Issues in Evaluating Compensation for Your Senior Management Team

January 5, 2011

In my role of mentoring software CEOs, the end of the year always brings on conversations about how to set up compensation plans for senior management teams. This is a follow-up post to one I wrote last year concerning this topic.

While working with my portfolio companies on the resulting performance and associated pay-out to their 2010 plans, we’ve devised some steps and ways to improve last year’s plans. Some of the issues that popped up:

Issue 1: Missed Revenue Targets

One company significantly missed the top line bookings target that was set at the beginning of the year, and also missed the bottom line. Entering into the second half of 2010, management had recommended a revision to the forecast for that period, reflecting the softness in top-line growth. That revision pretty much confirmed that the senior team would not hit the minimum required to get on the bonus plan. Should the CEO have recommended a change in the bonus plan? And should the board have agreed to a change that would ensure some bonus payout despite lower financial performance for the year?

This is a tough call for a board to make. On the one hand, bonuses are part of every senior manager’s expectations (right or wrong). But accountability is important. If the senior team is not able to accomplish the financial plan the team and board set out to achieve, why should they still expect to receive performance bonuses? This begs for a strong position by the board to forgo bonuses. If some managers don’t like it, they may leave. Is that a bad thing? Well, it depends on the manager.

The flip side of that coin is economic reality. In early stage software companies, it is exceptionally difficult to forecast a full year, especially in a tough economic environment. Therefore, boards need to dig a layer or two deeper to assess the inherent economics of the business and the macroeconomic environment in which the company operates. The goal is to assess how much of the financial miss is based on performance versus macro-economic issues.

Ultimately, no perfect answer exists. What is critically important in my opinion is establishing a culture of “hitting the number.” The more experienced the CEO, the harder he pushes to continually hit the budget top-line number. By standing firm on hitting the number, the CEO can then avoid a culture of excuses and motivate his senior team to stay focused on any and all innovations required to hit the number.

But we also can’t neglect the bottom line. Obviously, the board will not be happy if the management team totally neglects the efficiency and cash consumption of the business in the pursuit of the top-line.

But, hey… No one said building a software company was easy!

Defining Targets Accurately

Another issue that surfaced involved the definition of the bottom line target. In this case, the bottom line target was set around the relationship between gross profit and distribution cost (driving behavior towards optimizing the capital efficiency of sales and marketing).

The problem was that the compensation plan did not take into account the variance between contracts booked and revenue recognized in regards to accounts closed during the last few weeks of the year. Specifically, a large contract was closed at the end of the year – which helped the team hit the top-line target – but a staged product roll-out meant that revenue was not recognized – which meant that the bottom line target was not met.

Again, this is a situation where the board needs to make a tough call: do you keep the team motivated by celebrating the win (be flexible, bend the rules…) or does the board hold strong on instilling a culture of accountability and return on commitments? Tough calls every time.

Ultimately, there is no right answer. Scaling a business is all about flexibility in an ever-changing environment.

The Chief Executive Officer

Firas was previously a venture capitalist at Openview. He has returned to his operational roots and now works as The Chief Executive Officer of Everteam and is also the Founder of <a href="http://nsquaredadvisory.com/">nsquared advisory</a>. Previously, he helped launch a VC fund, start and grow a successful software company and also served time as an obscenely expensive consultant, where he helped multi-billion-dollar companies get their operations back on track.