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

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

 


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).
 
 
 
 
 
 

Posted by on Wed, May 24, 2006

COMMENTS

Another great post. I would also caution founders to be careful of not accounting for their time and investment from day one. I know you covered this, Dharmesh, but I will say that most investors will readily and easily "forget" the amount of investment you've put in when their money follows.

posted on Wednesday, May 24, 2006 at 10:57 AM by


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.

Hold it. Let's think about this. You are lending after tax dollars to the company. Then you are paying yourself a taxable salary with that money. And when the company pays you back, the interest to you is taxable. The capital pay-in idea sounds better. This is the kind of decision you should run by your accountant and when appropriate lawyer BEFORE acting. Even if they charge by the hour and just concur with your thinking, it's worth it for peace of mind.

posted on Wednesday, May 24, 2006 at 4:59 PM by Richard Wright


When paying startup team members, I've found that there are two golden rules:

1) Avoid no-man's land... pay either 75% of FMV or pay nothing at all. The goal is get the team member focused on the value of the stock, not the salary. My experience suggests that paying people at say 25% of FMV usually winds up focusing the team member on salary which creates resentment on both sides.

2) Be consistent and lead by example. If the co-founders aren't willing to work for below FMV and they have the largest slice of the pie, how can they really expect employees that don't share as heavily in the upside to make these sacrafices?

posted on Thursday, May 25, 2006 at 12:18 AM by Andrew Fife


Thanks for the comments.

Wil: I agree. Keeping track of this stuff is critical. Common rookie mistake to not track the details and account for them.

Richard: Agree with the point on taxation. This is definitely worth the time and money to get a CPA and/or tax attorney involved.

Andrew: I'm totally with you on leading by example. The article was really targeted at founder compensation (not employee compensation), and there are definitely differences.

posted on Thursday, May 25, 2006 at 12:23 AM by


One more thought with regard to taxation occurred to me.

The corporate tax rate is generally lower than the applicable individual rate, so when possible you want to legally avoid transfering tax liabilities from the corporation to the individual, and insofar as possible and allowed, you want to avoid double taxation; i.e., money comes into the corp, and it pays tax and pays the net out in salaries, on which the individual has to pay tax. Considerations like this can impact whether you want to file as an LLC or a true corporation (usually an S-Corp since a C-Corp carries with it a lot of onerous additional requirements). An accountant's advice is key in these matters, but you have to get it before you commit to action.

posted on Thursday, May 25, 2006 at 9:30 AM by Richard Wright


Dharmesh-
Your website is such a great resource for someone like me who is new to the startup world. You have done a great job so far building what has become an encyclopedia of startup tips. During these early stages of Xobni we have come to Onstartups.com for a lot of answers. The only thing I would like to see more of are specific stories from startups you have been involved with in the past.

posted on Thursday, May 25, 2006 at 7:08 PM by matt


A very nice article. It will help me a lot as I am in the process of laying the foundation of my start up ActivMOBS. Thanks.

posted on Sunday, September 02, 2007 at 12:27 PM by Vidit Choudhary


I have a hypothetical for you guys.

Two gentle start a project 4 years ago. They put a tremendous amount of work into in regards to research, and developing a business model at a tremendous personal expense to both of them plus they were successful getting through all the government red tape. The natural resource required for the project went up to an Expression of Interest from the government and they made a submittal for the resource and it looks as though they are the winning Proponent.

5 months ago they asked another gentleman to join their founders group and whereas he had more experience as a CEO in larger Corps. than either of the other two founders did they thought it best for him to take over a CEO. The 3 them done the Proposal for the Expression of Interest.

Three of them signed a Founders Agreement giving them 3 equal shares of the company pre-investor.

Now the new CEO is insisting that the two original founders give up more of their founder’s shares to compensate him as CEO before they take on investors. Even though the two original founders have put much more time and personal expense into the project than the new CEO did.

My question is:

Should his CEO compensation package be done now (pre-investor) or after investors are taken on???

Should the new CEO get more founders shares than the original founders?? If so, what amount is fair??

Any commitments would be appreciated.

Thanks

TN.

posted on Saturday, September 29, 2007 at 11:57 AM by Terry N


Great bolg and very helpful information!! Woudl appreciate receiving comments on the following : 
 
 
 
I am a tech person without any startup experience. I have an invention and partly developed technology (with patents filed) that has a promising market. I am planning to partner with someone with start-up experience, preferably an ex-CEO, to start a company and seek venture capital to commercialize the technology. I am assuming that my new partner will be a co-founder of the company. What is the split in company ownership for such situations? I have been working on this technology for the past three years and assuming that I should have major share of the company. Also, when we get new personnel involved, do we give them company shares? I am currently interviewing candidates for the partner and will appreciate any feedback on this. 
 
Thank you, 
 
Andrew 
 

posted on Tuesday, November 04, 2008 at 7:34 PM by Andrew Smith


HI, 
This is a great article. 
But i have a doubt. I an trying to get a start up from Angel Investors. So my question is how should i decide the debt/equiy ratio for my startup, assuming that i ask for 100% funding from the investors how much equity should they be offered? 
Since they are giving 100% funding, should they be given 100% equity?

posted on Thursday, April 02, 2009 at 4:52 AM by GVSN Raju


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