How to Effectively Compensate Your Management Team

Recruiting and retaining premier executives to manage developing entrepreneurial and technology companies is a problem that often can be overcome with creative compensation packages. While highly attractive executives often have an entrepreneurial mindset, they can and should be paid at a level matching their skills and financial needs.

For any developing enterprise, there are practical restraints to recruiting and keeping executives who may be accustomed to more generous compensation. To attract and maintain a motivated, proficient management team, a company must be creative.

A developing firm faces a double-edged sword. On the one hand, it wishes to attract a top-shelf management team, often from well-established multi-national companies, professional service firms and academia. On the other hand, limited resources prevent paying top-shelf salaries. Cash flow (usually negative for a developing company) precludes funding salaries, bonuses and certain benefits.

Alternative Compensation

Stock Options/Stock Grants

The most common compensation alternative used to attract executives is the granting of stock options. Stock options allow executives to enjoy an equity stake, tied directly to the performance of the company. The stock underlying the options should increase in value if the company performs well. Developing companies should establish a plan (including ISOs and non-qualified options) early in their existence.

Stock options can be valuable if a private company is later acquired. Not only do they provide an exit strategy to "cash-out," they can be an effective defensive mechanism if inside management has sufficient beneficial ownership. Finally, stock options are the primary exit strategy if and when a firm goes public. Some companies may make stock grants in the form of "founder's shares" to the members of the initial management team. The company should consider both the financial statement implications and the tax consequences of options or grants.

Bonuses Based on Achievement of Specified Milestones

Contractually-provided annual bonuses are atypical because of the uncertain cash flows of developing enterprises. Discretionary bonuses also are irregular because of the difficulty in determining "success." Normally, there is no steady income stream to measure, and costs can be expected to increase, especially in research and development. There are, however, alternatives.

An employment agreement can stipulate that an executive and the company will agree each year on milestones to be met in the next year. Achievement of such milestones will determine the bonus amount. For example, an R&D executive's bonus could be based on the number of software enhancements developed, prototypes built or products for which FDA approval is sought. A CEO's bonus may be based on the successful completion of a financing or product licenses. A CFO's bonus could be based upon increased gross margins, improved net loss or maintenance of budgetary restraints.

Change of Control Arrangements

A great concern for all executives is what happens to them if the company is sold or if an investor with a new agenda becomes the dominant shareholder. To alleviate these concerns, the company can offer change-in-control agreements by which executives may receive golden parachute compensation in the event of termination or reduction in duties. Although normally adopted to discourage takeovers, these agreements can be crafted as compensation packages to provide assurance that executives will enjoy the "upside" if the company is acquired -- even if they are subsequently terminated. Typical provisions include severance pay, provision of benefits, acceleration of vesting for stock options and granting of additional options.