Talent & Leadership
What Every Startup Should Know About Compensation
Does compensation even matter?
The topic of compensation is one of the most discussed aspects of the employee lifecycle—it gets a lot of attention from both employees and managers and is often the largest expense for any company. Yet ironically the research is clear that rarely, if ever, do we see it act as a driver of employee engagement, retention, or performance. And increasingly, we hear that compensation matters less for employees than factors like learning, flexibility, company culture, and the ability to make a meaningful impact in the organization and for its customers.
Why then do most companies spend so much of their resources on this one very expensive area of People Systems? Are we all wasting our time and money trying to get it right?
The answer, of course, is yes and no. Compensation, even on its face, clearly is an important reason why employees join and leave jobs. But a more useful framework to understand the impact of compensation is Frederick Herzberg’s Two-Factor theory of motivation. Herzberg recognized that:
- Compensation alone rarely increases job satisfaction
- But, if compensation is too low or perceived as unfair, it can easily decrease satisfaction
- And compensation rarely increases motivation for sustained periods of time
Herzberg called compensation a “hygiene factor” rather than a “motivator.” What that means is that within a certain level of having one’s needs met, compensation doesn’t move the needle much on retention, satisfaction, or performance. But at the extremes, it can make a big difference, especially when an employee feels wildly undercompensated. As an analogy, consider that taking care of your physical hygiene will rarely get you lots of praise and positive attention, but failing to take care of your hygiene will get you lots of negative attention. Compensation typically works in the same way.
How to get compensation right
Compensation is never just about the quantitative value of the money. It’s just as much (maybe more so!) about the emotional aspect of feeling fairly remunerated. Compensation consists of all monetary and non-monetary rewards that employees receive in exchange for their work. This includes:
- benefits (both physical and emotional)
While there are also countless intrinsic rewards for doing work (like meaning, progress, and belonging), compensation typically refers to extrinsic rewards (i.e., if you give the company X, then the company will give you Y).
Given the “hygiene” nature of compensation, let’s begin by focusing on how to prevent your compensation strategy from having a negative impact. In many ways getting compensation right is all about avoiding the most common compensation pitfalls. The following three factors are the most common compensation culprits:
1. Difficulty hiring and retaining employees
The most foundational way to get compensation wrong is to offer a comp package that can’t compete with the marketplace. To make sure you don’t fall into this camp, do the following:
Define your UEP (Unique Employment Proposition): Just as companies must have a USP (Unique Selling Proposition) to differentiate themselves from their competitors, employers need to have a differentiation strategy on the value they offer their employees. Very few companies can or should compete in all areas (e.g., salary, equity, benefits, perks, diversity, mission, geography, flexibility, learning culture). See the exercise below to narrow your UEP and set your compensation strategy.
Research market pay: Once you are clear(ish) on your UEP, you’ll want to determine what average compensation looks like for industries, company sizes, and geographies you compete with for talent.
- There are robust tools for this like PayScale, free tools like Glassdoor Salary, and input from your advisors and investors.
- More advanced data-based tools like Radford or Advanced-HR are great and highly recommended.
- You can also ask candidates to share their compensation requirements for research purposes—just keep in mind that it’s illegal to ask about compensation history because it exacerbates any pre-existing inequities in their salary. It often may be helpful to have a conversation with candidates about compensation expectations early on in the process to set expectations; please keep in mind that there is a risk of introducing harmful bias into your hiring process if you anchor offers to where candidates were in the past. It’s a much better strategy to identify a narrow salary range of up front and share that transparently.
- With your UEP in mind, determine where you want your compensation to land relative to market averages.
- Note here that not every company has to—or should—pay at above or equal to market ranges. By definition, about half the companies must be below the median, and especially for early-stage companies, it’s much more likely that a higher percentage of compensation will come in the form of equity than cash.
Given our increasingly virtual and distributed hiring pool, we recommend equal pay for equal work—with pay tied to roles versus locations. The only exception we believe it makes sense to consider is location-based pay bumps in hard-to-hire, expensive markets or pay bumps for roles that require in-person responsibilities. If someone moves from one of those pricier markets, we do not recommend cutting pay (since this is almost always highly demotivating), but we suggest simply freezing all pay increases until the employee reaches their new pay level.
Bonus tip: Once you do your research, share your findings with your employees so they understand how your business makes compensation decisions.
Stay current with the market: You’ll want to reassess your compensation levels every one to two years or whenever you notice an increase in departures or difficulty hiring. Especially in heated job markets, benchmarks rise rapidly, almost certainly faster than is reflected in external data sets. This is another reason why it’s helpful to have your recruiting team gauge candidate expectations so that you can keep current on where the market is moving.
Remember that employees today have access to a wide array of data on what others are getting for their roles. Inside companies, it’s common for people to share what they’re making (and we believe it’s a good thing because it fosters transparency and creates positive pressure towards fairness). Plus, in a strong job market, it’s likely your best employees are getting calls from recruiters telling them exactly what they can earn at other places.
So, when doing compensation reviews of your current team, adjusting to the market is often equally important as adjusting for increases in job impact and role responsibility. Keep in mind that:
- There may be lots of historical reasons why an employee is undercompensated relative to their peers— perhaps they were a very early employee or others negotiated better when they were hired (this is a big reason why we discourage companies from negotiating offers).
- Either way, employees will be increasingly resentful if they feel underpaid.
- While it may seem unusual to offer an underpaid team member a significant increase, consider how much it will cost you to replace that employee. In almost all cases, it’s far less expensive to retain existing employees than hire new ones. You will likely be paying that new employee market rate at the same premium “increase” you would have given to a known quantity.
Expand your hiring pool: Another way to make your compensation strategy work with your hiring needs is to constantly seek ways to expand your hiring pool.
- For example, can you hire in cities where cost of living is lower or job opportunities are more rare?
- Can you reduce unnecessary barriers to entry (like years of experience or specific education requirements) and search for potential over experience?
- Or perhaps you can invest more in employee onboarding and training so that employees don’t have to come in fully-loaded with all the skills and knowledge you need.
Remember: Cash is often not the most important component of overall compensation, and it’s certainly not the biggest driver of retention. If you are an early-stage company, it’s very likely that you don’t have a significant amount of cash on your balance sheet. But you do probably have meaningful equity to offer, perhaps with considerable upside. Leverage that when selling your offer—especially for candidates who believe in the long-term vision of your company. It can be a huge competitive advantage.
We’re big fans of using equity as a key aspect of compensation. It’s much more closely tied to retention and, more importantly, it aligns all employees around common, shared goals for company performance. Startups are often a marathon, not a sprint. You want to orient your compensation around long-term objectives and ensuring all employees have a real stake in the company’s success.
Just as businesses need to differentiate themselves from their competitors to attract and retain customers, they need to differentiate themselves from other employers to attract and retain talent.
To define your company’s Unique Employment Proposition (UEP), try this team exercise from LifeLabs Learning:
Based on the insights you glean from the discussion, narrow your UEP to 2-5 factors you believe can allow your company to compete for the types of employees you most need. Use this UEP as your guide to decide on your compensation philosophy and strategy.
Keep in mind that non-financial benefits are becoming a more impactful way to differentiate your company. For example, strong benefits around physical, mental, and financial wellness are increasingly important and compelling. Having a great company to work for often means you don’t have to pay the highest cash levels to employees to get them to join and stay!
2. Productivity loss
Another easy way to miss the mark compensation is to pay people so little that they can’t afford to be fully focused on and invested in their work. To avoid this situation, consider the following:
- Pay a living wage: Ensure that you’re paying enough for your employee to maintain a normal standard of living. Here is a helpful database to check your wages.
- Have sufficient benefits: Aside from salary, make sure your health benefits make it possible for employees to take care of themselves and their families to the extent your company can afford it. To get the most value from your benefits, do an annual survey to learn which benefits matter most to your team.
- Provide enough sick/wellness days: Don’t reinforce working while sick, which can harm productivity, engagement, and—as 2020 has taught us—spread illness to others. A simple solution here is to offer as many sick/wellness days as your company can reasonably afford.
- Offer financial education: Increasingly, we’re seeing companies go beyond physical and mental health support and also provide financial support, like 401(k)s, and education, like workshops or advising on paying down debt and saving for retirement. Companies like Northstar offer a powerful benefit to employees to help make sure they can focus on financial wellness and security.
Remember: While paying too little is the far more common scenario, paying too much also has its downsides. Overfocusing on extrinsic motivators can “crowd out” intrinsic motivation, making employees less engaged by their work and more dependent on earning larger and larger amounts of money to stay motivated. Paying more based on relative impact in a role can be a powerful motivator as long as it is done smartly and fairly.
3. Feelings of injustice
And the single easiest way to upset your employees with compensation is to create the reality and/or perception of injustice. It’s important to remember for many people compensation is as much an emotional experience as it is a rational one—the feeling of being paid fairly is often more important than objective valuation. To counteract this possibility and create a truly fair system, consider instituting the following norms:
Share your comp philosophy: It’s easy for people to make assumptions about why some people are paid more than others or receive a different amount of equity, inviting resentment to seep in. Prevent it before it starts by being forthright with your compensation philosophy (see the exercise below). Explain how you think about salary, benefits, equity, and any other aspects of your compensation and why you compensate your team the way you do. To see part of our internal compensation training at LifeLabs Learning, check out this video.
Use a transparent formula: Even if you’re not publishing each person’s salary transparently, make your formula for calculating compensation transparent.
- For example: Buffer’s formula is job type X seniority X experience + location.
- At LifeLabs Learning, we use the formula role band X skill level X tenure + location (if in a hard-to-hire city).
Distribute decision-making power: If a judgment call ever has to be made about someone’s compensation (e.g., assessing someone’s skill level), reduce the impact of bias by having at least two decision-makers and a third tie-breaker.
Do not negotiate: Decide on your compensation offer with your decision-making crew before making an offer (whether you’re hiring a new employee or hiring an existing employee into a new role). Explain to candidates and employees up front that you do not negotiate as part of your commitment to reduce compensation gaps and inequities.
Avoid the traditional version of “pay-for-performance”: A common but highly outdated salary model in the U.S. called pay-for-performance is at the heart of a lot of pay inequity and conflict. We strongly advise against it. This model assumes that it’s desirable (and possible) to pay people who are doing the same work differently based on their performance. In practice, there is no evidence that this model drives performance among knowledge workers and it is almost impossible to identify meaningful differences in individual performance. Instead, the impact is competition, frustration, pay gaps, and unfairness. Especially in early-stage startups where goals are constantly changing to a quickly moving marketplace, it’s difficult to apply fair and bias-free measurement of performance against others on a regular basis.
- Instead, hold the bar high for performance and impact and assume anyone in the role is at that level. Drive accountability and coach and develop to improve performance wherever you can. Rather than assuming you will pay employees differentially, ask the hard questions about why you’re tolerating sustained levels of lower performance to begin with.
- We recommend salary models focused on market-based pay for role responsibilities—with all individuals who have the same role and objectives (or same role band) being compensated equally within relatively narrow bands.
- We favor team-based bonuses over individual ones for most roles; especially in early- stage companies where you want to incentivize collaboration over competition, and the goals by which performance might be measured are often changing month to month.
To come up with your company’s compensation philosophy, you can start by assessing your principles around compensation:
After completing this team exercise, you’re ready to craft your startup’s compensation philosophy statement:
For example: At our company, we believe that compensation should be ______. So here is the formula/system we use to determine how compensation works for each role/person: ______. If you have any questions or feedback, please contact ______.
Whatever you decide, try to keep your compensation plan as simple as possible so that people fully understand how it works and why.
Want to consider different models for how you pay your team? Here are some less-common but increasingly popular models to explore (or mix and match):
- Tenure-based: Compensation increases with time (as long as employees are meeting all their role requirements and success metrics).
- Comp stack: Different components of someone’s role earn different amounts and employees can “stack” their roles with different responsibilities and change them over time (e.g., all employees get the same base-pay, then add on other roles).
- Self-set: Compensation is set by employees themselves, following consultation from a group of peers (if their peers do not believe the pay is justified relative to their contributions, they can choose to fire the employee).
- Marketplace: Employees can apply (or be recruited) for various projects and are paid on a per-project basis.
- Equal pay: All employees are paid the same exact amount regardless of their role.
Takeaways & next steps
Compensation consists of all monetary and non-monetary rewards that employees receive in exchange for their work.
While compensation rarely drives motivation, performance, or retention, getting compensation wrong can lead to disengagement and difficulty hiring and retaining employees.
The biggest compensation pitfalls to avoid are paying people in a way that’s perceived as unfair, paying so little that it impairs productivity, and failing to set a compensation strategy that attracts and retains the employees you need.
To get compensation right:
- identify your UEP
- stay current with the market
- keep expanding your hiring pool
- offer adequate pay and benefits to set up your team for success
- share your comp philosophy and formula
Limit the impact of bias by:
- distributing decision-making power
- avoiding negotiation
- offering role-based compensation rather than the dated pay-for-performance model
What to do first
If you don’t have one already, develop a brief overview of your UEP (Unique Employment Proposition) using the exercise above. Already clear on what makes you stand out as an employer to your target employees? Move onto developing and sharing a clear compensation philosophy.
Check out this M13 webinar hosted by Matt Hoffman for more ideas on creating a compensation strategy in the new world of remote work.