Bootstrapped Founder #28: Profit Sharing, & Upgrading vs. Grandfathering

Dear founder,

Before we start with the regular programming, I want to let you know that next Wednesday, May 27th, Tyler Tringas (of Earnest Capital, Founder Summit, and StoreMapper) and I will host the Founder Summit Remote webinar "How to Validate Business Ideas, Step by Step".

You submit your bootstrapping idea, we discuss how we'd validate it. Audience, Problem, Solution. Everything.

You can sign up and submit your idea here — for free. You can also just sign up to listen in, no idea needed. But I know you're full of ideas. So why not let us take a look at one of them. Hope to see you there!

We don't often talk about employee compensation in the bootstrapped space, as many businesses have few employees, and only start hiring when it's absolutely necessary. So making sure our employees are properly compensated for their work beyond their regular salary isn't one of the most prominent themes we have to think about.

In a recent conversation with a founder who is contemplating his first hire, we weighed the employee compensation options that we have in a low-funding, sustainably growing bootstrapped business: equity and profit-sharing.

The common way to have employees participate in the upside of a business is through handing them some kind of ownership, usually in the form of shares. That model is used by all businesses alike, as it's the traditional approach to incentivize long-term thinking and sticking around with a business. Extensive vesting schedules and retention clauses turn equity-as-employee-compensation into a complicated legal labyrinth.

And then there is profit sharing. In the bootstrapped community, ConvertKit has been a forerunner of this kind of compensation. In fact, CEO Nathan Barry has written a guide about this topic. Profit-sharing programs are usually quite straightforward: any profit that happens beyond a certain amount is shared with the employees of the business. They don't own the business, but they participate immediately in its success.

Which one would work better for you, your employees, and your business? Let's take a look at both through the lens of a bootstrapped business.

In particular, I want to focus on incentive alignment. Just like with co-founders, you really need your employees' goals to be aligned with the goals of the business. For most bootstrapped businesses, that would be sustainable growth, a long-term perspective of making a difference in the lives of a well-defined audience with a critical problem that you can solve reliably.

Equity in a business is relevant in two situations: when dividends are distributed and when the business gets sold. Dividends are tricky while a business is growing, as they are most often reinvested or deferred. As a minority shareholder, employees won't have much say about if they ever see any money from this, and it wouldn't be a lot, to begin with. That leaves the exit: the happy event when the business is sold for millions of dollars—a once-in-a-lifetime for most businesses. And then there are options, liquidation preferences, dilution, a lot of taxes, and many legal tripwires.

Equity incentivizes building a lot of value in hopes of a singular, far-in-the-future event at which the employee hopes to get a large amount of money, maybe. That's a lot of uncertainty, both about the present as well as the future. This results in a number of alignment issues for your bootstrapped business.

Strategic decisions are heavily influenced by the potential long-term yield they might generate. Big bets look enticing, with a lot of upside for the future valuation of the business, but with an equal amount of downside, threatening sustainability goals. The one clear alignment overlap is that employees who are also eventual owners of the business they work for will come up with long-term strategies, as those are much more likely to lead to increased share value.

Multi-year vesting schedules are supposed to strengthen this particular alignment. They force employees to stick around for a long time in hopes that they deserve their slice of the pie after having proven themselves to be "loyal enough." Complicated legal systems need to be set up to stop them from quitting the day after they receive their shares. To me, this doesn't particularly yell out "alignment of interest."

If things go well, the fully vested employee will have helped generate sufficient value to warrant handing over what is effectively a lump-sum payment. But what if their performance was not as stellar? Transferring ownership of an often significant part of the business to someone who burdened much less or none of the risk involved doesn't sound too good even in the best cases.

Profit-sharing looks much more compatible with the long-term strategy of running a bootstrapped business. In a way, profit sharing is the employee-compensation-version of recurring revenue. Instead of counting on the one big payout, employees are regularly sharing in the profits of the business they work for. Instead of hoping for a future event, profits are shared repeatedly, in short- or mid-term timeframes. Long-term strategies are encouraged just like with equity, but another critical concept is at play here: if you expect to get a profit share every few months, you won't go for short-term gains that threaten long-term goals, and you won't set long-term goals that threaten short-term wins either. Your employees will try to generate reliable, sustained upside along the way. They're working in the present moment, not some nebulous future.

At the same time, there is no singular point in time where the payout is complete in the same sense as fully vested equity can be considered "done." There will always be more profit to be shared. Long-term employee retention is not a carrot-on-a-stick play; it's an organic result of a sustained and ever-increasing flow of monetary compensation.

However, Profit sharing isn't risk-free, so it's only fair to mention a few issues that it may cause for you, the founder, your employees, and your business.

The world of venture capital has created a legacy of inflated expectations about the value of stock options and owning equity in a business. If candidates expect you to offer equity in some form, they might be less interested in joining your business when you "only" offer them profit sharing, no matter how much more they would benefit from that. Retaining one hundred percent of the ownership in your business might also make you look greedy and over-possessive, particularly when compared to many VC-funded founders who consider sharing equity a necessary evil. Of course, this is a psychological bias, but you will need to be able to address it nonetheless.

The most obvious point of contention with profit sharing is that it will result in less cash in the business. If you distribute profit to your employees, it can't be reinvested into growth efforts. The perception that this is a problem also stems from the legacy of Venture Capital funding, where growth at all costs has, for the longest time, been regarded as the prime operational principle. In a slow-growing, sustainable, bootstrapped business, sharing the spoils and carefully fuelling growth are not as exclusive as many people might think. It definitely requires everyone involved to adapt to unexpected circumstances, like recessions or severe market disruptions, but sharing profits and growing your business at the same time is a realistic possibility.

I enjoy seeing more and more businesses experimenting with profit-sharing instead of convoluted equity arrangements for employee compensation. In some way, this is not much different from the Shared Earnings Agreement used by Earnest Capital as a means to fund bootstrapped companies without requiring the fund to own shares. Income Sharing Agreements works well on the investor level, and create a lot of alignment between capital and business: profitable businesses pay higher dividends, right here and now. This is the kind of alignment that profit-sharing can create between your business and your employees.

The same kinds of Income Sharing Agreements are being used successfully as a payment method for coding bootcamps, deferring paying for tuition until a student has a full-time job. Moving away from "all-upfront" and "all-immediately-after" towards a time-dispersed approach seems to be a common theme in all kinds of compensation.

Shared earnings, profit sharing, and income sharing all revolve around one core principle: long-term relationships built on mutual trust and the belief that small recurring compensation events are more reliable, inclusive, and empowering than one-off lump sums. Risk is spread out, optionality increased, and alignment is synchronized at any given point in time.

If you're a bootstrapped founder considering compensating your first employees, consider profit sharing. Equity is a great option too, but by far not the only one. Whatever approach you prefer, make sure it aligns the goals of your employees with the goals of your business. After all, that's the point of compensation.

Not All Subscribers Are Equal: How to Deal with Plans That No Longer Work

This week, in addition to the topic of profit-sharing, I want to give you some insights into what I learned in many years of running subscription-based businesses.

You may have started with subscription plans that turn out to be problematic. At FeedbackPanda, we had started with a $5/month plan. After a few months of offering that, we sunset that plan because we noticed that it attracted a kind of customer we did not want to serve: bargain shoppers. The customers on that very cheap plan were using our customer support channels significantly more than those who were on more expensive plans. They complained more and requested more features than anyone else. So we closed off that plan for new users.

They hated it. Many people who had started their trial assuming that they would get a $5/month plan reached out to us and complained that we took it away before they got a chance to subscribe. While it always hurts to receive such feedback, it was still the right course of action. The voices of those who are bothered will always be much louder than the silence of those who don't mind. We saw in our numbers that our conversion rate didn't suffer from this change.

If you remove a plan, you have a choice: you either upgrade all users to one of the remaining plans, or you "grandfather in" their subscription, which means they get to keep their old plan even though it is no longer offered to new customers.

Upgrading All Affected Customers

Your best chance to increase your MRR immediately is to upgrade all of the customers on the plan that you plan to remove. This will also cause a lot of trouble if you're not giving your customers enough time and options to react to the announcement before a single additional dollar changes hands.

Inform your customers way ahead of time. Give them a month if you can. At least, a few weeks should be between the announcement and the actual change. Special focus should be on communicating this change clearly to your trial customers who started their accounts under the impression that this plan would still be available for them. If you want to be particularly friendly, allow those customers to still subscribe to the plan even while it's already unavailable for other users.

Some customers will cancel. A very effective course of action is to reach out to those who intend to cancel and try to get them to stick around with a discount offer. Often, giving them a month for free is enough of a sign of good faith for them to reconsider their cancellation.

Should they still cancel, think twice if it's worth spending more time and effort at winning them back. If at all, try to reactivate them via email a few days or weeks after they quit. New prospective customers who start a trial even though the lower price is gone are who you want to interact with at this point. They and your existing customers who are willing to pay more for a better product should be the focus of your attention.

Grandfathering All Affected Customers

Grandfathering can be great to keep your early customers around, but there is a risk of underselling your product significantly. It can be a business risk not to be able to claim the real value of your product as revenue just because you think your customers are emotionally attached to a lower price. Expansion revenue is made impossible if the customers who happen to be subscribers already are receiving a life-long discount. An excellent way to allow grandfathering is making it conditional and temporary: allow them to keep the lower price for a year if they upgrade to a yearly subscription. Else, force them to upgrade to the new price. Understand that they should pay for the product they receive today, not the product they signed up for years ago.

When we removed our cheapest plan, we decided to grandfather our $5/month customers. One noticeable consequence was that most customers who reached the limits of their plan eventually upgraded. Only a few customers tried to stay under the limit by deleting data diligently. They rather saved a few dollars a month than having access to their old feedback data. As this number was relatively low, we ignored it and never encouraged them to upgrade, as it wasn't worth our time.

We grandfathered our customers indefinitely, which is something I wouldn't recommend. Give your customers a high but finite amount of time to enjoy their old subscription plan. After a year or so, request that they upgrade to the correspondingly more expensive plan. Your product grew in terms of value, so all of your subscribers should compensate you accordingly eventually.

Links I Found Interesting

If you've ever made exploration or validation conversations with customers pre-COVID, you may have met them at conferences or for coffee. Well, not anymore. We're now all limited to video calls, and those interactions are much more formalized. Thankfully, Rob Fitzpatrick, author of The Mom Test, took some time to record a few videos explaining How to Change Your Customer Development to Work with Video Calls. I watched this, and now I am both reassured and instructed.

The fine people over at EmpireFlippers have written about SaaS Pricing Models & How They Affect Valuation. The article explains a lot of the often surprising consequences of picking a pricing model on the future sellability of your business. As usual, the Hacker News comments are dissecting the article critically, which is pretty important as EmpireFlippers is a broker — it's all about perspective.

Dan Benoni & Louis‑Xavier Lavallee of Growth Design published a mammoth of an article called The Psychology of Design:101 Cognitive Biases & Principles That Affect Your UX. If you've ever wondered what unknown unknowns still exist in your understanding of design, check out this article. I spent a few hours reading up on biases and checked out the well-designed (sic!) case studies. Particularly the commentary on the Anti-Examples is worth every minute of your attention.

Bootstrapping Success Stories

Jon Yongfook of Bannerbear reported reaching 25 paying subscribers this week. I've always really enjoyed reading his tweets and seeing his ingenious marketing efforts, clearly communicating the value provided by his product. Jon has focused a lot on integrating his product with other services to provide as much automation as possible after having pivoted Bannerbear from a web app to an API. Talk about focusing on what works!

NoCodery, the No-Code job board and teaching platform made by Gonçalo Henriques has just crossed $1k in MRR. It's a genius move to allow no-coders to sell courses on the same platform that no-coders try to find work on—so much potential for certifications and lead-generation from that combination alone. I'm looking forward to following the success of NoCodery.

I consider a journey full of learning and adapting to new circumstances a large success. That's why I want to include a podcast episode from the Failory podcast called 17 Years of Online Ventures, with Matt Giovanisci of Swim University. So many projects, so many forks in the road. Matt is the master of dusting himself off and trying again. I highly recommend checking out the brutally honest timeline that he titles "How I Built a Mildly Successful Six-Figure Business in 17 Years." What a champion! The MoneyLab podcast is worth subscribing to as well.

Thank you for reading this week's edition of The Bootstrapped Founder. If you like what I wrote about, please forward the newsletter to anyone you think would enjoy it too.

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See you next week!

Warm Regards from Berlin,

Arvid