We're often asked how to establish fair market compensation when it comes to CEOs of privately held companies, often with venture capital or private equity backing.
Below is one method that can be employed as a jumping off point for this calculus:
1) "De-risked," how much is a CEO worth? Is $500 -$1M a year too much? For our purposes here, we're talking about a talented CEO. Not someone below average, but above the average, one that a retained executive search firm, venture or private equity investor, or board of directors would be proud to put in the role. Rather than pick some arbitrary number, this should be "market set," by looking at what someone working for any global 2000 company (i.e. General Electric or other similar) earns annually. From our executive search experience and database of compensation comparables in these companies, base salary is usually between 250K and 400K, depending upon how big the divisional P&L responsibility is, there is usually a bonus that is between 50-100% of base, and an LTIP (long term incentive plan) that-once partial vesting begins-can generate from 100K up to 250K or more a year in cash.
2) So, the cash component of a comparable, including average base, annual average bonus, and yearly LTIP pay-out looks something like this:
Base ~ 300K
LTIP (cash only) ~ 200K
* This does not include any meaningful RSUs (restricted stock units) that are usually also part of that package, which could add another 200K or more per year in value to a general manager's package with true P&L responsibility for their division, group, or sector/segment.
* This is also not indexed to geography/cost of living. If the position is in New York City tri-state area (New York, northern New Jersey, southern Connecticut), San Francisco, Boston, London, Singapore, Hong Kong, or Tokyo, a multiplier factor needs to be used to level-set for cost of living increase required for those metropolitan areas.
3) Now, back out the cash portion of a CEO's compensation for the company that they're stepping into (say 250K a year in cash in smaller companies as all base, or combination of base + cash bonus). So you're left with say 500K that needs to be made up in equity, on a per anum basis.
4) Over how many years is the liquidity horizon (and/or vesting rate, 3, 4 ,5 years)? Let's say it's 4 years, at net 500K, equals ~$2 million
5) Now, this is with ZERO beta risk factor. Add back the beta risk of an earlier stage company. Let's assume a global 200 company equals "1." A CEO role in a privately held, externally backed company is not "1". It's probably a multiplier of 1.5, or 2. For a pre-revenue, VC-backed company with high burn rate, it could be as much as in the 3 to 5 range. Note that any illiquid company is inherently risky in terms of cashing in any equity at a reasonable price. Let's pick a beta risk multiplier of 2.5 times riskier than "average." So, 2M * 2.5 = 5M. Note that when there are preferences for the investors that create an exit hurdle rate before any common shareholders get paid, beta risk goes up accordingly unless the CEO participates in any exit event via cash carve out or other instrument. As mentioned above, a recent IPO that represents a reasonable market comparable netted a CEO who joined the company 4 years ago $20M. Using this number, the CEO's compensation was $5M a year, or a beta multiplier of approximately 5.
6) Then, are there any combat pay provisions you need to add in (warts that a CEO or executive team member is required to overcome and vanquish in their role that are above and beyond the normal call of duty)-reconstituting the executive team, or raising an outside round of capital because existing investors are tapped out, or starting up an Asia manufacturing capability that will require the CEO to take a dozen 15-hour flights one-way to get up and running.
7) Finally, you have to look at what likely dilution there is going to be to an initial options grant for the CEO. If you start with a 6% stake in an early stage company in a Series A funding, and you then raise a series B and C, depending upon valuation for those rounds, the CEO will likely end up below 3% as a "fully diluted" stakeholder. There is an argument to be made that any of the management team critical to the success of the company will be "topped off" at later funding events in order to keep them motivated. However, there is no guarantee that this happens. It's only good business sense to do it. For the CEO, it is more important what s/he ends up with, not how much with which they start.
8) Add water, and stir...
Notes & disclaimers:
- This is not intended to be biased in any direction, to any party, neither CEO candidate, nor company and/or investor.
- This is only one way of calculating compensation, indeed there are many others.
- There is no way an earl- stage emerging/growth company will be able to compensate a CEO in all cash, nor truly be able to offset the risks inherent in this stage of venture. The CEO either accepts this, or is not truly capable of working successfully in this milieu.
- Other than the impact of cost of living adjustments to base compensation, each CEO candidate comes with what we refer to as their own subjective "keep the lights on" cash needs. We calculate this simply as the amount of cash required on a yearly basis to cover their living/family obligations without having to write checks out of savings to cover it. Some CEO candidates may have 3 children in private school or college, while others may have no children and no mortgage. Cash needs therefore may range widely, and need to be adjusted for using equity as a "leveler" (less cash-needy, higher the equity, and vice versa)
- Alternatives to paying bonuses in cash might be to pay bonuses in equity, upon achievement of key milestones for the company
- This same calculus can be applied to the Vice President level as well, subject to appropriate adjustments downward in cash and equity
- In a circumstance where there is a "turn-around" required, equity may not be enough of a certainly to attract a competent CEO for the challenge ahead. In these circumstances, a cash carve-out may be warranted in addition and/or in substitution for a stakeholder role. The cash carve-out may be just for the CEO, or for the key management team required to achieve the turn-around. Often, the cash-carve out structure is a percentage of total sale price over a certain amount, with the possibility for an accelerator depending upon exit/liquidity circumstances/outcome.
- Often the question of anti-dilution comes up in an effort to assure a CEO of a certain percentage of equity upon liquidity. Granting 5% equity to a CEO at a Series A financing with anti-dilution would ensure that the CEO retained his or her stake across the growth and additional funding needs of the company. However, this is rarely a good mechanism, as the CEO becomes less interested in new company valuations at subsequent funding events, and becomes misaligned with the company's investors.