Startup Compensation

The second problem common with start ups is the seriously high pay the directors and senior managers get. One CEO (if you can call a guy in charge of 30 people a CEO) was getting paid £250 per annum. Apparently he was very good at what he did. Unfortunately it wasn’t running start-ups or small companies. Likewise the CFO and COO (who were part of those 30 people) were also on fantastic salaries.

After I had turned it around I commented to the main investor that they got paid way more than me – AND I MADE HIM MONEY!!

How was I meant to interpret this? I got a dirty look, not because I was wrong, but because I was right.

The point is, paying big money does not guarantee you a good senior manager, nor does it get you a good person; and even if you do get good people – they may not have small business skills. Remember this place only had 30 people, so a £150K CEO would probably have even been over the top; and even if it wasn’t, I am sure a £100k CEO would have done just fine.

Think of it this way.

You pay a CEO £250K per year for 4 years – that’s £1million out of your investment gone. And what have you got in return? NOTHING!

Worse, if you had spent £100K for a CEO then rather than getting 4 years of work, you would have gotten 10. Naturally if you were paying £250K for a CEO you would probably be looking at a successful company with good profits, with more than a few staff (depending on the industry) and revenues in the tens of millions.

If that point isn’t painful enough also remember to include the CFO and COO as well. After their 4 years of delivering no profits, I worked out that the firm could have cut 10-15% of their staff costs, just by getting rid of them. As a result of these large salaries, the primary investors have lost allot of money at the very time when it is most precious – at the start.

Naturally the investor wasn't happy and neither was I; my pay was less than half of the CFO. And if that didn't leave a bad taste in my mouth, they all went on to bigger and better positions; all very disillusioning.

The only good points of this sad tale is that if you want to sort out your compensation issues here are a few tips.

1. Change to a bonus system where the bonus paid reflects your risk as an investor. That is the companies start up risk. This bonus should be as big as possible - I try and push for 40-60% - but go higher if you can. Remember most firms make little attempt to use their compensation systems to over come the temptation of senior managers to shirk. After all, who cares of you lose 5% when you're pulling in £2000+ per week. But you will care when 40-60% is on the line.
2. Conversely make the salary part as small as possible. At this point, your senior managers will begin to jump ship – because they know gravy train is now over, and you are demanding results
3. Hire new senior managers – if they accept the large bonus and small salary – then those are people who in all probability can deliver to you those results
4. When you are about to hire them – hand them a resignation letter for them to sign but leave it undated. Again if they sign this – these are the type of people who will fully understand why you are doing this – so you can hold them to account. Put it in a safe place and never ever bring it up unless you have to use it

One of the great things about profit curves is the easy way they present your total revenue (in green) against your total costs (in red). As you can see when the revenue line is above the cost line then a profit occurs. Further if we were to take Total Revenues away from Total Costs we get either a negative or positive figure. This is the bottom graph. From both we can see that firm breaks even when it reaches a quantity of 3 or Year 3.

Both graphs are exactly the same but give you a good example of how to use them. I have presented same the graph with quantity on the bottom X access at the top and time on the bottom.

Now that’s you know the HOW – I will now give you the WHY.

Profit curves present a glaring example to the board of not only whether or not your firm(s) is making any money ( profits) but on these same graphs you can draw those lovely financial projections you were given.

Even better you can also see the breakeven points for your company, which is where the Total Costs equal the Total Revenues - this is always one of the most important indicator for investors, because this will tell you when (if ever) you can expect to start to see a return on your investment.

The graph below is a true real-life graph of an Internet service provider I consulted on.

This is where fantasy meets reality. As you can see, the costs were rising faster than their revenues.

In fact the more successful they became, the faster they lost money. That is, as the number of customers increased, the faster their costs escalated, and hence the faster they would lose money. This was pretty ugly; because ISP's typically have increasing returns to scale, so they had done a pretty bad job of it.

When I presented this to the board, you could have heard a pin drop.

This was another example of a business model made on a spreadsheet with out any critical thinking. As both a turnaround consultant and IT Director I have seen this more than once; business development creating models without any idea of how the costs work in an industry and without any involvement of engineers or operations staff.

As such I strongly encourage that all angel investors at board meetings start of with one of these, because they quickly tell you not only the good or bad news but they also display it in a rather blunt and objective way.

Further because the Total Costs (TC) is drawn out, board members and investors can very quickly spot out of control spending.

Even better news, if you have a marginally profitable firm, then you can plot the total cost of each senior manager on the same graph as well.

Like the previous blog, plotting a CEO or senior manager’s compensation for x years can show the outgoing in wages against the companies marginal profit / loss.

It may be that removing mediocre managers or changing the structure of those large costs can make a marginal profit slightly more palatable.

E.g. if you have a CEO costing you £250k per year and you are only making £100,000 profit, then perhaps a cheaper CEO will do the job for £100k, in which case you are already better off by £150k per year.

The mortality of profits and the lack of shame.

Going out on a psychological bent, one thing that continually stuns me is the lack of shame by senior managers of failing companies’.

The credit crunch present numerous examples, where there apologies presented in front of government committee hearings are just so pathetic as to make one sick to the stomach. Board meetings can be the same.

Rather than being ashamed or even angry over company or investment losses, the managers tend to just ignore any questions pertaining to them.

One CFO I encountered presented spreadsheet after spreadsheet of fanciful financial projections, all the while avoiding answering the simple question of ‘has the firm ever made any revenue at all?’

I tried to explain the investors were an insurance company and that the money came from people’s pension funds; hence someone’s retirement depended upon the firm making a profit; and that we were morally honour bound to make one – regardless of any legal fiduciary arguments.

I was met with either rolling eyes or cynical grins.

Somehow it didn’t seem to get through, or perhaps it was because it did get though, that the managers refused to acknowledge that there were consequences to firms losing investors money. That people hurt at the end of the day because of the messes they created.

A quick search of the definition of shame defines it as: A painful emotion caused by a strong sense of guilt, embarrassment, unworthiness, or disgrace.

The managers present, displayed none of these.

In fact their attitude was that because they had all gone to prestigious ‘red brick’ universities or had 20 years plus experience, they were some how entitled to their positions regardless of fact that they had not made money for their investors / shareholders.

The point is, in many turnaround situations, senior managers don’t have a moral reason as to why they must make money for their shareholders. They see it something you ‘hopefully achieve’ – a nice to have – not a need to have – and worse they don’t understand the ‘why the need to have’.

As such, without this moral imperative they may acknowledge the importance of profit intellectually but emotionally they don’t understand it. As such failure in these firms under that type of management is inevitable.

Change Management: Recessions reveal bad managers and bad investments to owners

Although governments have had to bailout more than a few incompetently run financial, automotive and airline institution's, most other businesses haven't been that lucky.

What is interesting though, is that now that the super-boom is over, many managers are finally being revealed for the charlatan's they truly are.
The old boy’s network and cronyism that was rampant during the boom is slowly coming to an end. In its place managers are finding they have to hire on merit, rather than risk hiring their friends and cronies.
The focus on profitability and the bottom line however, also shows how many managers were not focusing on these during the boom....and remember this was a 'long' boom.
For owners currently concerned about how their business's are being run, there are few things you can do right now:

• Accept your responsibility for not keeping an eye on them. Chances are you weren't intervening enough.


• Ask the question of senior managers at your next board meeting 'Cost cutting is a part of everyday business. The customer is always on the lookout for lower prices and we'll neeed all the cash we can during our startup and growths phases. If you are focusing on cost cutting now, what the hell were you doing for the last X years? Please explain.'


• Run a HR merit test. Ask for all the staff CV’s to be sent you and the board - YOU WILL GET A FEW SURPRISES! The resume's will tell you two things - a. is the company running on merit, b. who to speak to regarding the firm’s problems. (In one firm I found 2 PhD's and 3 MBA's all relegated to doing grunt work because they had 'rocked the boat'). Question your senior managment team on some of the staff and note how judgemental they are, and what standards they apply. If they are perhaps a bit slack for your liking - you have found a problem. If those standards are set too high for others, then apply the same standards to them. In short, apply the wisdom of King Solomon. That is, if the senior managers judge others harshly, apply the same unyeilding attitudes to them. If they are understanding, then likewise allow for this with them. As always it is the balance that counts, and listen carefully for excuses.


• Draw up a profit curve for each of your senior managers (if you don’t know what this is see the next blog) to compare what they cost in salary against what they deliver. This is the ultimate merit test.

From a turnaround and change management point of view, it is only when ‘hard’ competition returns to the market do the true colours of bad managers really get revealed.
Further research also indicates that the recession has revealed a bias of having too many CEO's from financial or management consulting backgrounds who didn't understand the operational aspects of their businesses (the banking sector being a case in point); and so built or added products that the firm didn't really have any competency in, let alone either build or to manage - CDO'S or Credit Default Swaps anyone?.....But that is for another time.

Restarting Startups - Startup spending problems

After consulting on a start-up that needed turning around or 'restarting'-up, I noticed that for some strange reason a few things keep turning up in start-up businesses.

Firstly the business loved to spend money like it was going out of fashion (and these days it is). This is a classic start up problem. The firms get all hot and sticky under the collar and to celebrate their own wonderful glorious success they decide to start shouting staff free cans of coke, pool tables and an xbox lounge with expensive coffee. As always - it's "someone else’s money" so let’s have a party. The most dangerous bit about this is that once the party gets rolling, it can get very hard to stop it. The few staff that are prudent are the first to find themselves sidelined, partly because they are a walking rebuke to everyone else. Another danger is that once people start spending, they stop thinking – literally. Business is about making the most out of limited resources – that's were innovation comes from. Once everyone starts signing off purchase orders, cash management starts to go out the windows and people stop thinking about the best way of doing things. Optimisation and resource management go by the way side.

After all it is easier to buy a second widget, than to figure out how you’re going to get by on one. Worse when the money starts to run out, management will spend more time on cost cutting, than they would have, had they done it all the way along; and this is at the very time when they should be looking for more customers.

Thesis work paper Motivating the Team

As with any turnaround, motivating the software team after redundancies can be particularly difficult. Unlike manufacturing situations where firm capacity is partly dictated by the factory machinery, motivating knowledge works is considerably more difficult. Davidson (Davidson, 2001) recommends involving the staff at the emergency action phase.
Normally staff are well aware of the firm’s problems and like Teng (Teng, 2002), observes that knowledge workers can frequently feel helpless because in many cases they are more qualified than the managers (who caused the firms problems in the first place) to solve particular operational or strategic issues.
However regardless of the abilities of the staff, deep personnel cuts are still important due to cash flow constraints, and Davidson (Davidson, 2001) observes that cutting too deep is better than not cutting enough at all.
Blumling (Blumling et al., 2002) recommends putting in a new turnaround management team because like most corporate recoveries, the credibility of existing management is usually questionable at this time. He observes:
“When a company is sliding, senior executives tend to lose credibility, attrition within the ranks becomes rampant, and organisational discipline grows slack owing to poor management. The worse the situation, the more probable it is that the CEO will be forced out and an outsider brought in to manage the turnaround. A C.E.O. hired from outside is likely to turn over the management of the company in order to change its skill sets and improve its credibility.” (Blumling et al., 2002).
Even when such management changes are made, Blumling (Blumling et al., 2002) observes that unlike other turnarounds, software turnarounds often need essential skills and controls in place prior to tightening discipline. This is because the need for cost cutting is so strong (and so deep) that resolute business controls are usually needed.

Thesis work paper The Development to Marketing Ratio

The Development to Marketing Ratio
Typical industry benchmarks for sales and marketing are that for every $1 dollar spent on Research and Development, $5 to $10 dollars will have to be spent on sales and marketing (Davidson, 2001). As such the cost of delaying a software product rises quite considerably, and eats in to the firms cash flow. The implied costs behind the “development to marketing ratio”, is part of the reason why turnarounds can be so difficult.

Thesis work paper Strategic Realignment: Check the Target Market and Complement Industry “Power Players”

Shapiro observes that information and software companies can focus too much on marketing features rather than customer benefits.
The software turnaround then, will most likely need a strategic and marketing realignment (which reinforces Davidson’s (Davidson, 2001) observations). As always, the focus must return to solving a customer problem and presenting them with a clearly defined solution, than advertising about particular product features. As Sutton (Sutton, 2002) remarks, sometimes it is merely a need to change the message of the advertising and to target the correct market, than a need for operational measures.
Shapiro (Shapiro et al., 2000), states that normally in the software industry poor marketing is the most common problem for firms (after lack of capital).
Furthermore, he observes that even in cases where firms have targeted their market correctly, the timing of the software release has been inappropriate, as many newer products require long-term market education.
Chakravorti (Chakravorti, 2004, 58-67) recommends strategically realigning what customers want with those of the industries ‘Power Players’. By complementing their products rather than merely seeking self-contained niches, firms can feed off their product growth. E.g. Adobe turnaround was aided by their redesigning their Acrobat Reader to work inside Microsoft’s Internet Explorer. Allowing their documents to be read via web pages. Further strengthening demand for their Adobe Acrobat Writer product.

Thesis work paper Check Pricing Structures

Check Pricing Structures
Hence in software turnarounds, many turnaround managers immediately reduce their prices to increase quantity. E.g. lowering the price of the software product “ClassPharmer” helped in Bioreason’s turnaround (Holtzman, 2004) (See Appendix C), while increasing the price further differentiated Microsoft’s Office Professional from its standard product offerings (Shapiro & Varian, 2000).
Shapiro (Shapiro et al., 2000) argues that the economics of the software industry requires differentiated pricing due to the high labour and marketing costs.
Further, Blumling (Blumling et al., 2002), states that software firms are in effect “in a double jeopardy game”. He observes
“Software companies benefit when their performance is rising, as their return on invested capital can exceed 50 percent and grows extremely quickly. During a downturn, however, they are hit twice once for their actual financial performance and again for what it implies about the value of their assets. If insolvency looms, investors flee because there are few residual assets to divide”.
Pricing for software is made even more difficult because firms have to factor in other additional costs. For example because technology depreciates rapidly, the average time constraints on selling software is two years (Shapiro et al., 2000). Next the firm has to ensure it has the sales volume and resulting sales costs necessary to amortise the R&D, recover the cost of selling the software and factor in the cost of supporting the software.
Davidson (Davidson, 2001) in addition, states the difficulty with selling software is that traditionally software firms have failed for one of two reasons:
• The firms sales costs were too high, or
• The firm doesn’t sell enough of the software to recoup the cost of developing it and it’s cost of capital.
These conditions ensure that inaccurate pricing will only lead to one generation of the product. Shapiro (Shapiro et al., 2000) warns that support costs can be particularly high, a view supported by Davidson (Davidson, 2001).
One form of strategic repositioning to avoid the double jeopardy scenario is to move away from selling software itself, to “opening up and supporting” the source code.
Davidson cites the example of Netscape using this strategy when it was competing against Microsoft.
Netscape’s turnaround involved repositioned itself and changing it’s business model rules by opening up its Netscape Navigator source code and then charging customers for supporting it.
Likewise Shapiro notes that software and other information firms frequently merge together when times are tough. As a turnaround strategy in markets where competition is fierce, merging together can help both ailing firms outlast other competitors. The irony of this situation, it that normally mergers occur once the firm is on its was to recovery, rather than in decline. The advantage of merging is that it is easier to reduce the combined staff head count, while allowing for better negotiation terms with venture capitalists and banks over new funding.
In many turnaround situations, the general recommendation has been to sell off the firm and let the buyer fix it, rather than merge with another company. It could be inferred that turnarounds and mergers in this industry are perhaps more concerned with personnel, capability retention and strategic issues than operational restructuring, because software companies have relatively few fixed assets.

Thesis work paper Removing Unprofitable Customers.

As Sutton (Sutton, 2002) indicates, inadequate cost cutting normally occurs because customers have not been ranked or sorted according to their profitability. Davidson (Davidson, 2001) likewise states that many software companies lack clear marketing plans (especially in their early years) and commonly this is found among smaller firms. Intrinsically then, the firms underlying profitability is affected because of the lack of focus on the correct target market. This manifests itself in incorrect pricing structures.

Thesis work paper Case 4: PeopleSoft

PeopleSoft started out as a Human Resources (HR) software company and later expanded into accounting software. As the company grew, the HR and accounting functions were expanded to include the manufacturing market.
However problems began when it’s new products fell behind schedule and industry competitors began lowing their prices. By 1999 the firm had lost $178 million, and its software products were receiving bad press due to software bugs and support issues.
At this point, the board hired Craig Conway as the new Chief Executive Officer (CEO) to turnaround the company.
Conway began by introducing spending limits and streamlining the budget and accounting processes. This follows Davidson's (Davidson, 2001) observation that spending disciplines are introduced first in software turnarounds rather than after restructuring and cutbacks.
Next the existing budget process was improved and semi-annual performance reviews were initiated to identify which workers were in the bottom 10% of performers in the firm. This was done to ensure the cutbacks did not remove valuable or productive staff. This same strategy is emphasised by Blumling (Blumling et al., 2002) in that cutbacks must not only be deep, but it is where the cutbacks are made that is equally important. Further it could be argued, that performance management is needed in software and other knowledge based company turnarounds, because identification of a knowledge workers performance is considerably more difficult.
Conway’s team went through each of the firm’s projects, and identified which were behind schedule and which showed the most promise (the exact same advice as given by Sutton (Sutton, 2002)). The market had labelled PeopleSoft’s current software as “legacy” and out of date, as such Conway’s team was looking for a new product that was not only different but would also improve revenue and spread revenue risk.
He went with developers new project, which was to upgrade the existing product to work via a Web browser, and build in more back-office functionality. The development team maintained the web interface was easier to use, easier to program, more customers understood how to use it and no other product on the market had anything similar.
Although seen at the time as a gamble, Conway’s team agreed that doing something different was definitely needed.
This selection of a new and different of product follows the view of Blumling (Blumling et al., 2002) that in software turnarounds firms,
“must invest in new category killers”.
Stepping up both the pace and budget on the new product Conway focused the company only on the product and delivery of PeopleSoft 8. Such a move is stated by Bibeault (Bibeault, 1998) as central to any turnaround. That is, the whole company must all be working towards the same strategic goal.
To ensure that everyone knew that financial position PeopleSoft was in, Conway presented monthly reports to the staff on “where the company at” on the turnaround plan.
He created a sense of urgency about concentrating and focusing on fixing the bottom line. A similar argument is cited by Hays (Hays III, 2003), where he states that turnaround managers must present the turnaround plan and keep the staff updated constantly. This is done so that not only can progress be seen, but to ensure that a sense of urgency is maintained in order to prevent backsliding from occurring.
Company metrics were improved and development was kept on schedule, with updates regularly communicated.
Furthermore Conway changed the company culture from the folksy, short and t-shirts, easy going, free lunches and “bring the dog to work” affair to wearing suits, no free lunches and eviction of non-employees (dogs).
Like Teng (Teng, 2002) Conway explained to staff that there would be “no free lunches” while the firm was losing money, and that the focus must be on turning the company around by developing and rolling out PeopleSoft 8.
By the time the performance review evaluations had finished, cuts were made on slower projects and in the areas of middle management where there was a perceived lack of skill in operations and scaling.
With the release of PeopleSoft 8, not only did revenues return, but also industry analysts estimated that the radical new product had left PeopleSoft's competitors at least one year behind. PeopleSoft returned back to profitability earning $146 Million in 2000.

Thesis work paper Case 3: Network Associates

Like Adobe and Intuit, Network Associates Incorporated (NAI) was another software company that was having trouble in the Internet boom.
NAI board members hired George Samenuk from IBM to become CEO of the troubled security software giant in December 2000 after NAI had posted consistent loses of US$159,901million for 1999, and US$108,014 million for 2000. Even worse, “accounting irregularities” had turned up, which required US$20 million dollar expense restatements on the financial reports that were filled to the American Securities and Exchange Commission (SEC).
With morale low and the companies best and brightest jumping ship, he bet some of his younger employees that he would grow a goatee if the company stock hit $20. Even better, he would shave his head if it hit $40 -- and get an earring if it hit $60.
To show commitment to the turnaround Samenuk addressed the talent bleed by repricing the company share options at $4.
As Sutton (Sutton, 2002) mentions, such declaration quickly gives employees the signal that the company is serious about turning itself around. It also provided an incentive to stay and work hard, while having little effect on cash flow.
Focusing on the security software maker's three weak areas, Samenuk addressed each one in turn.
First was the task of winning over customers who were beginning to look elsewhere due to late product releases, bad service and poor support.
Taking a page out of Sutton’s (Sutton, 2002) book he criss-crossed the globe to talk directly to clients and harried vendors to ask their perceptions on where NAI was going wrong. Most customers reported that late products in the antiviral area were of the biggest concern as was their lack of support.
Considering that the anti-virus software was NAI core competency, it become apparent that NAI had diverged too much from its central offering, and both product delivery and customer service had been effected.
As Hoffman (Hoffman, 1989) indicates, this is a classic symptom of the need for a strategic turnaround rather than an operational one.
Samenuk quickly sold off the flagging Gauntlet Firewall and the profitable PGP Encryption divisions, to refocus the company back on to what it was good at – anti virus software.
Although staff could understand the removal of the Gauntlet division, there was concern about PGP. But Samenuk indicated to the staff in the fortnightly meetings, PGP had never made much money, and encryption products represented a tiny market opportunity.
Further, both divisions had diverted NAI attention away from what it had done best (Bibeault, 1998), and all told NAI would actually save a compounded $50 million by ditching the two units. NAI was to refocus back on its core business (Barker III et al., 1994) .
Within the first year NAI had gone from a loss of US$108 million in 2000 to a profit in 2001 of US$83.2 million. By year two of Samenuk’s turnaround plan NAI’s net income had increased to US$128 million.

Thesis work paper Case Study: The Turning Around of Four Software Companies

As can be seen from above, the literature on turnarounds for software companies follow a differing path from conventional turnarounds.
As such, the case studies below seek to give an overview of the changes instituted by companies that have been turned around and compare these against the above literature.
The cases themselves will not focus in depth too much on the decline of the companies as further details of each firm and its problems can be found in the Appendix, but rather make references to the software turnaround methods outlined above.

Thesis work paper The Danger of Backsliding

The final danger of any turnaround is the danger of backsliding. This is particularly important for software turnarounds, because the chances for a normal company recovering after backsliding is only 5%.
Considering that Blumling (Blumling et al., 2002) states that software turnaround success rates are only 12%, indicates that that chances of a software firm recovering from a backslide are likely to be only 1% or 2% at most.
To prevent this, Sutton (Sutton, 2002) recommends setting even tighter defined goals and accountabilities. Furthermore he suggests hanging up the project development plans in the front office for all customers and staff to see. These should be updated daily in order to clearly identify where any delays are, and forces an attitude of total transparency and continuous improvement (Walton, 1996). Staff feel motivated to help overcome any delays, because any delays detract from the company’s image.
In addition, the danger of the delay project to the firm’s turnaround is apparent to everyone. Similarly Davidson (Davidson, 2001) states that by displaying progress and delays in front of everyone, problems will be solved early enough, before developmental projects have gone too far. Sutton (Sutton, 2002) recommends having staff display their work in meetings each week. This allows for staff to better gauge which work may need more resources, allows for easier enforcement and encourages staff to ask for help earlier (rather than trying to solve complex problems by themselves).
Sutton (Sutton, 2002) also states that it allows staff to take pride in their work, develops demonstration and public speaking skills and moves the marketing and sales function down to the front lines “where it should be”.
Finally Sutton (Sutton, 2002) maintains that the question and answer sessions prevent backsliding by forcing workers to think in terms of the “bottom line” and how their work will add value to the customer.
The result is not only an open environment that speeds up the firm’s development projects but ensures that staff “keep an eye” on the corporate recovery as well, because all projects map back to the turnaround plan.