Founder compensation is a hot topic in the blogosphere nowadays; it’s also a tricky discussion at the board level or between the company’s shareholders, even when the only shareholders are the founders themselves. At Nauta we believe variable compensation is a valuable tool and try to implement it where we can.

The total compensation for company founders usually comprises their salary and the gains from selling their shares (issued or phantom) in the company. To maintain alignment with the investors, the founders should earn a living with their salary rather than by selling shares, although there might be exceptions to this rule if all parties agree.

The founders are aligned with shareholders’ value in the long term thanks to the equity they hold, but we have seen it can also be useful to make the founders’ salary (i.e., short-term compensation) related to the value created for shareholders. This can be achieved by modulating the founders’ salary in both its fixed and variable parts.

Regarding the fixed part of the salary, let’s assume that it allows the founders to have at least a reasonable standard of living and to focus on the company as much as possible (eventually 100% of their working time!) with the least impact on the company’s bank account.

Regarding the variable compensation, we believe that (a) it should be implemented as soon as possible within reason; (b) it must be aligned with the company’s performance in the period without harming the company’s performance in the long term; and (c) it should be calculated in a clear, easy manner.

This article provides an overview of the approach we usually follow to calculate the variable compensation for our portfolio founders.

The best yardstick for the variable compensation depends on the company’s stage

The point of any variable compensation is to reward the founders in line with the company’s performance, with the overarching goal of aligning the founders’ short-term compensation with the shareholders’ value.

However, this short-term view must never hinder the long term of the company. If, at some point, the structure chosen for the variable compensation misaligns the founders and the shareholders’ value, decisions must be made to re-align them.

In the very early stages of a company, such as problem or customer discovery phases, it is difficult to establish an easy formula to estimate the company’s performance within a certain period and therefore a suitable variable compensation. In these phases, milestones typically take the form of non-financial based performance - e.g. technical milestones or top-of-funnel metrics.

The funding rounds (following the venture capital method or otherwise) may be considered the “least bad” yardstick of the company’s performance. However, we have never seen a new funding event triggering variable compensation as it could create perverse incentives.

In later stages, when the pain and the customer are clear and have been validated, usually there are detailed metrics or revenue that can be tracked. In those cases, a formula should be agreed upon to estimate the company’s performance and therefore to calculate the variable compensation for the founders.

But how should compensation be agreed upon?

Setting up a Compensation Committee

The first step is to set up a compensation committee, who will be responsible for negotiating the compensation of the founders and the management as well as bringing a proposal to the Board (or, if relevant, the Shareholders’ Meeting). Since a Board has been formed in most companies with investors, we will just use “the Board” for this article.

Typically, the compensation committee comprises the company’s CEO and two other members, one of whom usually represents the lead investor from the last funding round. This structure ensures that compensation decisions are fair and aligned with both company goals and investor expectations.

A compensation committee of three members enables a swift, open discussion; besides, the low, odd number avoids blocks and paralysis since a decision can be made as soon as one member convinces another member. Later, the founders and/or management shall propose the variable compensation for the rest of the team.

This will be approved by the Board as well as the relevant investor majority, if any. It is also recommended for the team’s variable compensation to be aligned with the company’s performance where possible and within reason, although often it also includes team- or individual-specific criteria.

Net New Annualized Revenue is a good basis for variable compensation at revenue-generating companies

In companies that are generating revenue, there are measurable metrics that evolve with the company’s performance, and therefore a variable compensation can be formulated and calculated easily. We recommend that the formula is simple to calculate and is based on a set of metrics that are easy to measure.

For companies that are above a certain revenue threshold (usually €100k-€500k annual run rate), we prefer to use the following metric to make it easy and simple to follow the company’s performance: the delta of Annualized Revenue in the period, i.e., Net New Annualized Revenue (NNAR), with Annualized Revenue (AR) calculated as 12 times relevant revenue in the last month of the period.

The compensation committee should agree on what is “relevant revenue”; we usually exclude from “relevant revenues” those that are one-offs or not arising from operating activities, and we would include recurring revenue and/or the average of transactional revenue in a certain number of months (often, last three months).

However, if a company faces a particular challenge, e.g., low customer retention or too high cash burn, additional correction factors may be introduced and applied (e.g., the variable compensation is reduced if gross churn is higher than a threshold). This helps to emphasize the importance of addressing those challenges.

Why not use Annualized Revenue to calculate variable compensation?

It’s important not to base the variable compensation on reaching a certain percentage of the target Annualized Revenue (AR) as such formula may backfire.

If this formula was used, the threshold in percentage of AR to trigger any variable would need to be closer and closer to 100% as the AR grows; otherwise, the performance-based variable compensation may not reward performance at all.

For example, if a company is at €10M AR and has a target AR for the year of €15M (50% increase year-over-year), and the compensation committee decides that the variable compensation starts accruing when the company reaches 75% of the target AR, the variable would kick in when AR reaches €11.25M, which is only 12.5% year-on-year growth.

This growth would probably be considered too low to justify any performance-based compensation. In some cases, depending on the existing AR, the target AR and the threshold of AR from where variable compensation starts accruing based on AR, performance-based variable compensation could be earned without any Net New Annualized Revenue in the period!

Calculating the variable compensation based on Net New Annualized Revenue

We’ll now explain how we typically calculate the variable compensation for our portfolio founders. You can see a sheet with our calculations here.

We can break the process down into three steps:

Step 1: Determine key figures

The compensation committee must first establish the following figures:

1. ‍Actual Net New AR (ANNA): the actual delta in Annualized Revenue in the period. ‍
2. Budgeted Net New AR (BNNA): the delta in Annualized Revenue budgeted for the period. ‍
3. OTE Variable (V_OTE): variable compensation if ANNA = BNNA.

Besides A, B, C, D as below:

Step 2: Choose the formula

The next step is selecting a formula (function, ranges, kicker, cap) that determines how variable compensation is awarded based on the achievement of BNNA. Nauta usually proposes three options:

1. Narrow range: A kicker of 20% of OTE Variable (suggestion) is triggered when ANNA is at 80% of BNNA; the variable accrues lineally starting at the kicker percentage from ANNA being 80% of BNNA to 100% of BNNA, when it reaches OTE Variable; and it continues the line up to two times OTE Variable if ANNA is 125% of BNNA. This range is recommended when the goal is to incentivize high performance while avoiding bonuses for subpar growth.
2. Medium range: The variable accrues lineally starting at nil from ANNA being 75% of BNNA to 100% of BNNA, when it reaches OTE Variable; and it continues the line up to two times OTE Variable if ANNA is 125% of BNNA. This option does not include a kicker, so founders receive no variable compensation below 75% of the target but would earn 20% of V_OTE at 80%.
3. Wide range: The variable accrues lineally starting at nil from ANNA being 70% of BNNA to 100% of BNNA, when it reaches OTE Variable; and it continues the line up to two times OTE Variable if ANNA is 130% of BNNA. This option does not include a bonus kicker. This range offers the broadest margin for earning variable compensation and works well when moderate progress is still considered valuable, especially in challenging periods.

Each range provides different goals depending on the company’s circumstances. For instance, a narrow range is appropriate when the objective is to incentivize hitting high-performance milestones. On the other hand, a medium or wide range can keep founders motivated even when growth is modest.

Finally, we usually cap the variable compensation at two times the fixed salary.

Step 3: Calculate the Gross Variable Compensation

The final step is the actual calculation of gross variable compensation (V), which is tied to the chosen range and the company’s performance. The formulas are included in the post-script to this article. You can see a sheet with our calculations here.

Conclusion

• A structured, transparent, and reasonable approach to founders’ compensation that reflects the company’s strategic objectives, is useful to protect and enhance shareholders’ value.
• By aligning the variable compensation of founders with the company’s performance with a clear, easy to calculate formula, Nauta ensures that the founders remain incentivized to meet and even exceed the plan and/or the budget.
• From experience, our typical formula for variable compensation based on Net New Annualized Revenue makes the budget discussions easier as the founders set ambitious but realistic revenue expectations (since it does not benefit them to make them unattainable), and this realism leads them to be less aggressive on the costs.

We’re always happy when founders are rewarded with high variable compensation, as it means they’ve been successful in reaching milestones and creating value!

See here the formulas usually proposed by Nauta for the variable compensation based on Net New Annualized Revenue (NNAR). You can see a sheet with our calculations here.

We define the variables:

• ANNA: Actual Net New Annualized Revenue in the period
• BNNA: Budgeted Net New Annualized Revenue in the period
• V: gross variable compensation for the period (in euros/other currency)
• V_OTE: variable compensation when ANNA = BNNA

And the functions: