Employee Compensation in Entrepreneurial Companies

• DOI: http://doi.org/10.1111/jems.12014
• Author: John R. M. Hand,Ola Bengtsson
• Published date: 01 June 2013
• Date: 01 June 2013

Employee Compensation in Entrepreneurial

Companies

OLA BENGTSSON

Department of Economics

Lund University School of Economics and Management

Lund University

Sweden

ola.bengtsson@nek.lu.se

JOHN R. M. HAND

Accounting Faculty

University of North Carolina, Chapel Hill Chapel Hill, NC

hand@unc.edu

Despite the central role played by human capital in entrepreneurship, little is known about how

employees in entrepreneurial firms are compensated and incentivized. We address this gap in

the literature by studying 18,935 non-CEO compensation contracts across 1,809 privately held

venture-backed companies. Our key finding is that employee compensation varies with the degree

to which VCs versus founders control the business. We show that relative to founder-controlled

firms, VC-controlled firms pay their hired-on (i.e., nonfounder) employees higher cash salaries,

provide stronger cash and equity incentives, and have more formal pay policies in place. We

also observe that founder employees earn less cash pay and face weaker cash incentives than

do hired-on employees, but have stronger equity incentives. We propose that the compensation

differences we identify arise because the preferences and capabilities of controlling shareholders

significantly influence the quality of the human capital attracted and retained by the firm.

1. Introduction

Entrepreneurs play a vital role in fostering innovation and creating economic growth as

they strive to commercialize their new ideas and inventions (Schumpeter, 2009; Baumol

et al., 2007). The highly personal nature of entrepreneurship therefore means that the

point in time at which a founder cedes decision-making control to outside investors is

often a watershed event for the company. Not only may outside investors move swiftly

once control is in their hands to make major changes to the firm’s strategy, operations,

and governance (Burton, 1999; Hellmann and Puri, 2002a,2002b; Spulber, 2009), but the

very nature of what it means to employees to work for the firm may be transformed.

In this study we expand empirically on this potential transformation by proposing

that employee compensation in entrepreneurial firms depends on whether founders

or outside investors control the firm. Our empirical analysis centers on privately held

companies that receive financing from venture capitalist (VC) investors. Venture-backed

firms begin as a business plan and, if successful, grow rapidly to become professionalized

We are grateful to VentureOne and Brendan Hughes for providing their survey data, and for valuable com-

ments from Xuan Tian, Andrew Ellul, and workshop participants at Drexel University, the Fourth Annual

Conference on Entrepreneurship and Innovation at Northwestern University, and the IFN Stockholm Confer-

ence. All errors are our own.

C2013 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume22, Number 2, Summer 2013, 312–340

Employee Compensation in Entrepreneurial Companies 313

businesses that are either taken public or acquired. Embedded in their prototypical life

cycle is not only the shifting of corporate power away from the firm’s founder, but also

a complex matching of the supply of employee skills and preferences with the shifting

demands of the firm’s production function.

Despite the real-world importance of human capital in venture-backed firms, rel-

atively little is known empirically about how such firms design their compensation

contracts because of a lack of detailed, large-scale compensation data on employee pay.

We address the data problem by using a large sample of proprietary surveys collected

by VentureOne, a leading data provider in the venture industry,during the period 2002–

2007. Our sample covers 1,809 different venture-backed firms and contains longitudinal

data on business performance, ownership structure, organizational design, and VC fi-

nancing. For each firm in a given survey, and for up to 50 employees per firm, we have

detailed data on employee salary, bonus, and equity holdings. In total, we study 18,935

compensation contracts spanning executives who hold the rank of chief (CFO, COO,

CIO, CSO, etc.), vice president, or director (hereafter referred to in total as “employ-

ees”).1Importantly, we exclude all CEOs from our sample, because we want to restrict

our attention to employees and not the firm’s primary decision maker.

The large and unusually detailed sample of compensation contracts that we an-

alyze allows us to take a detailed look “under the compensation hood” of private

entrepreneurial firms. Although the firms we study are small at the time we study them

(the typical firm is 4 years old, has 47 employees and $10 million in revenues), our data

frequently cover every employee working at the firm. As such, our “whole-organization”

perspective contrasts with prior compensation research in economics and finance that

has focused on large public companies, where the compensation disclosures requiredby

the SEC limit research to the five most highly paid management team members—clearly

but a very small fraction of all employees.

We undertake cross-sectional analyses on three dimensions of employee com-

pensation contracts across firm-years in which firms are founder-dominated versus

VC-dominated: (1) the use of formal compensation policies; (2) the level of employee

cash pay; and (3) the strength of cash and equity incentives. Weconstruct two proxies for

founder-dominance, defined as the degree of influence founders have over critical deci-

sions relative to VC investors. Our first proxy is an indicator set to one if one of the firm’s

founders is CEO at the time of the survey, which is the case in about 40% of firm-years,

and zero otherwise. Our second proxy is an indicator set to one if VCs own a minority of

the equity (they are “minority VCs”), which is the case in about 80% of firm-years, and

zero otherwise. We do not have access to detailed data on VC contractual terms, so we

rely on the argument that VCs in general have more influence over the firm’s decision

making when they hold a majority ownership stake (Kaplan and Stromberg, 2003).2

As predicted by the idea that firms with founder CEOs are likely to have raised less

VC financing and ceded less ownership to VCs, our proxies are significantly positively

correlated.

Webegin our empirical investigation of employee compensation in venture-backed

firms by building from prior work that has shown that VCs often professionalize

their portfolio companies by formalizing firms’ internal organizations (Burton, 1999;

1. Wedo not study employees below the Director level because their work tasks are more standardized and

thus less sensitive to the degree of founder/investor dominance. Unreported tests confirm this proposition.

2. Kaplan and Str¨

omberg (2003, p. 308) find that “when VCs control the board, they typically also have a

voting majority; when founders control the board, the founder group tends to control a voting majority.”