Why Does a Compensation Philosophy Matter?
It’s simple.
Repel the wrong hires, and attract the right hires.
Reduce churn, helping you retain your best talent.
Get everyone working towards the same goal which energizes your company.
Eliminate HR workloads associated with pay issues by 90%+. That isn’t a typo.
Make it easy for your senior and middle managers to hire and retain the best talent because they can use the compensation philosophy to communicate how your values trickle into compensation. This inherently makes your company easier to scale!
"Compensation is not a cost; it's an investment in your organization's future. When done right, it can drive innovation, collaboration, and growth." - Tony Hsieh, Zappos
The best part?
It’s easy for companies with under ~$30m in revenue to create & deploy a compensation philosophy.
Our Simple Flow
If you want to design a great compensation structure, here’s what you should do…
Read this blog. It will help give you context required to get the most out of the subsequent steps.
Set your core values. This informs the balance between performance and fixed compensation in your business. If you don’t have values, use the method outlined in Traction by Gino Wickman or Verne’s Scaling Up.
Buy Verne Harnish’s book, Scaling Compensation.
Use what you learn in step 4 to write out your compensation philosophy document. Sit on it for a few days, revise it, and then share it with your most senior team.
Trial the compensation structure with your senior team for a few quarters, and adjust it as needed. Your senior team should be informed that it’s in “beta” and will likely need tweaking based on their feedback before being deployed downstream.
Subscribe and share, yes…really. Just click the big pink button…
Key Considerations for DTC Brands When Designing a Compensation Philosophy
By “DTC brand”, I mean a consumer brand that is digitally native, deriving the majority of revenue from eCommerce channels. I am excluding food and beverage companies because it isn’t our core focus, and dynamics at those companies are different.
The biggest mistakes seem to stem from people believing they are a tech company. DTC does not have anywhere near the same operating leverage that tech does - which means compensation should work very differently.
Frequent equity raises, and therefore, markups are not common when compared to tech. This makes it difficult for you and employees with equity exposure to place value on your shares. It makes it very hard to create a sense of worth behind any equity compensation. Conversely, most tech companies are VC-backed and raise equity every ~1 - 2 years - making it easy for employees to see third-party validation of their equity’s value.
DTC does not scale as fast as tech. A few years before a liquidity event is very feasible in tech. Unlikely in DTC. Is someone making $100,000 or even $300,000 thinking that far into the future? Probably not, and justifiably so.
Outcomes are smaller. $1B+ outcomes do not happen anywhere as often as tech. This means it’s very hard for equity to solve out to life changing money unless current equity is ok with extreme dilution or there’s a dividend component baked in. You need to show your team how they will derive value from any equity exposure!
Question to ask yourself while designing your compensation philosophy:
How will you deal with the classic 10x engineer scenario? Is it possible for her to outearn a manager? It should be.
Does your compensation philosophy align with your core values? For example, if a value is “will-to-win”, your compensation philosophy should compensate your team for winning.
Simple to track, and inexpensive to administer.
Fairness is the desired outcome - not sameness!
How and with who is created value shared with? We like being transparent here, but that doesn’t mean it’s right for your company.
How will you balance performance based and guaranteed compensation? This flows from your values.
Verne’s Magical 5 Principles of Compensation Design
Verne Harnish, the author of Scaling Compensation, has 5 great principles he breaks out in his book that make it easy to design a compensation plan.
Align with organizational strategy: The compensation plan should support the company's overall strategy and goals.
Attract and retain top talent: The compensation plan should be competitive in the marketplace and should help attract and retain the best employees.
Motivate and engage employees: The compensation plan should be designed to motivate and engage employees to perform at their best.
Support the company culture: The compensation plan should align with and support the company's culture and values.
Be cost-effective: The compensation plan should be cost-effective and financially sustainable for the company in the long-term.
Our Compensation Philosophy!
Here’s a V1 compensation plan that was given to our senior team at one our portfolio companies. I’ve swapped out the name of the company, and some sensitive information because I don’t want our competitors to find it. Formatting is ugly thanks to Substack. It’s missing the pay grades/levels for obvious reasons.
Helpful background:
8 figure run rate, growing at ~150% YoY
~100 employees. Many of these are in production/operations roles. This number is not the same as 100 salaried employees.
A mix of distributed and in-person roles. In-house manufacturing means we have significant in-person work being done.
Compensation Philosophy - ExampleCo
What is a compensation philosophy and why do we have one?
A clear compensation philosophy explains how people in our organization are compensated and why. It allows us to build a better company doubling down on our best people that drive the company forward and align with our culture - and quickly remove those that don’t.
Distilled into bullet points:
Why are you paid what you are paid and how to increase your compensation.
Transparency around where value created by the team flows. What happens if we are excessively profitable? What happens if we aren’t?
Removes anxiety about pay increases or discussions about pay for team members by minimizing subjectivity and creates fair outcomes.
Makes it easier for management to set downstream pay and expectations.
Fully aligns incentives - when the company does well, you do well.
Reinforces our culture, and allows us to hire people that are a stronger fit out of the gate.
What is the role of compensation at ExampleCo?
Compensation allows us to attract and retain smart and hungry people that are aligned with our culture. Our philosophy facilitates rapid learning and generously rewards those able to grow their skill set while helping the company and our team reach our goals.
How does the value you create flow through the company?
Transparency behind where cash flow, equity, etc…goes is critical! A document like this detailing compensation philosophy is meaningless if actions differ from what is being said.
Value created by the team flows in the following order:
Bonus to the team - including stretch goals.
We believe well-designed and generous compensation facilitates excellent company performance.
Makes all aspects of managing talent easier. We can hire the best, reward those that perform, and rapidly discern who is a good fit and who is not a good fit.
Reinvesting in inventory, infrastructure, and the “physical” portion of the company.
Reinvesting in the company is critical if we want to keep growing the company and compensation quickly. You can’t increase compensation without increasing free cash flow!
New and exciting learning opportunities only become available to us if the company keeps growing. If we’re growing fast enough, you should always feel like you don’t know what you’re doing and that your role is changing rapidly.
Deleveraging the company.
As of 2021, we are currently running the company with a high amount of leverage. Although all of it is low-risk - as the company can default without many problems, it still makes it more difficult to manage the company. Running with less leverage will make things like vendor management, ad-hoc initiatives, etc… much easier to pull off.
Running with less leverage creates a buffer - allowing us to seize any great opportunities that might arise. For example, if a distributor we love became distressed and available for sale…we could buy them out instantly at a great price. It also protects us in-case something goes wrong!
Paying out Tranche 1 of our investors.
Our original batch of investors from 2019 wrote us cheques without running any diligence or asking us any questions. In other words - they put their complete trust in us with substantial chunks of their net worth. They were all understanding, have been very supportive, and fully appreciate that we tripled our personal cash outlay without diluting them. Morally, it’s critical we repay them by XXXXXXX as we said we would do this. We are only able to raise capital quickly, on excellent terms, and without much oversight because of our track record; we will never impair our ability to do this if we do the right thing.
Buying out this tranche of investors keeps us in control of our destiny and ensures we are never obligated to pay out dividends, which means dollars can keep flowing into growth.
What is our pay positioning relative to the market?
This is important for those joining our team to be fully aware of. Base pay is set to market; this scares away anyone who is a mercenary and not a missionary/not aligned with the company’s goals and culture. With bonus in, pay is substantially above market in order to maximize long-term outcomes as mentioned above.
Focus on performance flows top down and is proven by our team’s actions. Everyone has sacrificed some level of base pay in order to work with our team, grow the company and their long-term compensation.
As an extreme example, XXXX & XXXX are 100% performance based pay - taking $0 in distributions or salary over almost 4 years - and it’s important to us to push the same focus on performance throughout the organization.
What components make up pay and how are they divided?
Our team is diverse. Geographically, we’re split among several continents and even more countries! Outside of building an amazing XXXX, our hobbies and interests are not remotely similar.
As a result, cash compensation instead of fluffy benefits like “free lunch” make the most sense. Some of us might love free horse meat as a benefit, others would not. We’d rather give our team the discretion to do with compensation what they’d like.
Base salary is a function of pay grades driven by experience - mixed with location. Spread between the minimum and maximum of each pay grade is wide, and grades have significant overlap between them. This allows us to reward outstanding performance within the same pay grade. It can also lead to a scenario where someone who has a tactical role - but outperforms consistently - can be paid more than their manager. This is analogous to a football coach making less than a star player. Base pay is evaluated once per year and outperformance through the year is rewarded via the below bonus structure.
Bonus has potential to go up to 100% of base pay, and is driven by completing rocks, improving scorecard metrics, and company performance. It is divided into two parts; company and individual performance. It leans in favor of company level performance because we want to incentivize everyone working together to complete goals.
Moreover, mathematically, company performance is what ultimately dictates cash available to pay out bonuses.
Bonuses amounts for the previous quarter are paid out over the subsequent four quarters - which is a bonus cadence 4x faster than typical jobs.
Weighting and explanations:
Individual performance - 30%
Were your rocks completed? Did you take ownership around setting your rocks?
Did the scorecard metrics you are responsible for hit targets set in the beginning of the quarter? Do those rocks propel the company forward? Target improvements to scorecard metrics are outlined at the start of each quarter.
If you were blocked - did you proactively work with the right people within the team to remove the blocker, or jump in and help them?
Company performance - 70%
Did we reach revenue, gross margin, and net goals?
Did we complete company rocks?
Bonus is unlocked on a quarterly basis, and then paid out over the subsequent four quarters. Typical companies only bonus 1x a year and provide little to no feedback on how someone is doing.
Who makes decisions around compensation?
Decisions around compensation differ by seniority within the organization.
Senior management - those on our weekly EOS calls. Set by XXXX and XXXX.
Middle management - vary by department, but an example would be a junior warehouse manager reporting to XXXX, or an assistant customer service lead reporting to XXXX. Set by their direct manager with veto rights from XXXX.
Junior management - IE warehouse lead. Set by their direct manager.
Frontline. Warehouse, production, customer service, etc… set by their direct manager with input from the layer above them. For example, if a warehouse employee is due for a review, the warehouse lead responsible for them would determine if they are eligible for a pay increase and if they met requirements for a bonus. Our warehouse or production manager would help them lay out the logic for the increase and ensure it follows our compensation philosophy.
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