Leverage + measurement

Little Worlds
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All a company is is a group of people working together to do something people want. It’s doing something people want that matters, not joining the group.—Paul Graham

Should I start a company? Should I join one? Do I want to be a partner? An employee? What’s the difference? Does it change how you think about compensation?

A lot can be inferred about a company’s culture by their compensation scheme. Does the firm pay salaries? Hourly wages? How many partners (equity owners) to associated (employees) does a firm have? What does a small software design and development consulting firm’s compensation look like? (This is assuming that the firm can generate profit.)

The compensation system is a powerful tool a firm can use to provide incentives and motivate desired actions by its professionals. It sets the corporate culture. The goal is to align the actions of the individuals with the goals of the firm.

There are other professions that have a longer history of defining professional compensation models:

What is a partner?

“When someone stops measuring their compensation with market value and begins to split what is left over in the firm, it is at that point the person is a partner” – ViewPoints Partner Compensation

How does someone become a partner?

What are the criteria for admission to the partnership? Are they capital-based? Are they time-based? Do new partners dilute existing partners shares?

There is a balance between electing new partners and maintain the existing partnership structure. Adding new partners is ultimately dilutive to existing partners. “Does adding a new partner make the firm more profitable?”

  • Immediate capital contribution – Partners purchase a fixed number of partnership units (a percentage of equity in the partnership). Partners essentially contribute capital upon admission to the partnership.
  • Graduated capital contributions – There is no immediate capital contribution, instead new partners contribute a percentage of their pay over a period of time.

How are partners compensated?

There are 3 main models for partner compensation plus a fourth model that is prevalent in some medical markets.

  1. Salary plus bonus
  2. Equity-based distribution
  3. Performance-based distribution
  4. Capitation-based distribution

Salary plus bonus

Salary plus a bonus is exactly as it sounds. It is a minimum income guarantee that recognizes that partners should be paid for the job they do every day, before dividing profits.

Equity-based distribution

After expenses, profits are distributed based on percentage ownership to partners. The distributions can be forward-looking or backward-looking. David Maister provides some analysis on the advantages of a “look ahead” system that allows partners to make course corrections throughout the year to keep interests aligned. He describes the risks of “look-back” approaches where you are allocating funds on performance that has already taken place as a fight over differing interpretations of history.

Equity-based distributions do not exclude more complex distribution schemes that include tranches for splitting available cash. Quarterly distributions based on expected performance. At the end of the year distributions can be “trued up” based on actual performance.

Performance-based distribution

Also described as “eat what you kill”. The more you bill the more you get paid. This has obvious challenges to building a positive culture. It can create a competitive internal environment that deters citizenship.

Capitation-based distribution

This is typically only found in medical practices. Capitation is a fixed amount of money per patient per unit of time, i.e., $10,000/patient/year, often adjusted based on patients age, sex, withholding amounts, etc. This is then distributed amongst physicians.

moving on
Photo by pfig

Decisions Made

This is by no means exhaustive. But it is a way for me to think about compensation, measurement of performance and what’s next. Here’s to 2007, and to what’s next.

4 thoughts on “Leverage + measurement”

  1. <p>Great post Dave. (Actually good string of posts over the past week or so)</p><br />
    <br />
    <p>Getting restless? ;)</p>

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