When Ryan Lockhart interviews job applicants at his digital marketing firm in Hilton Head, South Carolina, one of his first questions is, "Are you willing to work for unlimited ramen noodles and peanut M&M's?"
He's joking--sort of. Junior copy writers at group46, the fast-growing agency he started with a partner in February of 2014, earn as little as $25,000 to $30,000 per year--half the pay rate of more established companies. Lockhart compensates by promising unlimited personal time off, an exciting place to work, creative freedom, and faster career advancement. "I would love nothing more than to pay these candidates top dollar," he says, "but the agency just isn't there quite yet."
Lockhart's approach is a common one for start-ups--but Darren Root thinks it's a mistake. Root tried the same thing in 1986 with his first company, a CPA firm in Bloomington, Indiana. For 17 years, he paid employees as little as possible but found himself so mired in day-to-day drudgery that he couldn't focus on growing the business. Exhausted, he abruptly changed course. He hired a young executive at above-market rates, gave him lots of responsibility, and was amazed to watch the company take off. Today, Root is the co-founder of two firms--he other a consulting practice for CPAs--with combined revenue of $6 million and a staff of 30. "Once you get your first 'A Player,' everything changes," he says. "That really freed me up to sell."
Lockhart and Root are taking opposite approaches to the vexing issue of employee pay that has always bedeviled entrepreneurs but today has reached a fevered pitch as wage stagnation and income inequality worsen. How a business leader can create a fair and sustainable pay policy is a riddle of economics and human behavior with no single solution and only seems to generate more questions: If you raise prices hoping to produce enough revenue to hire great people, will customers flee? If you rent a dumpy space so you can hand out holiday bonuses, will office morale drop the rest of the year? And how excited can workers get about the awesome culture you've created --Lip Sync Battles every Friday!--when they're eating ramen noodles for dinner every night?
"It's a complicated story," says Diane Burton, associate professor of human resource studies at Cornell University. Though conventional wisdom dictates that start-ups pay less than bigger firms, she says, economic logic suggests they should pay more to compensate for the risk of the firm going bust. And while established companies often pay more, they could make a compelling case for lower salaries because they are offering training, development, and upward mobility. "You could make arguments either way," she says.
So Burton decided to study the issue. In a paper published in June, she and colleagues from Yale and Aalborg University in Denmark examined a large cache of data on all Danish workers between 1991 and 2006. As you might expect, big firms paid more than smaller ones. But what surprised the researchers is that younger companies paid up to 16% more than older businesses of a similar size. Rapid growth seemed to be an important factor, since start-ups promote and hand out raises faster than more established companies.
Such insights only raise more questions, however: Was the faster growth by the start-ups caused by higher pay or the other way around? In other words, are well-paid workers more productive? While studies show a statistical correlation between pay and productivity, a causal link has not been established because there are so many factors involved--how interesting or boring the work is, how a worker's skills match with the job, whether the positions are entry-level or top management, various workplace conditions, and intangible drivers such as company culture and mission.
Up to a certain point, money can be a powerful motivating force. But focusing too much on external rewards can actually create a disincentive, according to an influential 1999 report by University of Rochester psychology professor Edward Deci and two colleagues. Dangling financial carrots, their findings suggest, can make employees chase the buck rather than enjoy their job. "Even when tangible rewards are offered as indicators of good performance," the authors conclude, "they typically decrease intrinsic motivation for interesting activities."
The effect of pay on productivity also depends on whom you are hiring. For Root, the key is attracting what he calls "A Players." He remembers well his moment of awakening. Root was running himself ragged, pumping out tax returns while low-paid underlings did administrative work, when the owner of another CPA firm, Adrian Lauer, told him he was heading off to the beach for a few weeks. "A CPA taking a vacation during tax season?" he says. "I couldn't imagine such a thing!" When Root asked how he did it, Lauer said, "Find good people, pay them well, and keep them for a long time."
Root took the advice to heart. In 2003, he hired Ryan Deckard, a recent college grad for $40,000 and sliced $30,000 from his salary of $125,000 to help pay for it. "I had to overcome the fear factor of hiring someone close to as smart as I am," Root says. He was prepared to make less money for a year or two, but was shocked when annual revenues jumped $100,000 in the first year and $300,000 after three years. Twelve years later, Deckard is still the firm's CFO.
The experience helped inspire Root to start a second company, Rootworks, to help other accounting firms become high-performers. Even his receptionist earns $18 an hour, well above the going rate of $12. "If people quit because they can find a higher-paying job, you lose a lot of intellectual capital--someone who knows your customers and how you do things," he says. "There are significant costs associated with hiring and training. The more you can avoid that, the easier it is to focus on things that are important."
Curious about whether his experience was shared by his clients, Root took a poll. Of the 516 CPA firms he surveyed last year, 41% reported that hiring the best talent was their primary hiring objective--not saving on payroll--and net profits at those companies was nearly double compared with firms that did not make hiring top talent a priority.
The challenge of paying employees well is most difficult during a company's early stages, when funds are tight. Even Dan Price, the Seattle entrepreneur who announced a $70,000 minimum wage at his small credit-card processing firm in April, admits that he could not have made such a dramatic move earlier in his company's history. In fact, he paid his first employee just $24,000 with no benefits.
That's about where Lockhart is today with the 20-month-old digital-marketing firm he started with a partner, Ed Houston, with just $5,000. group46 has ramped up quickly--attracting 24 clients in the last 10 months--and now has 9 full-time employees and 10 outside contractors. But without substantial investment capital, they can't pay workers any more than incoming cash flow will allow. "When we need a new computer," he says, "we have to save up for it."
Like countless entrepreneurs before him, Lockhart and Houston stress the intangible benefits of working for a hot start-up--in short, a great learning experience that will eventually translate into more money. The strategy worked with a new hire, recently married, who took a 30% pay cut to move to Hilton Head and buy a house there with his wife. "They buy into our passion," Lockhart says. "Some come from big ad agencies where they're one of a thousand people in a strict corporate structure. Here we have a family atmosphere, they have a voice, and their work can change the course of the company. Every new account is a celebration." He also offers team beach days, buys beers at a nearby bar, and says his employees are so devoted they do not abuse his policy of allowing unlimited personal time off for any reason.
For most of its first year, Lockhart had a rule to not hire anyone who had to quit an existing job. "We didn't want to ruin someone else's life in case we didn't make it," he says. "But we're more comfortable now and we make clear the risks involved with coming to work for us."
Lockhart has found it's easier to ask employees to sacrifice when they know the bosses are not cashing in. The founders pay themselves "nominal salaries" that are public knowledge within the company, he says, "so our team knows we're not getting rich."
Though Root stresses the importance of paying his A Players well, Lockhart says he finds top performers willing to work for a bargain price. "Sometimes I have to pinch myself when I see the caliber of talent who take a severe cut in pay to work with us," he says.
Certainly, that's the Holy Grail for entrepreneurs--great talent at a low price. But while that strategy may work in the short run, even Lockhart realizes it's probably not sustainable. That's why he hopes to eventually offer employees equity in the firm. "They are sacrificing now, so they deserve to have a piece of the action," he says.
In the meantime, Lockhart may have to decide when his company has reached the magic turning point when he can take Root's leap of faith and pay top dollar for top talent--then cross his fingers and hope it will boost sales enough to make the bet pay off. While some economists insist that labor is just like any other commodity and should be priced strictly accordingly, others like Paul Krugman argue that it behaves much differently for a simple reason: It is composed not of bushels of wheat but human beings who--despite our penchant for irrational behavior--generally respond to higher wages with better morale, lower turnover, and increased productivity.
"The key is to find a person that you know, or have worked with, offer them as much or a little more than they are making, and sell them on leadership and purpose," says Root. "Keep in mind, your team members have families, lives and dreams the same as you do. When you cease to remember that and you take them for granted, they will move on. Treat people like human beings, acknowledge their hopes and dreams, and they will help you create a company you love."