The Dangers of a High Compensation Culture

Every startup leadership team wrestles with trade-offs between growth and profitability at each stage of its quest to grow enterprise value. This is fitting and ever shall be.

What teams don’t reflect on sufficiently, in my opinion, is how a flawed compensation philosophy can make these trade-offs even more difficult than they already are.

The flaw in question is embracing a high compensation culture, a decision to pay premium prices for a technology company’s most important expenditure category by far: its people.  Whether decided by an intentional talent strategy, or muddled into by inertia, a high compensation culture (HCC) heavily burdens the journey of building enterprise value.

Founders should not assume they have no choice but to “follow the market” passively on pay as an exogenous factor. Instead, founders should embrace the crucial role they have in forging a tough-minded culture of frugality and long-term orientation.

What does “high compensation” mean? Well, any discussion of tech industry pay must accept some relativism: all technology jobs are highly paid relative to other industries, even after adjusting for education and location. I am not passing sanctimonious judgment as to what level of pay is “fair.”

Rather, by HCC, I mean a recruiting and talent management philosophy that embraces higher-than-average pay relative to other tech employers, or even higher than the average startup. Such a mindset can emerge from a syllogism I have heard many times in my Silicon Valley career:

  • Great companies are built by great people; and,
  • Great people know their value in a global talent marketplace; so,
  • Great people must be highly paid for us to attract/retain them;
  • Therefore, great companies have highly paid people — and so should we!

So expressed, an HCC is as much a state of mind as a practice. Characteristic behaviors flowing from this mindset include:

  • Crafting an aspirational comp peer group — companies that are larger, more mature, or particularly successful — on the argument that peers should be exemplars of “the kind of company we want to be tomorrow, not who we are today.”
  • Routinely paying above median salaries even within those comp sets — on the argument that “above-average results require attracting above-average talent.”
  • Seeking to match near-term cash comp when recruiting people from established companies — on the argument that talent can be rationally risk-averse and needs to be comforted in the leap to a younger company.
  • Adopting executive cash comp plans (plus near-guaranteed equity) that are many multiples of rank-and-file professionals — on the argument that leadership matters above all else and that “rock stars” are worth multiples of lesser peers.
  • Steadily increasing non-cash comp, workplace amenities, charitable contribution matches, boondoggle offsites and the like — on the argument that people who feel well-cared-for will be more productive and loyal.
  • Sourcing talent only or primarily in cosmopolitan locations and paying premium compensation — on the argument that the right talent is found only in these expensive areas (and needs to be “compensated” for the high cost of living there).

There is truth in these sentiments; none of the arguments above are false, as such. But as a mentor of mine used to say, the problem is that they “prove too much.” They can rationalize almost any level of pay and expenditure. In my experience, startups where these sentiments dominate tend to experience a steady escalation of expectations until there is a sharp reset — usually caused by competitive crisis or investor revolt.

Now, as a former entrepreneur myself, I believe that every venture relies on the exceptional, unreasonable efforts of super-motivated professionals — and I am wildly in favor of them being hugely rewarded when they defy the odds and create something out of nothing. We know that there is no ceiling on the value people can create, so there should be no ceiling on what they can earn.

The problem arises when that earning is assumed as an entitlement before the value is created, at both the individual and collective level.  And this is a strategic problem because compensation culture is structural and deeply persistent.

It’s easy to forget in boom times that the value of an enterprise is always ultimately determined by its actual or projected ability to generate durable long-term profitability.  Even in the most extreme cases of high-growth but unprofitable startups being valued on high revenue multiples, this valuation is a proxy — a heuristic, a shortcut — for estimating their profitability in the future.  The more distanced and more burdened that profitability, the higher the growth must be to justify that valuation.

By taxing the effort to generate durable long-term profits, an HCC taxes enterprise value.  And because it is the dramatic expansion of that enterprise value that drives the most important reward for everyone in a startup, an HCC renders success that much harder to achieve for everyone involved.

A further problem is that HCCs are more operationally volatile than frugal cultures. A high expense base and a more intense growth mandate increase the risk of overreach — missing the plan by large margins and requiring sharp corrective action.

At its worst, an HCC’s “gotta spend money to make money” logic can impel a desperate cycle of overreach and over-expenditure that leads to jarring disappointment for all involved.  And more frequent or larger magnitude overreaches lead to deeper and more traumatizing layoffs.  Examples of this are legion in Silicon Valley today.  I won’t name names here, but it is not a coincidence that some of the most extreme examples of overreach-and-crash also had egregious HCCs.

Yet another factor is cultural. HCCs are more brittle — less cohesive, more excitedly short-term, more vulnerable to demoralization in the face of challenge.  Talent drawn to an HCC has at least partially self-selected for mercenary intentions and is likelier to have been fought over by competing recruiters. The “winner’s curse” applies in consistently coming out as the top bidder in these talent wars. Not only are you competing for the talent most motivated by near-term compensation, but you are also paying the most for that group!

Now, is it easy to persuade talented professionals to join when they are being offered more cash elsewhere? Of course not! But that is the founder’s burden. It’s easy to offer a great culture, great opportunity, great mission, and more guaranteed money. To earn his or her way, the entrepreneur must resolve to do with less, often much less. Just as a high-comp culture is a state of mind, so too is its opposite: a frugal mindset, a culture of deferring gratification, of building the long-term engine rather than taking loans against future value.

In my own journey, it was miserable losing over and over again to more glamorous, much higher-paying companies in recruiting competitions (especially Facebook and Google, both within 30 minutes’ drive).

But the answer was not to raise more money to win these talent auctions (not an option even had we wanted to take it!). Rather, the answer was to foreground the three extraordinary things a startup has to offer: (1) equity value that can grow to many multiples of present value, (2) an opportunity for profound learning and rapid growth in the service of a world-changing mission; and (3) the immense professional reward of participating in the emergence of a new market leader.

Younger professionals often underappreciate the last of these. As with well-invested capital, career success compounds over time. To maximize the economic return to one’s talents over a career, it is far more important to advance within quality companies than to get top dollar in early salary. The opportunities unlocked with success are usually much more remunerative than the initial success itself.

If the founder is striving to persuade on the grounds of mission, culture, adventure, equity growth potential and the opportunity to grow into something greater — but still needs to pay above market average — something is wrong. It may be the message. It may be the messenger.  It may be the individual or the talent pool being targeted. But something is off.  Sometimes, looking for a completely different category of people in completely different places is the only solution.

Needless to say, these founder appeals must be made while leading by example. Founders must walk the walk –it will not do to preach austerity while living extravagantly. The leadership of an early venture has the most to gain from deferring gratification and should therefore be digging deeper than everyone else. It doesn’t require sainthood, but the deeper the better!

Getting this right is a superpower. Just as a strong balance sheet unlocks strategic opportunities that are closed to the sub-scale and thinly capitalized, a frugal organization can go much further with less and survive winters that kill the less disciplined.

Remember: the very premise of every new venture is that wealthier, larger, more established incumbents are complacent and unworthy of their market share. It follows that frugality should be second nature and a source of fierce pride for a startup. Compensation is the first and most important place to build that identity.

The information contained herein is based solely on the opinions of Marcus Ryu and nothing should be construed as investment advice. This material is provided for informational purposes, and it is not, and may not be relied on in any manner as, legal, tax or investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any fund or investment vehicle managed by Battery Ventures or any other Battery entity.
This information covers investment and market activity, industry or sector trends, or other broad-based economic or market conditions and is for educational purposes. The anecdotal examples throughout are intended for an audience of entrepreneurs in their attempt to build their businesses and not recommendations or endorsements of any particular business.