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Jennifer Azapian

How Investors Assess Startup Teams: Zeroing in on Compensation

All content (c) 2024 Jennifer Azapian, DALL-E Image Prompt (c) 2024 Jennifer Azapian


Several years ago, I wrote about how investors think about assessing startup teams, focusing on four key areas: Competency, Complementarity, Coachability, and Communication. Today, we'll revisit these crucial factors and introduce a fifth 'C' that has become increasingly important in the current startup ecosystem: Compensation.


As I noted in my previous article, founders often focus their pitches on Product, Problem & Solution, while investors spend most of their time reviewing Financials & Team. The focus on financials and team is even more significant for investors since the landscape has shifted over the last few years, particularly in how compensation is viewed and structured within startups.


Let's briefly recap the first four C's before diving into the critical topic of Compensation:


1. Competency: Investors look for teams with the right mix of skills and experience for the company's current stage.


2. Complementarity: A high-functioning team is greater than the sum of its parts, with members bringing diverse, complementary skills.


3. Coachability: Investors value founders who are receptive to feedback and capable of learning and adapting quickly.


4. Communication: Clear, transparent, and responsive communication remains vital in all interactions with potential investors.


 

The 5th C: Compensation - A Crucial Factor in Today's Startup Landscape

Compensation has always been an important consideration for investors in startups, but recent market shifts have brought it to the forefront of investors' minds. Here's why compensation has become such a critical factor and how it's evolving:


Valuation Crunch and Capital Efficiency

With the recent tightening of the venture capital market and a general trend towards more conservative valuations, startups and scaleups are under increased pressure to stretch their funding further. This has several implications for compensation:


  • Longer Runways: Investors expect startups to demonstrate how they can extend their runway through efficient compensation structures and hiring plans.


  • Equity vs. Cash Balance: There's a renewed focus on using equity compensation effectively to conserve cash while still attracting top talent. Note however that managing option pools is also a priority, as time between funding rounds also implies a need to manage carefully, given that company valuations may stay steady longer in the current market. For some helpful insights, see Carta’s data on changes in equity grant sizes and terms along with some useful option pool benchmarks from the last few years.


Capital Efficiency and Team Size

A common misconception is that smaller team sizes mean higher individual compensation, especially when a funding round seems relatively large. In reality, the trend towards leaner teams is about capital efficiency:


  • Startups are focusing on hiring key roles that drive significant value, rather than building large teams quickly.


  • The emphasis is on productivity and impact per employee, not headcount. (This can be reinforced by intelligent use of variable pay and bonus plans - see more below.)


  • Compensation is tied to measurable outcomes and value creation, rather than simply role or seniority. Ongoing performance, along with retention is a key measure to consider.


Transparent and Equitable Compensation Structures

Investors are placing greater emphasis on startups having clear, fair, and scalable compensation practices and structures:


  • Scalability: Compensation structures should be designed to evolve as the company grows, but avoid the need for major overhauls that can be disruptive.


  • Transparency and Pay Equity: There's an increased focus on ensuring fair compensation across gender, race, and other demographics, driven by multiple regional laws in the US and globally, mandating fair pay as well as access to pay ranges for both potential hires and existing team members. Liability and risk of potential lawsuits loom large for investors in due diligence. Many startups have been pushed to adopt more thoughtful and proactive communication around compensation policies (but not full transparency), which can also boost trust and motivation among team members.


Performance-Based Compensation: Tying a larger portion of total compensation to company and individual performance metrics has become more common. There are a few drivers for this:


  • The drive towards pay transparency means that the spread between base salaries for incumbents in a given job and level are narrowing. More focus is being placed on variable compensation for pay differentiation.


  • Higher variable and lower fixed compensation for budget and accounting purposes enables a more conservative approach to long term financial planning.


  • Employees are now expected to exceed expectations and outperform to earn in the high percentiles of total cash comp ranges – it’s no longer a given based on the need to retain talent in an overheated market. With many bonus plans being only partially funded (if at all) when companies don't meet or exceed their own business and revenue KPI's, bonus payments must be earned. Placing more focus on outcomes links to a higher proportion of compensation being variable, not guaranteed. 


Shifting Supply and Demand for Tech Talent

The tech talent market has undergone significant changes in the past two years for a variety of reasons (See “The Unseen Consequences of the Great Resignation’s Hiring Frenzy”). After a period of intense competition and inflated salaries in tech, we're now seeing a correction in pay practices. This shift has been driven by:


  • Layoffs in big tech companies, along with hiring freezes and shutdowns of tech startups, increasing the available talent pool


  • A more cautious approach to hiring in startups


  • A reevaluation of the true market value of different roles


Rather than pressuring founders to curb compensation, investors can now reasonably expect startups to have a more balanced and sustainable approach to compensation and hiring, one that reflects the current market realities rather than the frenzied hiring practices of the recent past. 


Reduced Need for "Make Whole" Packages

In the past, startups and scaleups often felt compelled to offer high cash compensation to compete with public market companies and essentially attempt to "make whole" candidates leaving lucrative positions. However, this approach has become less necessary and less feasible:


  • There's a renewed recognition that joining a startup involves a different risk-reward profile than working for an established public company.


  • Investors are less willing to fund outsized compensation packages that mimic the valuations of public company offerings. Stock options at a startup are structured, function, and are valued (and taxed) differently than RSU’s at a publicly traded company.


  • “Make Whole” sign-on bonuses have also all but gone away, with a few exceptions (currently usually reserved for exceptional AI/ML talent, key executive hires). This is true for both private and public companies. Due to 2 years of ongoing tech industry layoffs, as well as hiring freezes and startup closures/sub optimal acquisitions, employers currently don’t need to offer sign-ons.


Impact of generative AI in the workplace

This is a topic unto itself; companies are in the early stages of finding the right balance between compensating human talent and investing in AI technologies.


As generative AI helps employees and teams become more productive, the impact on compensation, and the ROI of headcount and technology investments for productivity become critical to measure. 


Early data on headcount reductions and reorganizations related to AI has been in the news recently with companies such as Intuit and Klarna. The extent to which this is another tool companies use for headcount attrition and financial modeling in the coming years is yet to be seen. Headcount planning may shift from a linear relationship with business growth to a more dynamic model, where AI augments or replaces certain roles (See "The AI Workforce is Here: The Rise of a New Labor Market" published by NfX). 


Overall, this is a good thing for the startup ecosystem. More companies can be viable with lower overheads. However pricing a job in new market where AI is a human complement across functional areas is still TBD. As mentioned earlier - smaller teams do not necessarily mean higher compensation per team member. 

Some helpful insights on AI at work are published by Microsoft/LinkedIn.


Founder Compensation

How founders compensate themselves remains a critical point of scrutiny for investors, and this is one area of compensation where the longtime standard advice for startups seeking funding still holds true:


  • Modest salaries that align with the company's stage and funding level are viewed favorably.


  • A willingness to tie a significant portion of founder compensation to company milestones demonstrates confidence and commitment.


  • Excessive founder salaries are often seen as a red flag, potentially indicating misalignment of interests or lack of understanding of the equity/cash compensation tradeoff.


  • Vesting of founder shares is typically required and may be reset in a given investment round. Founders are expected to stay the course in alignment with shareholder interests. 


 

Implications for Founders and Startups

Understanding these shifts in how investors currently view compensation as part of their diligence and governance is crucial for founders. Some best practices:


Develop a Clear Compensation Philosophy: Be prepared to articulate your approach to compensation, including how you balance cash, equity, and performance-based incentives.


Stay Informed on Market Trends: Regularly benchmark your compensation against industry standards, using quality competitive market and employer data, considering both cash and equity components.


Plan for Scale: Design a compensation structure that can grow with your company, avoiding unsustainable commitments early on.


Emphasize Value Creation: Focus on how your compensation strategy drives performance and aligns with company goals.


Communicate Proactively: Clear communication about your compensation approach can be a powerful tool in signaling management savvy to investors and top talent alike.


In conclusion, while the other four C's - Competency, Complementarity, Coachability, and Communication - remain crucial, Compensation has emerged as a key factor in how investors assess startup teams. 


A well-thought-out, market-appropriate, and forward-looking compensation strategy can be a significant differentiator in today's competitive startup landscape. It demonstrates fiscal responsibility, aligns incentives, and positions your company for sustainable growth - all qualities that savvy investors are looking for in their next successful investment.

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