Lateral Capital Management, llc

Designing A Great Bonus Compensation System

One of the tasks faced by Early Stage companies (ESCs) is the need to design powerful, sustainable compensation plans. This includes the issue of equity sharing, but that generally involves a small number of employees and is not discussed here. What needs to be considered from day one, however, are bonus plans for managers and profit sharing incentives for other employees. This topic is as old as time.

Royalties are a well-understood financing structure in music, electronics and other technologies.

The advantages of Royalty-Based Financing (RBF) can be compelling for investors and certain types of companies. There are some downsides, of course, and both investors and entrepreneurs should take them into consideration. Remember, our thoughts here are no substitute for professional advice.

What is Royalty-Based Financing? – In a nutshell, the investor (Lender) advances money against a revenue stream which the company (Borrower) is relatively certain of receiving. In return, the investor is promised they will receive a fixed IRR or dollar-based return. Generally, the “cost” of this money to the Borrower approximates that of an equity investment (25-30% IRR to the Lender) – with the advantage that the term is fixed and in the control of the Company/Borrower.

The best example of this kind of deal would be payments from a licensee, where the company has agreed to out-license some of its intellectual property. Typically, these licenses have minimum payments attached to them which are paid annually to the licensor; often by big, well-financed licensees. In these situations, the investor would be pretty certain that some money will come into the company and be credited to them. Assuming the licensee is reputable, investing against a contract which pays the investor as license fees are received by the company should be pretty safe – even if the Company itself is not yet profitable. To be clear, timing here can be left open: The Investor/Lender receives some or all of the license revenue stream until their capital is returned – plus enough money to produce a specific return.

Why is this Attractive? –  Royalty-Based Financing can be seen as a “safer” way for the Investor/Lender to get a return they will be happy with. They really don’t care what else the company does, so long as there is relative certainty that they will be paid back as License or Royalty revenues come in the door. For a compelling stream of license revenue, this may be quite a comfortable proposition. And it can be done without extensive due diligence or painful arguing about the company’s valuation. For the Company/Borrower, RBF has one huge upside: it can bring much needed cash in the door without giving up equity. When the cost is generally higher than traditional bank debt, it can be more attractive then raising equity. The rest of the company’s assets may not need to be encumbered if the Investor/Lender is willing to rely entirely on the licensees’ ability and willingness to pay the guaranteed minimum license fee.

Downsides for Investors

  • Capped Returns – Investors who are used to “swinging for the fences” may cringe at a more certain, but fully capped return. If the payout is capped at the IRR agreed to upfront – 30%, for example – and the company ends up to be the next Google, that’s all the return the investor will receive.
  • Uncertain Period – If the Royalty-Based revenues are tied to product sales (“$100.00 returned for every widget sold”), investors are at the mercy of the market. No one can know for sure how long it will take for capital to be returned, if ever. This is why stable, predictable revenue streams from licensees may be a preferred approach.
  • Tax Status – From the standpoint of taxing authorities, Royalty-Based Financing could be seen as a loan. This may also disqualify angel investors from claiming angel tax credits, because they can’t claim tax credits on a loan and the returns may be deemed as interest income, on which income tax rates will be paid.

Downsides for Early Stage Companies

  • Growth Impediment Instead of investing all of its cash in future growth and R&D, the company has to use some of the cash to make regular royalty payments. This may be fine if the company is using the money borrowed to fund marketing and sales activity, for example, for a finished product. But if the company needs every dime? Perhaps going after more equity is a better approach.
  • Non-Committed Capital – Opponents of RBF stress that royalties are based on a percentage of revenues. The company has to make royalty payments even if it’s not profitable. This can end up eating into operating capital.
  • More Liabilities – Royalty-Based Financing is usually carried on the Balance Sheet as a secured loan. RBF investors have rights that are similar to those of traditional creditors. If there’s a change of control, for example, investors will want their unpaid return to be paid off the top.
  • Risk of Default – Unlike traditional equity financing in which returns are based on capital appreciation, Royalty-Based Financing is a loan that relies on repayment of the debt. If the company defaults on repayments, it can be forced to liquidate other assets in order to repay the entire advance.

Net, like anything else in the world of fundraising, there are puts and calls on all sides

  • All the plans should be easy to understand, be fair and (more important) appear to be fair. They should be based on principles the company is prepared to live with. They should aim to provide meaningful incentives to the employees and be “affordable” by the company.
  • The more directly a manager controls his/her group’s profit, the easier it is to design a meaningful profit-based bonus plans. By contrast, the further down in the organization, the more debatable the individual’s contribution and the less meaningful a straight profit-based bonus plan is.
  • The more objective the plan (the more tied to actual numbers), the better. The more subjective (i.e., the more tied to the boss’s opinion), the more debatable and less well received the plan will be.
  • A plan that allows the employee to know during the year how he/she is doing is more desirable than one which creates year-end questions about “how much will I get paid?” Year-end surprises, good or bad, are often the result of discretionary bonus plans or a plan with a significant subjective component. Don’t guess and don’t make your people guess.
  • “Formula plans” which impose an upper limit on total comp cause problems. Pragmatically speaking, the plan should be designed so that the organization is delighted to pay the extra increment for truly outstanding performance. This applies particularly to sales people, who should (particularly in Early Stage companies) consistently out-earn the CEO!
  • Sometimes there are valid company goals that cannot be measured in a given year. Achievement of these results can be best rewarded in some form of combination of soft and hard goals – or better yet, a rolling 2-3 year profit-based bonus plan.
  • All employees who participate in an incentive type pay plan should only participate in one plan. For example, Sales people should participate in a quota-based reward system, but not in the general profit sharing plan for all other employees.
  • Top management bonus plan should pay out annually – after all the numbers are in. Other plans, for lower-level employees should pay out quarterly, as the cash flow impact should be recognized as closely as possible to when it is incurred.

Types of Plans – There are five different types of plans, some of which are described below. There are numerous variations, but the general advantages and disadvantages listed here seem to hold true.

  1. Discretionary Plan – The Board approves a total amount based on sales or profit targets for the Company. Management divides the total among the various number of participating executives, using a formula known generally to everyone but administered “confidentially” by the Added Compensation Committee.
  • Advantages:
  • The company has total control each year over the amount distributed. By definition, it never gets out of whack with the company’s results and the Board is never surprised.
  • The company can control the amount, the number of participants and the makeup of the group. Some people can be in it one year and not in it the next.
  • This allows disproportionately large awards for outstanding achievements that are not tied to a single year’s profit (i.e., outstanding technical achievements for a software developer or a very important customer win for a sales person.)
  • Disadvantages:
  • Appears paternalistic and is often resented.
  • Fairness is always debatable.
  • The allocation formula always gets out.
  • Year-end surprises create year-long anxiety.
  • Doesn’t answer the question of “How am I doing?” during the year.
  1. Multifactor Formula Plan – The formula includes performance of the overall company goals and the individual’s performance against his/her own agreed upon goals. Aside from the question of how to set the weight of each factor, the following comments seem to hold true:
  • Advantages:
  • Broad-based.
  • The plan can be closely aligned with specific corporate and personal development goals.
  • Disadvantages:
  • Somewhat distant from individual responsibility and contribution.
  • Tends to lead to game playing in “negotiating the bogey.”
  • Very time consuming to administer.
  1. Straight Percentage of Pretax Profit or EBITDA – While there are many different “return on asset” yardsticks, using pretax profit seems to be the most closely aligned with the ultimate organizational yardstick: Net earnings. For private companies, this measure is often recast as EBITDA. While this is good in that it reflects what employees can actually influence, it is misleading in that it fails to acknowledge the cost of capital required to grow the business – interest expenses, returns to preferred shareholders, etc.
  • Advantages:
  • Clear and direct.
  • Totally aligned with the most important corporate goal.
  • Disadvantages:
  • Only really lends itself to top decision makers who really control the profit. It is less meaningful down the line – and of no value to people who can’t influence it.
  • If the pool of dollars gets too large, the percentage payout may have to be modified, which is always poorly received.
  • Tends to lead to low salary and very high bonus (with good performance) structures for the company as a whole.
  • It is a struggle for Early Stage companies, in that it can be a disincentive for essential long-term investments which are “EBITDA painful” in the short-term.
  1. Bonus Based on Profit Improvement – The company bonus “pool” is computed on a percentage of that part of a given year’s profit which is in excess of the preceding year’s average profit. (For Early Stage companies, this could also be done on the basis of sales growth.)
  • Advantages:
  • The bonus never gets too large because the basis keeps moving up.
  • Disadvantages:
  • Can be a real demotivator when the company takes an “investment year”, makes an acquisition which has a short term negative profit impact or when a big customer is lost – through no “fault” of the individual employee.

One variant of this approach is a two-part structure. Part One pays a straight percentage for improvement over the accepted annual plan. Part Two pays the same with the upside limited.

  • Advantages:
  • Straight and clear.
  • Reset each year, therefore, always in line with the company’s actual results.
  • Disadvantages:
  • Leads to sandbagging at the end of each year, which is the habit of holding new sales or other initiatives until the “profit will mean something to me.”
  • Pays as much for the accuracy of the prediction as it does for the value of the performance.
  1. Plan Based on Sales Growth and Pretax Profit – Employees are given an individual annual bonus potential expressed as the product of a percentage of their annual salary multiplied by a company performance factor (CPF) from a matrix listing annual sales growth and EBITDA. The example below might be highly appropriate for a fast growing company that is rolling out new, more profitable technology. Here, the CPF can be from 0.2 to 3.4, with 1.0 being at the nominal “acceptable objective”, i.e., 50% annual sales growth and 10% improvement in pretax profit. But the matrix can be set in any of several ways to inspire different mixes of sales, profit, etc.
  • Advantages:
  • Recognizes that increases in profit and sales are not either/or – they are both.
  • Performance objectives are clear and are not renegotiated year to year.
  • Everyone lives or dies by the same CPF, as a team, irrespective of their place in the company.
  • Disadvantages:
  • Can be very tricky to formulate without unanticipated consequences.

What Works Best? Early Stage companies are by their nature focused on maximum possible sales growth; to achieve a leading position as the market develops. Ultimately, however, their gross margin has to be “brought down to the bottom line.” The game, therefore, is a continuous three dimensional tradeoff between investments for future payoff, rapid current sales growth and the need to prove that the company can make money – so someone will pay a lot to own it!

To maximize the likelihood of achieving the dual target of sales growth with profits, all employee profit sharing or bonus plans should be closely aligned with these goals. Therefore, you might think about two separate plans, both of which are based on the CPF system. A specific example, again using the CPF chart above, might look like this:

  • For Top Managers/CEOs – The plan would pay a multiple annually of the target bonus potential in the 10% to 25% range of salary, depending on the position, level and seniority.

Example: Assume a manager earns $80,000/year and is given a nominal bonus potential of 10% or $8,000.00. If the Company’s performance for the year is 60% sales growth and 8% pretax margin, then from the CPF matrix, we get a 60% sales growth and 8% pretax profit, a factor of 1.0.  Therefore, the bonus will be $8,000. Note that setting the “target bonus” is very important, and that sales people might have a higher percentage of their total comp in “target bonus” than an engineer or marketing manager.

  • For All Other Employees – The plan would pay quarterly based on quarter versus year ago comparison. The target bonus would be available to all eligible employees.

Example: If an employee earns $40,000/year, and the bonus is 5% of salary, he or she will have a 5% of $40,000/4 = $500 quarterly bonus potential.

Of course, there is no one right system for every company. But reviewing the options here with your Board of Directors may help produce a thoughtful outcome.