Earlier this year, a founder called me because one of his Senior Account Executives found out that she was being paid 5% more than a new Account Executive, who was more junior.
The Senior employee had been with the company for 18 months and the new joiner had started a few weeks before, but was poached from a competitor. They were having lunch together and started talking about earning potential, and base pay came up.
By that afternoon, the senior employee was in the founder's office asking why the new guy was making almost the same base pay while being more junior.
Pay equity concerns aside, this is also how pay compression begins at a startup because each new hire’s compensation is handled independently on a case-by-case basis.
In this episode, I’ll cover what pay compression is, what causes it, what it costs fix it, and how to find it in your own company.
What Pay Compression Is
The story I just told you has two problems.
The first one is pay equity. We have a senior employee who is making almost the same as a junior employee, and there's no documented reason for the difference.
The second problem is pay compression, and this is the one I’ll focus on here. Pay compression is when there's very little difference in pay between workers who have different levels of skill, experience, or responsibility. Something like your senior engineer making almost the same as your mid-level engineer, or a team lead making almost the same as the people who report to her. When this happens, the pay stops reflecting what each of those roles is worth to the business and the added responsibility and accountability that comes with it.
It usually happens because starting pay for new hires goes up faster than the small annual raises you give your existing employees. You hire someone new at whatever the market is charging today, while your existing team has been moving up in small increments, the typical 3% to 5% per year, and after a few hires the gaps close up.
Pay equity and pay compression both come from the same place, which is making compensation decisions without deciding first what each role is worth to the company.
What Causes Pay Compression
There are six causes I see over and over again. They’re split between external and internal.
External causes:
- Rising market rates. In a competitive job market you have to pay higher starting wages to attract new talent.
- Minimum wage laws. When the government raises the minimum wage, entry-level pay goes up, and nothing automatically raises the pay of your senior staff.
- Inflation. When costs rise quickly you end up adjusting your low-end pay scales to keep up with the cost of living, and the top of the scale doesn't move with it.
Internal causes:
- Small annual raises. Low merit increases or small cost-of-living bumps don't keep pace with what the outside market is doing.
- Stagnant pay structures. Outdated salary bands and rigid compensation limits stop your managers from fixing a gap even when they know it’s there.
- Inconsistent pay practices. Ad-hoc salary bumps for a specific hire or a specific promotion, made without looking at what everyone else in that role is making.
What It Cost This Founder to Fix It
Let me go back to that company and tell you what we did, because fixing the issue cost the founder less than he expected.
His instinct was to bump up the base pay for his senior account executive to settle it and move on. But I told him that would work for a short while, and then he'd be in the same position with every new hire, so I recommended we start somewhere else.
The first thing we built was a compensation philosophy. That's a set of decisions you make once, in advance, about how you pay each role. For example, you decide how pay is distributed between base salary, commission, or bonus; and why. In sales you want the upside in performance-based commission rather than in base pay, because a high base with a cap on commission tends to make people comfortable, and the whole point of a sales incentive is to keep someone selling.
Then we built a salary framework for each role that was anchored by market data, and it listed the criteria that decide where a person sits inside that range, which included things like performance, experience, and impact. From that point on, there was a clear and consistent way to justify why someone was paid what they were paid, and it was all documented. For example, if someone performed better than their peer in the same role, they could earn up to 5% higher in the range.
We ran the senior and junior Account Executives through the salary framework. The senior employee went from $100,000 to $110,500, which is a raise of 10.5% and a cost of $10,500 a year. The new joiner stayed where he was, at $95,000, which is where the model placed him anyways.
Now compare the additional $10,500 a year to what the other option was going to cost the founder.
The senior account executive was bringing in more than $5 million in annualized revenue. If she left, that pipeline would take an immediate hit, and the new joiner was still onboarding so there was nobody to cover it. It had taken the company about 3 months to find and hire their account executives. So assume it took them another 3 months to replace her, then add onboarding and ramp up time on the other end, and you're looking at 6 to 8 months before a replacement is able to produce at a comparable level.
So the choice was $10,500 a year against 6 to 8 months of lost revenue in the range of two to three million dollars.
"That's Just the Going Market Rate"
Here's a common objection I get almost every time I’m discussing this with founders.
They’ll say something like this: “I had to pay above my pay band to land this person, that's just what the going market rate is. If I level everyone up every time I make a competitive hire, my payroll will balloon.”
There are three problems with that logic.
The first problem is that if you're saying this, then you don't have a pay band. When you decide compensation for one candidate at a time, then you don’t have a standardized methodology to base all of this on.
The second problem is the definition of market rate. Market rate comes from research against companies of a similar size, in a similar industry, in a similar location, and it accounts for the scope of the work and the person's credentials. What a candidate asked you for on a phone call is one number from one person who wants more money.
The third problem is that the whole conversation is revolving around base pay. What you're offering is a total compensation package, and that includes base pay, commission, bonuses, and benefits. When base pay is the only number you focus on, you are devaluing the rest of the components of your compensation package.
Then there's the budgeting problem, which is the one I push hard on if you are concerned about the cash runway. Market rates for talent are always moving. If you price every hire from scratch, you can't budget your hiring at all, and you'll come in over budget every time, because candidates will always ask for more money when they can. This is the same discipline problem that shows up when companies plan headcount without planning the cash behind it.
In the last five years I've sat in at least 50 of these salary negotiations. Most candidates focus on base pay and other forms of cash compensation. Every time I moved the conversation to total compensation and showed them how we make pay decisions, what the role can earn, and what the career path looks like, more often than not they accepted the offer on the table. Where there was still a negotiation, it happened inside a range we'd already set and already budgeted for.
So a compensation philosophy with real pay ranges will save you money. It lets you plan, and it protects your runway.
Rank Your Roles Before You Price Them
I used to believe that people higher up in the organization, with more seniority, should make more money by default. I don't believe that anymore.
Compensation should match the impact that the role and the person deliver together. A critical role delivers much less if you have the wrong person in it, and your most talented person delivers much less in a role that doesn't match their skills or what the business needs.
So I'm comfortable paying a senior engineer more than a director in another function, especially if that engineer is building the features and services that generate revenue.
This is why I ask companies to rank their roles by importance before they touch a single salary number, and to do that ranking based on how each role helps the company hit its goals, as opposed to sticking to the hierarchy from the org chart.
What Pay Compression Costs You
There are two ways in which pay compression can cost you as a startup.
First, it creates a flat company where most roles are paid about the same. I've worked with companies where the Executive Assistant made almost the same money as a junior engineer, who made almost the same money as a Product Manager. Those are three different jobs with three different levels of impact, and in a software company there's no arguing that the Product Manager and the engineer move the business more than the Executive Assistant does. When you pay them the same, you take yourself out of the running for good people in the roles that matter most, because your money isn't going to the positions with the biggest upside.
Think about what that means for an e-commerce company that manufactures and sells its own products. Logistics and supply chain can sink a business like that, so you want the best supply chain team you can afford, and the ranges for those roles should sit clearly higher than the ranges for other roles. If the market average for a Logistics Manager in your industry is $80,000, you might decide to pay $90,000 or $100,000 and start your minimum at $80,000. That range is a statement about what the role is worth to your business. On the other hand, a Warehouse Assistant is not a critical role for this company and they can decide to pay at or below the market based on what the total compensation package looks like.
Second, pay compression narrows your salary ranges because they’re being squeezed from the bottom up. When you end up with only 10% between the bottom and the top of a range, you're paying nearly the same money for genuinely different skill sets.
Companies that carry both problems for long enough end up in one of two places:
- Some of them realize that they're overspending on talent across the board, and that realization usually arrives alongside serious headcount reductions, and only then does anyone go and look at the comp structure.
- Others find they can't attract senior talent into the roles that matter, so they plateau and get stuck at a level of growth they can't get past. The people they attract match the compensation they're offering rather than the ambition they have.
How to Spot Pay Compression
Most founders never go looking for this, and I understand why. An early-stage founder is worried about growth, cash, and surviving the next two quarters. Compensation structure doesn't feel urgent until you find out you needed it yesterday.
If you're at 80 to 100 employees with several people in the same role, and you already have job levels inside a function, then you’re testing salary distribution. Look at the gap from one job level to the next. In other words, compare the salary of your most junior engineer to that of your most senior engineer, and do the same for every role in between. If the step from one level to the next is under 15%-20%, you likely have compression, because your pay ranges aren’t moving with the responsibility and impact that come with these roles.
If you have anywhere between 30 to 50 employees, then running that same test doesn’t work at your size because most of your roles have one person in them. So there are two other checks you can do instead:
- Compare where each role ranks on pay versus how you ranked it on business importance. For example, if you ranked a job number 5 in importance but it ranks as number 20 in pay, it’s likely you’re overpaying for roles that are not critical to your business while underpaying for those that are.
- If you see two roles that have very different levels of impact on your business but their pay is almost the same, you have found pay compression.
An important reason to check these proactively is that you almost never fix pay compression in one shot. You fix it by planning ahead and working through it over several months, so the earlier you find it, the more options you have and the cheaper it is to fix.
Communicating Pay Compression to Employees
Let's say you run these checks and you find a gap. Here's how to handle that conversation.
Start by making it clear that the underpayment wasn't deliberate, and prove that by grounding everything you say in market data and in the numbers your company found. Lead with what you learned, and keep the apology and the budget explanation out of it.
Here’s an example: “We recently benchmarked compensation across the company, and we found that your role needs to be at $110,000 rather than the $100,000 you're on today. Here's our plan for getting you there.”
Then you commit to a timeline depending on the size of the gap and how many people are affected:
- Close a small gap almost immediately. For a gap of 5%-10%, depending on how many people are involved and what it does to your budget, this should happen right away or within a very short period of time.
- Close a larger gap within a quarter. When the gaps are bigger or more people are affected, a quarter is what I usually recommend, assuming the budget and runway can sustain it.
- Phase out anything above 20%-25%. For gaps that size, make gradual increments over 6 to 12 months, assuming the cash allows for it.
Some of you will find a gap that you can't fund in the near future. Even so, you still have options, because you have more to work with than base pay. Additional equity is a good incentive when the company is growing but can't carry a higher payroll. Profit sharing works too, and in some ways it works better, because the payments only happen when the company is making more money and it gives the employee a stake in getting there.
Whichever road you take, put a plan in place and communicate it. If you stay silent, your employees will assume the worst case and start looking for other opportunities, and as I mentioned earlier, this means that you'll bear the full price of the problem without spending a fraction to fix it.
Most importantly, only commit to a plan you can execute. I'd rather you promise a 6-month phased correction and hit every milestone instead of promising a fix this quarter that you end up missing.
The Audit You Can Run This Week
Here's what I want you to do. This entire process takes anywhere from 2 to 4 hours depending on the size of your company.
- Build a simple compensation spreadsheet. List every employee, their job role, and their current base salary. Add columns for any other compensation such as bonus and commission so you see the whole picture.
- Rank your job roles. Create a new tab within that same spreadsheet and list all your job titles without employee names, and rank them by most critical to least critical to the business.
- Cross-check the two rankings. Compare those two lists side-by-side. Is your highest-paid role also your most important role? If the lists don't match, you’ve found a compensation problem.
- Highlight the mismatches. Mark the people in roles that you ranked as high importance but who have lower pay. That’s your first signal of where you might be underpaying your most important people.
- Invest in market data. Comp data providers like Salary.com or PayScale sell benchmarks per job for a couple hundred dollars. Just buy data for your 10 to 15 most critical roles. If you already use HR software like Lattice or BambooHR, then you might already have access to compensation data depending on your subscription tier.
- Plot your pay ranges. For any team with more than one person, check the gap between the lowest and highest paid. If that gap is smaller than 15% to 20%, you have pay compression. If it’s just one person in a role, just compare their pay to the market average to make sure you’re paying a competitive wage.
- Start with the top 10% of your roles. Prioritize the roles that move the needle for your business. If they are paid below market, or if they’re making the same as less essential roles, then that's where you should start.
Frequently Asked Questions
What is pay compression?
Pay compression is when there's very little difference in pay between employees who have different levels of skill, experience, or responsibility. It usually happens because starting pay for new hires rises faster than the small raises given to people already on the team.
Why does a new hire earn more than an existing employee doing the same job?
It’s usually because the job offers were made at different times, usually months or years apart. Since the market price for the role had changed, the new employee negotiated a higher salary, and there was no set pay range to compare it to. This creates a pay equity issue, which is often the first clue that a larger pay compression problem is hiding underneath.
How do I fix pay compression at a startup?
First, rank your jobs based on how much they help you reach your goals. Then, use market data to set fair pay ranges and clear rules for where someone fits within that range. Finally, if you find any pay gaps, make a plan to fix them over time based on what you can afford.
Should I match a counteroffer or fix the whole range?
You should fix the pay range. If you just give a raise to the one person who complained, you're only putting a temporary patch on the problem. Since your underlying pricing process hasn't changed, you’ll run into the exact same issue the next time you hire someone.
How long do I have to close a pay gap once I've found it?
If it’s a small gap, like 5% to 10%, try to close it within a month. For bigger gaps or larger groups, aim for the end of the quarter. And if you’re looking at a massive gap that’s over 20%, then break it into smaller raises over 6 to 12 months. The most important thing is that once you set a timeline, you stick to it.
