How to Design an Effective Bonus Plan

There was a time when pre-IPO companies didn't have bonus plans. Generally, such businesses are still unprofitable and no one is interested in increasing the burn rate through bonus payouts. No more. Most of my pre-IPO companies today offer bonus plans to at least some of the management team. I have even warmed to this idea - having previoulsy been alarmed at the thought of paying bonuses while the company burned cash.

So, what are the key ingredients of an effective bonus plan? This question is one that I have wrestled with over a number of years as a board member and chairman of numerous compensation committees. Based on experience, I have learned that a bonus system should incorporate 5 specific elements to in order to be an effective motivator. I discuss these below.

My philosopy of bonuses is straightforward. A person's paycheck is for his or her regular work. The paycheck should suffice as appropriate compensation for someone who performs as expected. If she performs her duties as requested, and does an adequate job in that effort, then the paycheck is her reward.

A bonus, on the other hand, is a reward for doing something more and it has a two fold objective. It is, foremost, compensation for work performed at a level above what is expected. But it is also a tool. A very effective tool I might add. It allows a CEO to put a spot light on a specific objective that must be accomplished in a particular time period. Achieve that objective, and you will be rewarded with cash or stock remuneration. It is this aspect of the bonus that I like best. People can be motivated by money. If you want to motivate a person to achieve a certain objective, put a price tag on what it is worth to you. When an employee hears "get that system installed and operational in one quarter and you will earn $20,000 in bonus money", that tends to focus his mind on making sure it happens.

Now, onto the elements that must be incorporated in any bonus plan to maximize its effectiveness.

Timely - This means quarterly, not annually. An annual bonus simply takes to long to bear fruit. Also, consider the challenge of laying out a specific set of objectives in January that will still be relevant to the company in December. Not very likely. The quarterly bonus has one more attractive dimension. It gives the management team and the board a reason to evalute people on a frequent basis - and adjust priorities as needed. That is extremely valuable.

Meaningful - The reward being offered has to be a motivator. What that majic dollar or stock grant amount is depends on a lot of factors. Just make sure the bonus matters.

Predictable - The best bonus plans are ones in which a person can easily calculate what he is going to earn. This means emphasizing objective measures of performance. I hate subjective standards when it comes to bonus plans. Making an employee guess what he might earn is not a motivator. Lay it out in with simple math. To that end, the components of the bonus calculation should include no more than 3 variables. For instance, a VP of Operations might be bonused on 3 measurements: COGS, product shippments and customer satisfaction results. I have seen too many bonus plans with 15 + factors driving the bonus award. That is too many. It makes it nearly impossible for the employee to quickly assess how his contribution to a given task will affect his bonus. And ultimataly, you want him thinking that way. You want to influence how he spends his time. When an employee must make the inevitable trade-off between doing one thing versus another, you want the information provided by the bonus to guide his efforts.

Consistent - The structure and mechanics of the bonus plan should be remain consistent over time (as much as possible). This means that things like the payout frequency (quarterly), the bonus amount (% of salary for instance) and the number of variables in the bonus (2 or 3 is best) should remain constant. What can change - and likely should - is the specific activity or result that the bonus will be based on. For instance, the VP of Engineering may have her bonus for Q2 based 50% on the delivery of a certain product and 50% on hiring objectives. The next quarter, all of her bonus might be based on opening an offshore development center by a certain date. It is fine to change the specific activity being bonused, what should not change (at least not often)is the method by which a bonus is calculated and paid.

Fair - The purpose of a bonus is to motivate certain behavior to obtain certain results. So it makes a lot of sense to ensure that the employee can actually influence the results she is being bonused on! That is what I call fair. Seems obvious but it doesn't happen often enough. In my opinion, "group goals" suck! Remember what the bonus is for. It is to communicate to the employee what you - the CEO or board - find important and to motivate him to achieve certain results that you desire. This requires a bonus scheme that he can influence.

My final advice. As you put together your bonus plan, ask yourself, is the reward being offered Timely, Meaningful, Predictable, Consistent and Fair. If so, you probably have the makings of a bonus plan that will drive the results you are looking for.

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Google's Lurking Problem....

Yes, even Google has problems. Some are well discussed - like its difficulties in trying to break into the hand held market - and some are not. All great companies follow an arc of some sort. They rise to prominence. They become the status quo. Eventually, they fade as someone else invents a better approach to solving the same problem.

Generally, it is only in hindsight that you can see where the troubles began for a business. Generally, but not always. Occassionally, a serious problem is hiding in plain sight. What problem am I referring to with respect to Google? Project managment. Specifically, the thousands of projects being undertaken by Google employees without proper corporate oversight of which ones makes sense and which ones don't.

Google has proven itself competent at monetizing search results. Nothing more. Even the idea of exactly how to do that, of course, didn't orginate with Google. That idea came from Bill Gross, who started GoTo.com (later renamed Overture and acquired by Yahoo). That is it. Google has a great pay per click business but no where has it shown itself exceedingly capable at inventing other billion dollar ideas. Which isn't to say it isn't trying. It is just going about it all wrong.

Google prides itself on its management edict that 20% of an employee's time is his (or hers) to do with as desired. The hope is that these bright and motivated workers will come upon a big new idea for Google to exploit. Fine in principal but not in practice. Consider that for all of Google's impressive revenue growth quarter over quarter, over 95% of its revenues still come from one source: Adsense. Yet, massive investment in money and time is being spent on thousands of other initiatives. What happens when its base business slows? My prediction? A radical wake up call to all of the employees who today consider it their right to explore projects willy nilly without regard to their realistic revenue potential. When that day comes, the culture of Google will have to change. Business discipline and accountiblity will become the new watch words. The strain this will put on the organization will be immense. Reeling in a loose culture and creating a layer of cold analysis is never welcome by line workers. At Google, it will be down right despised.

Now, aside from increased management oversight (which will come from where in a company that has never had any?), what do you think the impact will be when subsidized cafeteria, dry cleaning and car washes get eliminated.

Were I on the Google board, working on establishing a durable culture would be my top priority.....

The One Thing I Love To Hear in a Pitch

In a lot of ways, venture capitalists are like any everybody else when it comes to the listening to presentations. Keep in mind that they listen to lots of them - maybe 100's - in a given year. They get distracted. They get bored. They wonder (and hope!) that the speaker will say something thought provoking. Want a sure fire way to gain their attention? Make a prediction!

The best presentations I have heard over the years have been ones where the CEO or founder takes a position on where a market is headed over the next 2 to 5 years and then intelligently walks through where the opportunity will arise from that. Why 2 to 5 years? Because that is a time frame managble for a start-up. Guessing what will happen 'eventually' is a lot easier than putting a time stamp on it.

Let me provide a few more details on what I like to see when it comes to predictions. Start with a discussion of where your market is today. Who are the incumbents, who are the relevant new comers and what does each contribute today. Now project out 1 year, 2 years, 3 years. How will the market evolve? How will the needs of the customer change? What will each market participant focus on? At the end of this story - and yes you should construct this part of the presentation with a story metaphor in mind - it should be crystal clear to anyone listening to you speak where the opportunity lies and why all the other players - except you! - will have a tough time addressing it.

A well thought out analysis as I have described above is a great way to engage your VC audience. Who isn't curious about what the future has in store for an exciting market.

By the way, I openly acknowledge that what I have described above is a tough assignment to carry out. It takes deep thinking and, frankly, brilliant insight that most people just don't have. Of course, that is as it it should be. Few are bright enough and driven enough to see and pursue what the rest of the world doesn't. But what a rush when you make a prediction, place your bets on it - your time, your money, your career - and it happens as you guessed! Those are the joys of starting and building a great business that few ever experience.

Are VCs All Hardware Haters

What a strange 12 months its been in the enterprise equipment space. Last summer, a crop of relatively young but fast growing public equipment companies were being aggressively valued in the public markets. Riverbed, Aruba Networks, Acme Packet, F5 and Isilon and were all trading at multiples of 5 to 15 times sales. VCs took note. Most of these companies had recently gone public. Many VCs, myself included, thought the public markets were once again embracing the enterprise IT investment theme.

There were lots of reasons to believe the valuations of these small cap businesses would maintain their attractive levels - at least for a while. All were growing revenues at 25% to 100% annually. Gross margins were 50% to 70%. Most importantly, the enterprise IT market seemed like a relatively safe bet for the next 2 to 3 years. Following the tech recession of the early 2000's, business IT investment shrank significantly. But after 5 years of belt tightening, it seemed a new investment cycle for IT was due. Sadly, the past few months have shown otherwise.

With fears of recession and certain high IT spending verticals, like financial services and retail being hard hit, growth in enterprise IT spending in 2008 is now in doubt. This cloud of uncertainty has leveled the market caps of the enteprise equipment sector. Many of these small cap companies have seen their valuations cut by 50% to 75%.

So what do VCs think about all of this? Theoretically, VCs are not to supposed to care about the day to day price gyrations of the stock market. Practically speaking, however, the retrenching of the enterprise equipment sector will have an adverse effect on venture funding. With many of these companies needing $100 million or more to reach breakeven, a dip in the public market comparables makes it harder to justify an initial investment.

So what should entrepreneurs - or CEOs of existing equipment companies - do about all of this? More on that topic in my next blog post.....

Value of *Certain* Angel Investors

Most of the companies Clearstone invests in have angel money. In the past few years, angels have become much more active than they were following the tech crash of 2000. As a VC, I divide angel investors into two buckets. The first group includes angel investors who know the space they are investing in. Perhaps they previously started a company in the same industry or were part of a successful company targeting the same market. These investors can spot a new idea with potential from a me-to copy cat with limited prospects. When a company comes to Clearstone with some money in the bank from smart in-the-know angels, we get interested quickly. As it happens, angel investors in this category usually know the VCs who invest in their space and can be a great help in introducing a start up to smart venture capital investors. Better still, these angels typically know the going terms for a start up in their market. Accordingly, they can help the entrepreneur get the best deal warranted given the progress of the business.

The second bucket of angel investors are those who have some spare cash to invest but don't have any familiarity with the target market. These investors are generally not known by VCs active in the specific market the start up is pursuing. In most cases, they can't help with follow on fund raising. Because they don't know what the going VC terms are, they often set terms for their investment that make it harder to raise money in the next round.

So, here is my advice to entrepreneurs when it comes to raising angel money. First, it can help a great deal if you raise angel money from a prominent person in the space you are targeting. This prominent person could be affiliated with a large potential customer or could be a brilliant technical person who lends street cred to the technical platform being built. Seek out the well known people in the industry you are involved in! Their money means something. VCs can't know everything about an industry. So how do they get comfortable with a new business? They rely on smart people who are accomplished and well connected in that industry. If someone of that caliber happens to already be an angel in your business, raising venture capital just got a lot easier.

What Start-Ups Should Do About the Recession.....

As a venture capitalist, I am dealing with this question continuously with all of my active portfolio companies. At board meetings, the conversations inevitably center around whether to reduce spending, and deal with the commensurate slowdown in business growth, or whether to stick with an aggressive growth plan while others are hunkering down. Truth is, as tough as a recession can be on an established company, it can be fatal to an early stage company. One of the things board members get paid for, of course, is making the tough calls. So, in the last 60 days, I have been giving the following advice to my portfolio companies.

Secure Financing
This is pretty straight forward. If your company will need capital in the next 12 months, I would recommend obtaining capital now. Yes, the extra cash could wind up being unnecessary. On the other hand, if the economy gets worse, it might be difficult to find capital when you need it.

Hire a CFO
This is one of my pet peeves as a VC. Too many start ups, and even some investors, don't appreciate the value a competent finance professional can provide. This is not the time to skimp on financial oversight.

Re-Evaluate Your Sales Team
Is your VP of Sales up to the task? Too many CEOs delay making a change in the sales role until it is too late. My advice: establish firm targets for the quarter and this time don't accept excuses!

Bring on a Top Notch Independent Board Member
This is a great way to expand your network of potential customers and capital providers. In addition, a board member who has been through tough times can be a valuable asset in 2008.