So, you are a company that wants to create new products or directions within itself. Most likely, you are preparing to integrate these projects into your company later (strategic thinking). To be able to say “Mischief managed!”, you need to find a clear answer to the question:
How can you build an incentive system for project managers — arguably the most important people in this plan?
Firstly, accept that no one will build a brilliant product for you unless you agree to share. It’s all about partnerships or, at least, about the founder-investor relationship.
Secondly, the incentive system should be divided into three parts: short-term, medium-term, and long-term.
- Short-term incentives are all about competitive salaries (at market rates or a bit higher, since “competitive” is open to interpretation). It means not too high, not too low. Your employee shouldn’t be sales hunting in order to save up money and/or stress about paying for their kids’ kindergarten. Simply put, the salary must fully cover the current needs of your product manager. It’s in your own interest.
- Medium-term incentives are bonuses for intermediate achievements. We all are looking for employees who are ready to work their tails off, but it’s psychologically draining. When there are no victories and visible achievements, while substantial amounts of money are still far beyond the horizon, a leader’s motivation… decreases, to put it mildly. Needless to say, you really don’t have to be like that. Once or twice a year, there should be pre-agreed intermediate goals and bonuses for achieving them. Depending on the achievements, a bonus can be equal to 1–5 salaries.
- Long-term incentive is a share in a project to be created. It’s the most valuable and expensive part, so we’ll talk about it in more detail.
At the start, the project lead owns 90% of virtual shares and initial capital to test the idea. Each company should have its own limits for it, depending on the market size, idea verification, etc.
Then the project lead contacts their manager to get additional funds for development in exchange for some shares (a spitting image of how it goes in the wilderness of the venture market). For example, a startup would receive $50,000 for 5% of shares, then $100,000 for 7% in the following quarter, etc. By the way, the initial estimate is a fixed price with a default growth of 20–30% after each round; but I’ll share more on that later.
When it comes to larger rounds (>$500,000), the subject is brought up before the investment committee of the company. But with small amounts, the person in charge can make a decision alone.
Thus, the founder gradually reduces their share, exchanging parts of it for money.
When the project finds its product-market fit (a milestone where the team switches from developing a product to improving financial metrics), you can assess the project according to a predetermined formula.
Advantages of the approach
- Transparent and market-based methodology, close to venture capital.
- The right relationship with the project lead: they donate a part of their share in exchange for funds, thus increasing the “value” of money.
- Encouragement of the founder’s autonomy. With an independent founder, it’s easy to spin-off and bring a project to the market as an independent company with a clear distribution of shares. Equity would be the same as in the company, depending on how much it diluted by the end of the spinoff.
- This approach could interfere with an aim for more subordination and control over the unit (if there is one). Who is responsible for the results? According to the share distribution, 90% is on the founder. Therefore, they will consider the project their own and listen less to the corporation.
- The project manager might get overly cautious, not taking money in order to avoid equity dilution. The project could theoretically grow faster, but it will slow down instead to maintain equity. Indeed, this is a common problem, and the company will take much less risk than it can, which directly affects possible rewards.
At the start, the project lead has a share of 10–20% which doesn’t dilute. The overall principle is the same as in the “Bottom-up” approach: there is a budget limit, and when the project reaches it, founders ask their manager for an increase. When it’s less than $500,000, the decision is made independently. But with bigger funds, it is brought up before the investment committee.
It is motivating because each round increases the project manager’s share value.
Advantages of the approach
- When the company has a 80–90% share from the start, it perfectly conveys who is in charge and/or responsible for making key decisions. This way, it will be easier to integrate the unit into the company.
- If a rich company plans on building units in large markets, such a system would allow it to run faster, motivating both the founder and the company to invest more in the project. This way, the former increases the value of their share, while the latter gets a faster growing asset in its market of interest.
- For the lead, there is less value in money, since they lose nothing by receiving them. On average, such projects spend more than those from the “Bottom-up” category.
- If a person is not a seasoned founder/leader, they might have a hard time understanding the value of these 10–20% in a large project with regularly increasing estimates.
Conflict of project investments
With a Top-down approach, you can end up pouring an unstoppable flow of money into a project, which is quite undesirable on one hand. On the other hand, you always need a project lead to have shares (i.e. stay motivated). Therefore if the company wants to invest in a project, it’s not as crucial since you’ve got a person who is interested in it and drives its growth.
With a Bottom-up approach, an issue may arise that founder’s shares have already diluted down to, say, 10%. You might still want to keep scaling and investing, but it would almost dilute founder’s shares to zero. It means that the most growing project would not have a strongly-motivated leader.
Overall, this conflict has its pros and cons that compensate each other in the long term. When deciding which system to use, I wouldn’t recommend taking them into account.
Alternative: virtual convertible loans
If neither Top-down nor Bottom-up approach is suitable, you can postpone this question for the future and start your project with a basic 51/49 split in favor of the company. In the future, it is funded in the same way (manager, then investment committee), but with virtual convertible loans.
The logic is simple: “We don’t have enough data to agree on ’Top-down vs Bottom-up’, so in the meantime, let’s build something.” When your project gets closer to product-market fit, look at how much had been issued in virtual convertible loans by that time. Who remained in the team? What are the prospects and plans for this project? Then it’s time to decide how virtual convertible loans translate into shares, whether the project will operate internally or externally, etc.
In fact, you only need to record your project’s expenditures and postpone launching the Top-down or Bottom-up approach until you reach product-market fit.
- While the project is young, there is no point in evaluating it. It’s just a waste of time. Instead, take some average cost of innovation as a fixed price for early-stage projects in your company. For example, a seed-level project costs you $1M for the Eastern European market and $2M if you launch it in the USA (pre-money).
- Use convertible loans when participants refuse to discuss valuation. Postpone the question to later stages until there is enough data for assessing a project with common market methods.
- Whichever system you choose, the shares must be issued with a 4-year vesting and 1-year cliff. In a nutshell, it means that if a person leaves the project in less than 1 year of employment, they receive no share. What is owed to them will be issued gradually over 4 years. This is a classic strategy of the venture capital market that protects investors and projects from people who aim for a sprint instead of a long run.
So far, unfortunately, the legal registration of shares is a difficult and lengthy matter that doesn’t only depend on your lawyers (although their number would increase greatly if you decided to execute everything at once). I would recommend keeping a virtual record and actually registering shares once a year or when triggered into it — for example, when the project grows to a certain level of revenue.
What if the new direction is internal / there is no possibility to register and/or separate an entire legal entity?
I propose to stick to the described mechanics: all three parts of the incentive system, where Bottom-up or Top-down approach defines the long-term motivation. The difference should only be in what the share is converted into: company shares if you want to separate the project into another business, money if there will be no separation. Say, three years later, the company’s and project manager’s shares divide 60/40. But how can the manager’s shares become liquid?
Evaluation of the project during a liquidity event
If the company decides to sell the project or buy it out, then it’s easy. By that time, you have your shares distributed (the very same 60/40), and your product-market fit provides all the financial metrics. There should be two project evaluations ready:
- Estimate for cash-in investment — when a company invests money in a project and its development. It is always much higher than the cash-out option.
- Estimate for cash-out investment — when money is withdrawn from the project as profit. It is usually 3–6 times lower than the cash-in estimate and calculated by a different formula.
But what’s next? How can you motivate the project manager in further stages of growth? This question requires another article, but long story short — it’s all about the transition from a project-level incentive system to the level of the entire company.
If the manager continues to work successfully (I assume this is exactly the case, since the company is interested in the asset and the possible buyout), then you can increase the market size or the number of units for the manager to deal with. Accordingly, you are to motivate them by transitioning to the level of the entire company (or division).
At the moment, I consider the scheme described above the most optimal. It’s not perfect, but it balances the interests of the parties well. If you have any suggestions on how it can be improved or replaced with a better version, throw me a line or two, I’m always glad to learn.