Paying Startup Employees: Hourly vs Salary

Sooner or later, a startup must to begin hiring employees. First-time founders, or those without previous management or small business experience, may find this challenging. After all, where does one learn hiring strategies or how to build a employment package? Before hiring, founders must develop employment policies, such as vacation and benefits, and of course, cash compensation. Founders have two choices with respect to paying their employees; either an annual fixed salary or an hourly rate. Each option has advantages and disadvantages that founders must analyze before making a decision.

Forecasting

One advantage of salaries is that founders can more easily calculate their burn rate and forecast their monthly and yearly spend. For example, paying a developer a salary of $60,000 per year means that the maximum cost for that resource will not exceed $60,000 for the entire year. In this situation, founders can plan their finances and cashflow to ensure they have the resources available to cover all employee costs for their entire year, helping to reduce the stress of fiscal planning.

Paying hourly rates means employee costs are much more volatile. While a baseline work time estimate of 40 hours per week (or 176 hours per month) can be used to calculate employee costs, the actual value may vary wildly depending on the amount of work being performed. During busy times, employee costs can easily exceed forecast, such as during a product launch or major system outage. If founders have estimated poorly and do not have appropriate cash contingency, the financial situation of the venture can quickly become dire.

Incentive

Paying workers an hourly rates gives them a very important reason to work extra hours; the more time an employee spends working results in a larger pay cheque. Employees are now much more motivated to work longer to get the job done, which can be crucial at times. There will no doubt be many occasions in the life of a tech startup when a service disruption or a missed deadline could spell disaster for the venture. When these times occur, a highly-motivated workforce willing to work extra hours with little hesitation are essential.

Salaried workers may be discouraged from putting in additional time at the office. Since they do not receive any direct tangible benefit, they may hesitate or be unwilling to sacrifice their leisure or family time to work extra hours. While this issue may not arise when requests for extra work are few and irregular, it will increase quickly as employees are asked more and more to work overtime. Frequent requests for additional time can lower morale for the entire team and create conflict between team members and founders.

Impact of Product Changes

Change is constant in a startup, particularly early on when product/market fit has not been fully established and the product is being constantly pivoted. In these situations, founders will often direct their product development teams to add new features, change designs, or improve performance. They believe that these modifications will make the product better that will lead to more purchases, more revenue, and more profit.

The issue is that changes cost money, and rapid product changes in an early-phase startup are often not budgeted. When paying workers a salary, the financial cost of ordering changes is neither realized nor appreciated. Not having an awareness of the cost of a change means it is impossible to determine if making the change will create positive return on investment. In the case that a change has a minor return, founders will not know when (or after how many sales) that change will pay for itself.

This issue is much more manageable when employees are paid an hourly rate. Multiplying the labour estimate of making the change by the hourly rates of all the workers involved calculates the estimated cost of the change. For example, a change estimated to require 40 hours of a developer’s time at a rate of $100 per hour means the change will cost around $4,000 to complete. Founders can now critically analyze this change to determine their confidence in whether this change will bring in at least $4,000 more revenue, and if so, when. Of course, estimates are rarely correct, but the exercise will at least provide a rough idea that can be used for simple evaluation.

In reality…

There are a number of key advantages to paying startup employees an hourly rate rather than a salary. However, the overwhelming majority of clients that I serve have chosen to pay salaries. For them, having a predictable level of expenses each month overshadows the added transparency and incentive that hourly rather offer.

For ventures that choose to pay salaries, there are other ways to benefit from the advantages of hourly rates. Workers can track their time in a simple spreadsheet or time-management software, which will provide founders with an idea of the amount of effort their teams are putting in each week. Another benefit of time-tracking these hours is that the information is necessary when applying for SRED tax credits. Founders can also use option pools or vested equity agreements to incentivize employees by sharing in the overall financial success of the venture.

Something to keep in mind is that employee compensation policy can change as needed as the business grows. Flexibility is a key benefit of leading a startup. However, this is a topic founders should give some thought too before they being hiring employees. The policies established early on in a new venture will have lasting impact over its life. Setting stable employee policies early can help retain highly talented first-hires with key knowledge of the venture and avoid conflicts with newer hires who receive different compensation packages. Ensuring all employees are motivated and satisfied will help founders maintain a stable workforce focused on building a great product.

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