A Framework for Principal Compensation

Every principal agrees that their pay is important, but how do you set that? And how do you handle a scenario where there are multiple partners?

Where the Data Comes From

This comes up frequently in our work, and we touch on it in many ways:

• When Benchmarking a firm’s performance in relation to its peers.
• When conducting a Total Business Reset, which starts with that same module.
• When building a Valuation in our merger/acquisition work.

The data behind this is also incorporated in:

• Financial Management of a Marketing Firm
• The IP that is licensed from us by the major software packages.
• A new digital benchmarking tool we are releasing soon, to be available as a monthly subscription.

If you don’t pay yourself well, two things happen. First, there’s nothing to drag you across those rough roads when your engagement level wanes temporarily. Second, you are setting the overall bar lower than it should be and relieving the appropriate pressure that should force your business to perform.

Fixed Comp ≠ Profit Distribution

Let me clarify one point, first, because many firms just don’t get this: your compensation is not your profit. Your compensation is what you pay yourself regularly (via payroll, ideally, but in some tax environments, it could be distributions), every fixed period, regardless of how well the business is doing. If the business is struggling, there might not be much profit, but your base comp is still there. More on this shortly.

What follows, then, is a seven-step framework for principal compensation. If you’d like to see how this particular metric fits into the eight major ratios, here’s a recent article on Eight Important Gauges. And this article on Overall Compensation Strategy places your own compensation inside the total compensation at your firm. And finally, if you’d like to listen to a podcast episode on this same topic, grab that episode on 2Bobs.

Here we go: a seven-part framework for your own compensation.

1—You Get Paid for Three Things

It’s important to separate these three things, too. When the lines get blurry, a cloud can settle over the discussions and principals feel slighted. So assign everything you get paid to one of these three categories:

1. You get paid for what you OWN, and this comes up in in two instances: when you sell some equity and also when the corporation distributes profit to the shareholders. Here, we’re only discussing the second instance. This distribution is variable, based on the performance of the firm, which varies over time. An owner who doesn’t participate in a very profitable firm will get distributions. An owner who participates in a firm with no profit will get none. Distributions of profit, based on what you own, have nothing to do with participation, which is next.
2. You get paid for what you DO. This is based on the time that you spend applying your skill to meet the needs of the company in the marketplace. The amount you get paid is something we’ll discuss later, but the fact that you do get paid, regardless of the company’s profit, is a function of what you contribute. A non-participating owner, even the sole owner, gets no regular paycheck—just distributions of profit.
3. You get paid for the unique, quantifiable RISK that you take as an individual. Picture two equal partners of a firm that hits a rough spot, and one of the partners loans funds to the company from a personal portfolio (this is known as “paid in capital”). That is a unique, quantifiable risk that only one person is taking, and so that person should demand an interest rate that properly reflects that risk. The business accepts that premium, acknowledging that paying the loan back is not guaranteed, and there might be a 1 in 10 chance that the firm fails and defaults on the loan. So a 10% return might be reasonable (just to make the math easy).

That’s where we start: distinguishing between the three categories.

2—Principals Contribute Uniquely but Equally

Adam Smith coined a phrase in 1776 that’s now considered a settled economic principle: “the division of labor.” This described how individuals in an advanced economy specialized to improve efficiency and productivity. So the best system doesn’t look like a stack of plates, where each principal runs their own firm, so to speak, finding opportunity and servicing it with their own little company within a larger one. No, the best system is one where there is one single entity, each served by different principals with unique strengths. That could be new business for one partner, managing people for another, tech/innovation lead by another, etc. Instead of a stack of plates, think of slightly overlapping Olympic rings.

This makes sense on its face, but it also helps with one other big thing: it doesn’t invite comparison. In little companies where each principal is killing whatever they eat, it would be natural to compare one principal to another…and then that would naturally lead to paying some principals more than the others. This creates unnecessary tension, first, and it doesn’t reflect all the other things that are just as important in an organization but are not quite as measurable, financially. Someone who tracks and analyzes performance, or someone who establishes and then guides the culture, is doing God’s work, too, even though that impact isn’t as measurable.

So we do not want to invite unhealthy comparisons in contribution, and we want to take natural advantage of every person’s unique strength.

3—Some Principals Are More Equal Than Others

Let’s say that you agree with the previous point about unique contribution that’s valued equally. Now picture a firm with three principals: two have a 45% ownership stake, each, and the remaining one has a 10% ownership stake. Should that minority partner make the same as the other two?

That answer is no, but we need some objective boundary, and we have set that at 20%. So every principal who owns 20% or more would be paid equally. This cutoff is informed, in part, by legal and tax precedent, and we’ve implemented it fairly for decades. It’s also a judgment call, and there’s room for you to choose differently. But whatever you choose, memorialize it in writing.

4—“Doing” Should Pay More Than Highest Paid Non-Owner

That’s a big heaping bowl of word salad and reminds me of a speech from HBO’s “Veep” show, so I’ll unpack that. We haven’t yet set a specific amount for principal comp, but whatever fixed amount you pay for the “DO” part of their comp should be higher than the highest paid person who is not an owner.

There are exceptions to that, but they are quite rare. We talked on an episode of 2Bobs about how some sales people who aren’t equity partners can make enormous amounts of money, but that exception proves the rule.

So for now, whatever pay you land on should be more than any other person makes. I mean why not? The burden of proof lies with anyone who believes otherwise.

5—Larger Firms Can Afford Higher Principal Comp

This is a framework, remember, so we’re trying to arrive at universal principles that can be applied, no matter the firm. That argues against a set amount of pay for a sole principal regardless of the firm’s size. That makes no sense. 

The bigger the firm, the more you’d rightfully expect the principal(s) to make. But on the other side of that equation, fixed comp will likely hit a ceiling, above which variable profit distributions are added to that equation (Or in a publicly traded company, options or grants of that company’s stock.)

The theory behind this is the same theory behind employee salary bands, which are higher for larger companies. The CFO of a 120-person agency would expect to make more than the CFO of a 30-person agency. Same with principals.

6—Multiple-Owners Brings No Economic Advantage

If I haven’t already lost you, this might be where it happens! I wish this weren’t true, but I’m addicted to data. From an anecdotal standpoint, we all know of single-owner firms with remarkable results…and multiple-owner firms that struggle. So there’s obviously no direct connection. But is there any data that supports the idea that, in general, with obvious exceptions, multiple owners run firms that are consistently more profitable? The answer is no, and that comes from a deep analysis of thousands and thousands of firms where we have verified data.

So what’s the point? Here it is: if there is no economic advantage, then we must assume that there is an economic penalty. But I need to be clear about something. There are many advantages to having multiple partners—companionship, bringing different strengths to bear, take sabbaticals, etc.—but having multiple partners means, by definition, that you’ll have to split the pie into smaller pieces. You’ll see this reflected in the recommendations at the end of the article.

7—Taxation is a Separate Issue from Compensation

An S-Corp in Tennessee, where our corporation is based, is incentivized to run everything through W-2. There are a few other states like that, but most of the states (corporations are a state-based entity, not Federal) incentivize a minimized W-2, shifting the rest of your comp to distributions. But whatever your specific state (or even country), separate these two issues in your head.

For example, say there’s every incentive to minimize your fixed comp and route most of it through distributions. Well, then make those distributions somewhat fixed so that a) you can count on them and b) the company can count on paying them.

Some Specific Benchmarks

I like to think in frameworks, before applying specifics, and now you can see what informs these very specific suggestions. They are oriented around the size of the firm, including principals, with an adjustment for the number of principals (over 20% equity):

Total Team Count	Principal Comp*
01–04	$120,000
05–08	$170,000
09–12	$220,000
13–16	$270,000
17–20	$320,000
21+	$370,000

*Add $100,000 for every subsequent principal

So to illustrate this specifically, a firm with 11 people total, including one principal, would normalize that leader’s compensation at $220,000 and distributions would be on top of that. If there were two principals and nine other employees, the normalized principal compensation would be $320,000 ($220,000 + $100,000), divided by two, or $160,000 each, and so on.

You would also need to adjust for the firm’s overall financial performance…and locale, and by locale I mean country. We have adjustments for developed and developing countries, but we’ll not burden you with that data.

How to Apply This

If you don’t have partners, this should be easy to solve.

If you have partners, then try to figure it all out while you’re getting along.

Make sure that you keep the total compensation allowance, including your own, within that 45% allowance referenced in the article at the outset.

Aim for at least a 20% net, after normalizing comp.

If a partner is working less than full-time, adjust their “doing” comp accordingly, but their “owning” comp should be the same.

Thanks for sticking with me for this very complicated article!