The last thing you want to do is pay mediocre employees star-level salaries.
Figuring out salaries can be one of the most complex jobs in running a small business. Your competitors aren't likely to respond to your phone calls asking how much they are paying their people, and salary surveys (which can be helpful) don't often cover the multi-tasking required in a business with fewer than 20 people. (After all, you may need someone who can do marketing and accounting, while the business across the street has the marketing done by the same person who handles HR.)
And when you're hiring, you're as reluctant to bring up salary first as the companies you used to work for were. The result of this can be that you're paying your employees the wrong salary. We all know the problems associated with underpaying--lack of motivation, high turnover, and general disgruntledness. But what about the problems with overpaying?
Other than the obvious fact that the more you pay your employees, the less you take home, there are other problems inherent in overpaying your employees. Here are three.
You discourage the right type of turnover. Turnover isn't always bad. You want the mediocre and bad employees to leave. You can always fire them, but that's got its own set of problems. It can be financially and emotionally devastating for your employee, and unless you've got a heart of stone, it can be very difficult for you as well. Add to that, if someone is going to sue you, it's going to be over a firing. It's far easier to have someone leave. But, if their paycheck is going to be substantially lower at a different company, why would they leave? Even if you start giving your mediocre employees the less desirable assignments, it may only result in them hating you, not leaving.
Your employees may begin to feel entitled. Have you ever had a great year and given everyone a fabulous bonus? Then when the following year the bonus was at "normal" levels, people were upset? Funny and annoying, isn't it? Likewise, when salaries are too high, people start to believe that this is what they are entitled to. And since they know they couldn't do better elsewhere (or even equally elsewhere), they assume that, for whatever reason, you owe it to them. And it actually discourages hard work, because they're already getting the reward. So, why take on more? And furthermore, as they become slackers, they become more and more satisfied with their jobs.
You may be bound to that high salary. Ever heard the term "similarly situated employee"? Well, what it boils down to, in employment law, is that you need to have a really, really good reason for treating two employees who have the same job function differently. If their jobs and performance are similar, their salaries should be similar. Now, it makes sense that if you're overpaying Salesman A, when you expand and hire Salesman B, you would make his salary match the market rather than the first person's salary. This is fine and good, but what if it's not Salesmen A and B, but Salesman A and Saleswoman B? When she finds out that her counterpart (who does an identical job) makes significantly more money than she does, do you really think she's going to buy that it's not because of gender? Or race? Or national origin? Any of these could put you in the very uncomfortable and expensive situation where you are forced to prove that you are not discriminating. Additionally, what if your second salesperson outperforms the first? Sure, give her a 10 percent increase and give the long term guy a 2 percent increase. Only, that may still leave her substantially below him, when, according to performance, she should be above him. In other words, you've got a mess.
How do you avoid this problem?
First, take the time (and money) to carefully consider salary before you offer one to someone.
Second, be involved in industry groups so that you can be aware of the current market rates for your positions.
Third, don't be afraid to honestly evaluate your employees and their performances and give out raises based on performance, rather than just cost of living increases. You can lower a salary (it is legal, as long as you don't have a contract and you don't do it retroactively) but it will destroy the relationship you have with the employee.
Fourth, in a volatile market, consider offering a substantial portion of compensation as a bonus. It's easier to adjust a bonus down than it is to adjust a salary.