Startup Founder Compensation: The Good, The Bad and The Irrelevant

May 24, 2006

The issue of startup founder salaries is a tricky one.   Many entrepreneurs tend to simplify this and pick one of two extremes:
  1. Founders get no pay.  (“Salaries, we can’t afford no stinkin’ salaries…”)
  2. Founders get paid close to fair market value.  (“We raised outside capital so we could reduce our risk, might as well pay ourselves…”)

I believe that the issue is more nuanced than this and depends on a variety of factors.  Here are some thoughts on founder compensation
Startup Founder Compensation:  The Good, The Bad and The Irrelevant
  1. Investors vs. No Investors:  If you’ve raised money from angels or VCs, chances are that your salary will be governed to some degree by your agreement with them.  This should not come as a big surprise.  Investors want to protect their interest and in order to do so, they need to ensure that management doesn’t arbitrarily raise it’s salaries and extract inappropriate levels of cash from the company.

  1. Co-Founders vs. No Co-Founders:  If you’re the only founder in the company (and there are no investors), then chances are you can make the salary decision based on things like available cash, tax optimization (within the law) and fair market value.  Most bootstrap startup founders tend to minimize the salary they pay themselves as it is not to their benefit to take large salaries because of tax implications.  If there are two or more founders, things get a little trickier because each founder will now be impacted by the salary draw of the other (in essence, the founders are shareholders and as such, are impacted by the allocation of salary much like investors would be).  In this case, salaries are likely better determined as a function of fair market value (whereby each founder is working at some fraction of fair market value).  Of course, fair market value is not always easy to figure out – but based on roles, responsibilities, geographies and experience there is data out there that can be used to get reasonably close.  

  1. Deferred Salary:  I often advise startup founders that plan to raise external financing some day to allocate some “fair market value” salary to themselves, but simply treat this as a “deferred expense” item on the accounting books.  Basically, this is tracked as a liability for the company.  When an outside investment does come in, some portion of this liability may be “paid off” (i.e. cash taken off the table when the investors write the check), or it is maintained as a liability until some future liquidity event (like when the company is sold).  This often becomes a negotiation point with investors, but a reasonable argument can often be made for some fraction of the deferred salary to be paid at the time of financing.  One possible tactic to use here is to actually make a loan to the company (treated as debt) and pay some salary to yourself from that.  The debt can then be carried on the books and paid when cash is available, or converted to preferred equity when then financing occurs.  [Note:  A deeper discussion of debt, equity, preferred shares, etc. is outside the scope of this article]

  1. Founder Cash Investment Is Irrelevant:  In my mind, whether or not a specific founder invests cash in the company should not impact her salary and compensation.  These are two separate matters.  [Note to self:  Write a future article on how founder cash should be handled and how founders shares should be distributed].  So, the cash investment should likely be treated as some form of debt or equity and does not entitle the founder investing the money to a higher salary.  Further, just because founder X put in some cash (lets say $500,000) does not mean that salaries should not be paid to founder X, Y or Z.  If the cash is in, it should be treated as a resource of the company and appropriate things done with it.  Having said that, it’s important to have an agreement as to what can (and can’t) be done with initial seed investments by founders (much like you’d have an agreement with outside investors).

  1. Founder Time Is Not Free:  Entrepreneurs often make the mistake of assuming that because they’re not paying themselves, their burn rate (i.e. amount of money being lost) is low.  This is simply not accurate.  For example, if you’re running a Web 2.0 company and paying just $100/month for the hosted server and working out of your apartment with another $400/month in expenses, your expenses are not just $500/month.  Your time is worth something.  You have an opportunity cost, regardless of what you decide to pay yourself.  It irritates me when these kinds of founders claim they don’t need to worry about revenues because they can run their companies “for years” because their expenses are so low.  But, surprisingly, despite this irritation, my life goes on.  (And, not surprisingly, many of these entrepreneurs eventually figure this out and either start making money, raise more money, or shut down).

As far as magnitude goes, I think it is unlikely for a startup founder or executive to make the same amount of money at a startup as she’d be able to get at an established company.  The reason is quite simple – there’s likely a significant equity component in the equation.  Granted, if you determine the “value” of this equity by discounting appropriately for risk, it may not be that big.  But, it’s still more than zero.  In my case, I tend to use something like 25%-50% of fair market value to determine salaries (and even then, some of it may be deferred, based on cash-flows).  The rest of the FMV is made up with equity.  But, my behavior is skewed by the fact that my startups have been “internally funded” and have not had VC investments.  For VC-backed companies, I’m guessing the salary would likely be closer to 75% of FMV (or higher) based on stage of company.  Of course, one can (and should) wonder why anyone would work for < 50% of FMV for a bootstrapped startup.  The answer is that many of us actually enjoy the startup lifestyle and the autonomy, learning and energy that goes with it.  Though from a financial perspective, it may not make sense in the short-term, we still continue to do it simply because we like it – despite the long hours and roller-coaster like swings.  Note:  I’m talking here only about founders and executive management.  Others get close to FMV because their equity piece is not that large.
My biggest advice to you if you’re trying to figure out compensation for the early team is to try and base your decision on some objective standard and apply that consistently.  In these situations, it’s often just as important to be consistent and fair as it is to be “accurate”.  It’s also important to be transparent about the risks involved.  Startups, and especially bootstrap startups, are not for the faint of heart.  If you have investors, they likely have lots of experience with this and can often act as a good sounding board (not in terms of magnitude, but at least in terms of structure).
Summary of my points:  This is an important issue and can lead to much frustration if time is not spent coming up with something that is clear, transparent, equitable and reasonable.  If you’re planning on raising money, having a rational approach to founder compensation is a good way to send a positive signal to potential investors.  Sometimes, it may help to have an objective and knowledgeable third-party help work through the structure (particularly when there are multiple founders involved).

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