit distribution based on ownership.  Salary is for work performed and profit distribution is dependent on ownership, or how much

risk you took on with your investment.  Base your salary on the 

work you do plus market levels for that kind of work.  Base your

distributions on how much of the company you own.  When you start playing the game of taking no salary because you are an owner, etc.  it can get ugly and complicated very quickly.

posted on November 29, 2006

John Dillard said:

Great comments here. Interesting observation on business development—I agree with David that there are some dangers there. In my case, I happen to be doing a lot of BD, but that’s only because my partner is covering the backoffice. I don’t think it would be fair to assume that I am the sole reason we are winning the work that I happen to be developing.

Another wrinkle revolves around how to bring in the new partners—perhaps a law firm, buy-in model is what works best, with a distinction between partner distributions and a solid base compensation based on the partner working role.

posted on December 2, 2006