Crypto Pay Guide – Compensation Model
0xEB2c
February 28th, 2022

The Crypto Pay Guide is a series of articles that will be authored and released by C3 over the coming weeks. Each article will cover a separate compensation topic, focusing exclusively on full-time employees or contributors in web3.

What has the Crypto Pay Guide covered so far?

  1. Objectives & Compensation Risk

***

The following article defines a “compensation model”, summarizes the model used among web3 organizations, and addresses its pitfalls. C3 also introduces some recommended changes.

Compensation Model

C3 defines a “compensation model” as the pay components used, as well as the percentage allocation of each component (i.e., pay mix). There are three types of pay components commonly seen among traditional corporations:

  1. Base salary: Provides guaranteed, fixed compensation. Base salary level should reflect the individual’s competencies, responsibilities, and accountabilities. Thus, base salaries are higher for individuals with greater scope.
  2. Annual bonus: Represents variable pay, usually expressed as a percentage of base salary. Payout is typically in cash based on achievement of pre-determined annual performance goals.
  3. Equity: Awarded in restricted stock or stock options, or tokens for web3 organizations. Grant size could be set as fixed dollars (e.g., $100,000) or fixed number of shares/options/tokens (e.g., 200,000 tokens). It is considered variable pay since the value is tied directly to the price of the equity vehicle/token.

An organization should regularly evaluate its compensation model by employee level to ensure it is meeting its talent objectives. There is no “one size fits all” model, although organizations that use all three pay components are better equipped to accomplish their compensation goals because they will have more levers to pull. For example, an organization that wants to improve retention can allocate a greater percentage of pay to service-based equity that vests over several years. Or, an organization that wants to motivate its employees towards achievement of short-term goals, such as a project roll-out or revenue growth, can allocate a greater percentage of pay to its annual bonus.

Below are important considerations when developing an appropriate and fair compensation model:

  • At-Risk Compensation: Percentage allocation to variable pay (i.e., annual bonus and equity incentives) should increase as employees have more strategic responsibilities and oversight. Base salaries for corporate executives, for example, account for less than 30% of their total compensation – the remaining value is allocated in variable pay, such as an annual bonus and equity. More variable pay ensures incentives are directly linked to company performance, which creates a pay-for-performance model where employees and share/tokenholders realize value at the same time.

    For lower-level employees, base salaries should represent a greater portion of total pay because these individuals have little to no impact on strategic decision making. These individuals also tend to be more risk averse as they have not built-up sufficient wealth.

  • Retention: Organizations need an appropriate mix of cash and equity/token incentives. Cash is needed as it protects the employee from decreases in equity/token value, particularly during bear markets. Equity/token compensation is needed, especially for leaders, to promote retention via time-based vesting and to ensure alignment with share/tokenholders.

  • Motivation: Organizations should use compensation as a tool to accomplish their short- and long-term objectives via performance-based pay components, like annual bonuses and/or performance-based equity.

  • Simplicity: Programs should be easy to understand and relatively stable year-over-year.

The Crypto Compensation Model

The compensation model used among crypto organizations today is similar to the one used among technology start-ups. This makes sense considering venture capitalists and early crypto employees are familiar with investing in and working at start-ups.

The start-up compensation model consists of a base salary and an up-front grant of equity, typically stock options, which generally vest over three to five years. Start-ups utilize equity compensation in lieu of an annual cash bonus or a higher base salary. The equity award is often granted upon hire, although an employee may receive subsequent grants (i.e., top-up/refresher grants) in future years based on tenure or performance. The equity is also granted at a favorable price which allows the employee to realize significant upside potential upon a liquidity event, such as an IPO or transaction.

For the start-up, heavy use of equity allows for compensation without burning cash, which can instead be used to grow the business. More equity compensation also promotes retention and ensures employees work towards a successful liquidity event. The downside of this model is that employees lack liquidity prior to an IPO, which may last seven or more years, depending on hire date. If an IPO is delayed or unlikely, lack of liquidity can force employees to seek opportunities elsewhere. Lack of liquidity may also make hiring risk-averse employees difficult, like new graduates, who may value higher cash compensation.

Overall, this compensation model has been successful for technology start-ups. The major technology firms that went public (e.g., Facebook, Uber, Netflix, etc.) had early employees realizing life-changing, generational wealth from their equity, partly because it was granted at low prices. These opportunities have caused others to try their luck at technology start-ups, creating a circular effect which grew the talent pool and lead to countless of companies being built.

Currently, a similar compensation model is present among crypto organizations. Employees receive an annual base salary and/or token compensation. Annual bonuses are also less prevalent as revenue/cash generation is less common. Token compensation represents the pay component with the most earning potential.

The high allocation to token compensation will likely attract talent to the crypto industry because individuals recognize the high earning potential. We can already see this happening - a plethora of tech talent is choosing Web3 over traditional routes in an attempt to realize such gains.

Although the talent pool will likely increase, other effects are less translatable. More specifically, crypto organizations will not as effectively retain and motivate their employees with the start-up compensation model. This is because crypto organizations differ from start-ups in two important regards:

  1. Liquidity: tokens are liquid meaningfully earlier than start-up equity and crypto markets are very, very volatile, which results in pay volatility (read more below).
  2. Governance: web3 organizations have a stronger relationship with communities than start-ups and are thereby subject to more compensation transparency and scrutiny. Thus, crypto employees need to be held accountable with performance-based pay elements (read more below).

Liquidity

Tokens are liquid (i.e., tradable) meaningfully earlier than start-up equity. The average start-up takes about seven years to IPO, while an initial coin offering (crypto’s version of an IPO) is one of the first steps a web3 organization takes. This is because a native token is required for product use and/or community involvement.

Liquidity has a direct effect on an employee’s realizable compensation. Realizable compensation is hypothetical and represents the perceived value of compensation at any given time. For example, suppose one was awarded 10 tokens at a $5.00 price, the realizable value on day 1 is $50. Then, on day 5, suppose each token appreciates to $10.00 . The total realizable value of the tokens is $100, or two times the value at grant. Realizable pay does not consider vesting periods because it is the perceived value to the employee at any given time. Even though the tokens are unvested, the employee perceives their compensation to have doubled in the example above.

Realizable compensation is important because it affects retention. Intuitively, if an individual’s realizable compensation is 10x their granted value, then they are less likely to leave a company. If an individual’s realizable compensation is one-fifth their granted value, then they have little incentive to stay, regardless of vesting.

Start-ups take a two-pronged approach to retention via their equity:

  1. The lack of liquidity retains an employee. Even if the employee was fully vested in their equity, they would not be able to realize that value until a liquidity event occurs, like an IPO or transaction, which typically takes many years.
  2. Realizable compensation is positive and stable through an IPO. This is because the employee receives equity at a favorable, low price and the equity has plenty of runway to appreciate given an IPO takes many years. Their realizable equity compensation is also stable because it is not tradeable and outside firms only periodically value it (e.g., every quarter, every year). These valuations also do not incorporate exogenous market factors or intangibles that public markets would otherwise consider

This two-pronged approach does not translate to web3 organizations because liquidity comes sooner. Unlike startup equity, tokens are publicly traded and have an immediate realizable or perceived value. For pre-launch projects, tokens are awarded at favorable prices, therefore realizable compensation at ICO may be above granted value. If a token’s price decreases following an ICO, realizable token compensation will be less than the intended grant value. For post-launch projects, tokens are awarded at spot. The crypto industry is subject to substantial price volatility which in turn causes an employee’s realizable token compensation to constantly change, thus affecting retention.

The early days for any organization are often the most tumultuous. A start-up can make mistakes and learn from them, all while being left unpunished by markets because their equity is not traded and public disclosures are not made. Web3 organizations do not have this flexibility. Since their token is traded, web3 organizations are subject to immediate market criticism. Mistakes will be made – but markets will react, and thus token prices will fluctuate accordingly.

Token price volatility will be further exacerbated by exogenous market factors outside of the organization’s control, which tend to be quite strong for the crypto industry as regulatory developments are ongoing. During bear markets, employees will see the realizable value of their tokens decrease. Employees may seek opportunities elsewhere, particularly at firms who are willing to spend more on talent, offer more cash compensation, or provide more upside. During bull markets, employees will see the realizable value of their token compensation increase. For employees with unvested tokens, a bull market promotes retention. However, for employees with vested tokens, a bull market can incentivize them to sell tokens at a profit and seek opportunities at firms with more upside or where cash compensation is offered.

Finally, the value of an employee’s tokens is highly contingent on the hire date. For a start-up employee, the value of untraded equity is relatively stable, so all employees begin from a similar starting point and are targeting the same goal – an IPO. For crypto organizations, the value of their tokens is contingent on the price upon hire. An employee that is hired during a bull market receives less tokens than an employee that is hired during a bear market. This can lead to unintended consequences, differing incentives, unfairness, and may cause employees to change jobs mid-cycle to receive beneficial token awards at other firms.

How can the crypto compensation model better address pay volatility caused by immediate liquidity and volatile markets? C3 recommends the following approaches to mitigate pay volatility, which will be covered in detail in future articles:

Governance

As stated earlier, because tokens are traded immediately, web3 organizations are subject to greater market criticism than traditional start-ups. Web3 organizations also have a decentralized and transparent governance structure where tokenholders have a strong influence on the organization’s overall operations. This decentralized governance structure creates a strong link between tokenholders and the employees.

Despite this relationship, very little progress has been made on aligning incentives of tokenholders and employees. Yes, both tokenholders and employees are motivated by an increase in token price. But, what happens during prolonged bear and bull markets? How do tokenholders ensure employees are working towards financial or strategic goals that continue to push the organization forward despite exogenous market factors?

Crypto’s governance structure is more similar to that of a publicly-traded corporation than that of a start-up. Therefore, we can leverage compensation mechanisms present at corporations, which better-align the incentives of the employee with that of the shareholder.

How can we ensure accountability of leaders via compensation and align incentives with token holders? C3 recommends the following approaches, which will be addressed in future articles:

***

The Crypto Pay Guide is a series of articles that will be authored and released by C3 over the coming weeks. C3 is the world’s first Crypto Compensation Consulting group.

We advise crypto organizations and communities on compensation levels, incentive design, and governance practices. We have experience advising both large public corporations and small technology start-ups.

Please read more about our firm and services on our website. If you are a leader, investor, or community member who would like to work with us, please contact us at info@c3.email or via Twitter.

Follow us to stay up to date on future installments of the Crypto Pay Guide!

Arweave TX
0_rcuqwOTJwJ9FeFLVd7arL3v-k7Qrh-5hwZcaPGXCA
Ethereum Address
0xEB2c19e574D1A59eA18D94Ae27c16E3d798B5674
Content Digest
D8XA0v1v0B0fquPEL9BEJk1jNJCcT7q1gncoEArLNvo