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Dr. Earl R. Smith II
Managing Partner, The Federal Circle
DrSmith@Dr-Smith.com
Dr-Smith.com
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In the first three parts of this series I discussed major areas of focus for investors considering funding a company. Briefly, they were:
- Implementation – Are the founders implementing or just talking about implementing once they get the funding?
- The Value Proposition – How scalable is the business model, what are the margins and are they sustainable? Have the founders proven that they can monetize the value proposition?
- The Team – Is the team balanced, experienced and operating as a team? Are there weak members? Are they a team or a gaggle? What are the tracks in the snow that show that they can build and manage a company?
Generally these and many more questions have to be answered satisfactorily before a professional investor turns to the financial projections provided by the founders. Amateurs will start with them, but this is more an indication that they are amateurs than anything else. Financial projections need to be analyzed within the context of well developed and tested knowledge of the team that is providing them. Otherwise, you are looking at a series of spreadsheets that may or may not be realistic or reliable projections of an achievable future.
Projections
One of the two most dangerous pieces of software is Excel (the other is PowerPoint). They support a shallowness of analysis and a facility with manufactured fantasies that result in presentations that seem sensible on the surface but have no direct relationship with reality. ‘Investment grade’ projections are well based in direct experience and connected directly to the monetization of the value proposition. When reviewing a presentation, investors pay attention to these issues to a greater extent than to the actual numbers on the spreadsheet. Consequently, the projections that come with requests for funding tell investors a lot about the founders and their team. Most investors pay a lot more attention to the structure and attention that has gone into producing them than the actual numbers themselves.
- The Hockey Stick: There is something about this fiction that almost every entrepreneur feels a need to salute. It is a central part almost every business plan. Year one revenues are zero, year two a bit better and then, in year three, the hockey stick starts to kick in. To be fair, investors have done as much to perpetuate this fiction as entrepreneurs. It is almost considered required by both sides. Entrepreneurs are trying to establish a valuation that will cost them as little as possible for the funding. A valuation of a million dollars will yield a forty percent equity exchange for four hundred thousand. One of four million dollars will reduce that share to ten percent. But, of course, the valuations are completely fictional. There is a better way. The correct valuation for early-stage funding is the sum of the investment plus a small amount for the founders. Such an approach shuts down the con game. The founders are compensated according to their ability to deliver. Such an arrangement will contain an earn-in program that allows the senior team to accumulate equity based on performance against pre-agreed to metrics. These programs can allow the team to achieve controlling interest in the company. This approach has several advantages. First, it virtually assures that projections are achievable in the eyes of management. The days of ‘promoting’ investors into a deal using hockey stick projections quickly fades away. Second, the plan allows investors to maintain a steadily increasing value while splitting the value created by the founders and management between the two interests. Third, it establishes clear performance metrics from the very beginning; before any investment has been made. Fourth, such a plan will only be attractive to teams confident of their ability to deliver; paid consultants will wilt under the bright light. Finally, this approach melds the perspectives of both sides into a solid, working framework.
- Use of Funds: Investors generally divide the use of proceeds schedule into two broad categories. The first includes expenditures which are directly connected with the development of a going business while the second lists overhead and related expenses. The latter category includes the salaries and benefits paid, expenditures for equipment and supplies not directly related to delivery on the value proposition and other ‘perks’ that the team includes. Most investors are very leery of presentations that show a very high percentage allocated to this second category. One extreme example was a ‘Use of Proceeds’ schedule that provided for full salary payments to a fully expanded team from day one. In this case the company was pre-revenue and not expected to generate revenue for the first full year. The investors regarded this team as ‘paid consultants’ and quickly came to the conclusion that the company could not afford them. Another example was a schedule that provided for purchase of sophisticated laptops and cell phones for the entire senior team. When asked why this expenditure was necessary, the response was ‘we need to establish a successful image’. The investor, to his credit, patiently explained that such an image was established by successfully generating revenue; then showed them the door. Good entrepreneurs understand that scarce financial resources should be used in ways that generate customers and revenues. Overhead is corrosive of that objective. Investors know this and look for teams that act on this wisdom.
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99 Responses to “The Money Chase: What Does Investment Grade Mean? Part 4”
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Investors think differently at various stages of a company’s lifecycle. It is almost unheard of that early stage investors would fund salaries for the founders. The entire point of seeking funding at early stages would be to accelerate productization and market development. Founders get equity, but certainly should discuss a pay for performance model with investors in order to arrive at a risk profile that is acceptable to everyone. As the company begins to generate revenue and needs more funding to build out, then salaries can derive from profits.
To your question of the best use of inward investment, it depends on the industry and the market. For instance, in industries with long investment horizons (such as smart grid) the money might go more toward R&D and the cultivation of relationships with established entities. In a software vertical such as mobile apps, it might go more toward early reference customer cultivation, and feature set.
I think it’s also worth noting that funding may take forms other than investment by VC – and what type of event that might be would depend on the goal.
Posted by Rich Johnston
This is a very interesting question. I am in the quandry of running a startup and funding it with consulting revenue. The issue with going to an investor would be whether I can concentrate on the startup (enough to satisfy an investor) while staying on consulting revenue. If not I would need to use investor money to work full time on it. As it is I work about 60 – 80 hours per week between consulting and the startup and have now had to farm out my developers on other paying projects at least 3-6 months a year in order to stay afloat. When I am lucky I get to be paid working on projects which help to develop the software products we are building but putting me and the developers full time on the product would accelerate things dramatically..
Posted by Michael Clarke
Hello,
I like this topic.
The best way to use the money of an inward investment is to focus on investing in the actions and the people who are going to bring the project to the next milestone according to specs and within time and budget constraints.
The investors’ point of view is sometimes puzzling.
Who is going to generate the added value? And why should these people not be paid at fair market price?
There is a lot going on saying that entrepreneurs must “suffer in order to deliver” sic.
I believe that an entrepreneur is managed by her/his drive to succeed, not by the promises of good and easy life with plenty of others money to spend.
An entrepreneur is not a manager and that’s what investors have to find out and decide about when they “scrutinize” the team.
That goes for large groups as well where you can hear comments such as “if we buy the company and run it then we pay twice” (remember you exchange some cash today against some revenue tomorrow, no matter who’s doing the job.
“Our people are our best asset”! How many times have we read/heard this? Naturally, the cheaper the asset the higher the ROI? Well we also hear you pay peanuts you get monkeys.
Keep investing in ideas, and people!
Posted by Jean-Louis Roux dit Buisson
Hope that the whole world news media and reporter report this information
Dear journalists, reporters from around the world:
I started the creation of International Language Organization, I call, The whole world any one country Provide Dwelling place to the international language organization.Please report the news. Your report is the language of progress to The human being’s contribution. International Language Organization will record your achievements.
Relative to the economic and scientific development, The human being’s language development is Fall behind. Create International Language Organization, will drive The human being’s language was great progress, today’s The human being will evolve to advanced The human being.To create the International Language Organization, needs a Country Provide Dwelling place; as the United States to Provide Dwelling place as the United Nations.
Any country has the right and obligation to Provide Dwelling place, Become the founding country, this is for The human being has made great contributions to progress in the language. Founding country The whole world will be the language of the Holy Land, will be The whole world praise, will be a great honor, to increase international exchanges and friendship.
Following is introduced, International Language Organization’s basic situation:
1, International Language Organization’s Mission: to promote The whole world of Linguistic science development; promote The human being’s language progress.
2, International Language Organization’s main tasks: (a), brings together The whole world the power of each country, bringing together academics and language for each language the power of institutions to carry out linguistic research; (b), the creation of the language of most scientific theories; (c) to promote the progress of language evolution The human being; (d), to solve the problem of international communication language barrier.
3, International Language Organization of Organize way: the implementation of national membership, The whole world of any country has the right and obligation to become a member. International Language Organization invited The whole world all the linguists, language enthusiasts, language groups, to participate in language studies.
4, International Language Organization of institutions: the Assembly of Member States; Council; executive council; Chairman; Secretariat; academic research; member departments; diplomatic service; Protection of National Language Commission; Association honorary president for life (in the Lifelong honorary president of the a large number of cases, the establishment of this department). Subsidiary body of academic research: Language Sciences; the world’s common language research center; World Universal Grammar Research Center; World General Punctuation Research Center; World Language and Culture University; Language Foundation; Language Progress Award; world language forum.
Posted by gaigai lun
5, International Language Organization’s main features: between the national organization, the forces of Member States to maintain the organization, for The whole world involved in the organization that specializes in promoting language and progress of activities, not engage in other activities.
6, International Language Organization’s position: its status agreement between the Member States to determine, not to determine any country’s internal register. It determines the status of its activities are international, worldwide, does not belong to any country’s internal affairs, free from the jurisdiction of any country. International Language Organization’s relations with any country are diplomatic relations. International Language Organization’s creation is not based on Founding country’s laws, but on the idea of the founder. Founding country in accordance with the Founder’s request, to the International Language Organization to provide shelter, this is for The human being the contribution of language progress.
7, International Language Organization of Dwelling place: it determines the status of its Dwelling place is an international, not by individuals or groups should be provided by a sovereign state to provide diplomatic treatment, as did the United States to the United Nations to provide shelter. The whole world appears to the International Language Organization of a country to provide Dwelling place, mark International Language Organization to create success. Founding country must be treated to the International Language Organization: Provide Dwelling place, construction of headquarters building, necessary facilities, support and help. International Language Organization is funded by Member States.
8, International Language Organization’s honorary president for life: Anybody helps the founder (great help) , will may become the lifelong honorary president; Anybody helps the founder (general help) , will be the International Language Organization of friends.
Sincerely,
Founder gaigailun
Posted by gaigai lun
Earl – as with most things I think there needs to be some balance. Clearly, you can’t have cash starved firm allocating a disproportionate sum to executive payroll. Similarly, directed investments can’t be so narrowly focused that the investor is, in effect, abstracting the owners decision-making ability.
1.) Entrepreneurs need to be ready willing and able to take a substantial discount on their “market rate.”
2.) Investors need to remember that you’re investing in a company and people, not just a product and idea. The latter will generally wither without a motivated and focused team. I.e. people worrying about paying bills aren’t the most productive…
3.) Owners need to construct realistic operating plans which include their compensation; too often I see owners playing tricks with their P&Ls and balance sheets in order to pretty up their net and cash flow forecasts.
4.) Investors should focus less on directing inbound cash and more on supporting the owners use of it. I.e. force multiply the cash with operational and revenue generating support.
5.) Not all cash is equal – entrepreneurs need to do their due-diligence as much, if not more, than the investor; and,
6.) Identify your funding options before you need them – not only is it a distraction to be raising money when your company should be selling, designing new features et al…but you lose leverage by waiting until you’re in th red-zone to secure funding.
Posted by Matt Caston
John, I am intrigued by two parts of your response. the first – “Between the two is a debate between person and investor” – seems to put the investor in a non-person category. Although this may not have been your intention, I have seen such attitudes on the part of some founders. They see the investor as merely a bank balance and, therefor, in inhuman terms. The second – “then I consider a salary is a fair recompense against what has been given up” – is another interpretation that I frequently run across. Some founders seem to think that they ‘own’ 100% of their company and need to ‘give away’ some of that ownership in order to get funded. The truth is far more subtle. They may ‘own’ 100% but, without funding, that ownership is mostly worthless. It is somewhat like saying that flour is 100% of the bread making process because that is what you start with. But flour does not become part of bread until yeast and other ingredients are added, the correct process of mixing is followed, the heat of the oven is applied correctly and the judgment of the baker guides the process to completion. A better way of looking at it is that the founder brings some things to the recipe, the investors others and a whole range of other organizations and individuals add as well. Value is only created when these ingredients are mixed and processed in such a way as to create a viable and profitable company. Dr. Smith
I think this could depend on level of equity taken by the investor. If that whish is being invested in leaves the person the major shareholder etc and – therefore – benficiary then personal salary should not be a consideration…expenses etc etc yes but salary no.
If the person becomes a minor shareholder – say less than 25% – then I consider a salary is a fair recompense against what has been given up.
Between the two is a debate between person and investor.
Posted by John Moffat
No investor should want his entrepreneur to struggle financially (its a distraction). So, entrepreneurs are entitled to a fair salary; that doesn’t mean exhorbitant, it means what “industry source” averages would indicate. What percentage of the total is “ok” in your opinion?
Posted by Jay Fraser
I hope this isn’t a trick question… my take is that the proceeds should be invested in fine tuning and launching the vehicle(s) that drive revenue, assuming the business plan is aimed at generating revenue. To pay an entrepreneur’s salary before or during the business plan being put in motion seems too generous and optimistic, not to mention backward, for an investor to agree to… assuming the entrepreneur is pursuing a new vision and not one he or she has seen to fruition (and/or can be used as a basis for a salary based on experience and results). Now, your question is directed toward an investor approach on use of proceeds, and I would have to question any entrepreneur that requests funds be allocated to salary; I am an entrepreneur and perhaps it is ethics, business sense, etiquette, or a combination of any/all, but as an entrepreneur seeking an investor, I would think the goal is to procure and secure an investor through the potential for revenue by means of a solid business plan and (hopefully) knowledge of and proven acumen/experience in complementary… or a strong background that lends itself to driving the business plan as proposed to an investor. I would be intrigued to know of an investor or entrepreneur performing successfully in the manner mentioned, funding the entrepreneur’s living/unknown expenses rather than the business plan, provided the plan does not center on that necessity somehow. Anything is possible, but I would bet on my sweet dog- he is a bar of gold on 4 legs, that anyone operating otherwise will not be doing so for long, provided there is not a pool of investors that get a thrill out of giving money away without consideration of the return, if any. I hope I didn’t miss something and am curious to see the thoughts of others chiming in!
Posted by Kim Callaway
Dear Dr. Smith,
In my limited knowledge, I would perhaps consider putting proceeds into a 50 day profit loan account, with profit share plan extension.
Posted by Sandra Garcia
It is up to the entrepreneur to decide how revenues are put to use. That’s what the entrepreneur is supposed to do – just like the chief of any other business.
The income of the entrepreneur is vital and motivating to the entrepreneur, and a legitimate business cost. It is pure silliness to think otherwise.
The investor’s role does not include authority over the enterprise – unless the entrepreneur is selling shares in it and even then an entrepreneur wouldn’t sell the majority.
The only investor-influence should come when any contractual agreement is made regarding the conditions under which investment is made. The entreperneur might, for example, guarantee a minimum dividend. I suggest the only sensible commitments are based upon conditions of performance, profit, etc. The investor’s return on investment should be considered a benefit from the enterprise not the whole point of it.
It is the role of the entrepreneur to create new business and wealth, and to determine how best to re-invest; it is the role of the investor to sit quietly and await benefits when due.
Posted by Dave Chesworth
Dr. Smith,
I’m am all for higher salaries. However, I’m betting that when CEO asked for investors he didn’t say “Hey, Give me some money, and I’ll use it buy myself a new Tesla, and a bigger house”.
Warren Buffett is PAID $100k/year, Steve Jobs gets paid $1/year. Neither are poor (unless $5Billion is considered poverty), however, they receive their pay based on the SUCCESS of the ventures they run.
Odds are, the first few year’s profits are not really profits, they are returns on Investor’s Money. At some point they will want this money back, and if GROWTH is a way to accomplish this, then that is what should be done.
Dan
Posted by Dan Sobel
mrjeffbarnes.com|leo:2Emrjeffbarnes%2EcomAs a person looking to raise capital for my own ventures, I have asked myself, and others, this question several times. The best answer I have is that your investors must understand that in order for your venture to be successful, you cannot personally live on ramen noodles and sleep in your car.
Every investor is a person as well, and they understand that in order for you to fully commit to a project, you have to be paid a certain salary to stay afloat. That said, they do prefer that the money goes toward increasing the value of the business and thereby provide them with a decent return.
My own approach is to forecast how my business will do in a given market under certain conditions. I then detail out all the areas that my funding will go to as precisely as I can. I inform the investors that I will need ‘X’ dollars in order to run the business for a certain amount of time, and that my salary expectations are ______ during that time (fill in the blank). If properly prepared and explained, I don’t feel that investors will balk at the idea of the founder getting a small salary. However, asking for 50% of the funding be for a salary expense would be ludicrous.
The goal is to show how the investment will be used to get the company up and running, and provide me with a livable salary until the company is generating a profit. At that time, the investors will begin to see returns on their investment before my salary increases.
Links:
[ http://www.mrjeffbarnes.com|leo://plh/http%3A*3*3www%2Emrjeffbarnes%2Ecom/s74W ]
Posted by Jeff Barnes
Michael, You lost me at the end. Maybe I just am not reading you corectly. What do you mean by “money works when you don’t have a leader”? Dr. Smith
Michael Beason wrote,
Compensation should be about attention – where the founders place their attention. If they can’t pay the bills, or their car keeps breaking down, then their attention is not going to be in the right place. So short term compensation needs to make sure the founders can keep their attention on building the business. You don’t create attention by creating a “carrot” – short term attention is about what needs to be ignored day to day.
“Carrots” – improved lifestyle, longer term equity, bonus, and all forms of reward are for when you succeed. Success is about leadership. Scientific leadership in some cases, people leadership in others – but nevertheless, leadership creates companies. Most leaders that succeed are not motivated by “carrots” and “sticks” but rather by the vision. Many investors don’t know how to manage leaders – they think it’s about the money. But money works when you don’t have a leader.
Robert Clark wrote:
S&U = “Sources and Uses” of offering proceeds. It’s a critical area (which this discussion is an integral part of) along with the Cap Table, Management, governance, transparency and provisions in the shareholder rights (pre-emptive, tag & drag, etc.), that many VC’s will glance at first. If those sections aren’t done correctly, you could have the greatest idea in the world but you’re probably not going much further.
magicsoil.commagicsoil.com
John Crockett wrote:
Compensation largely based on Earned Profit: Absolutely people need to be able to cover their living expenses, to have a roof over their head and food on the table. People perform better when respected, which means their basic needs are covered, and IF collective team performance results in profits, it’s reasonable, I BELIEVE, to share the profits.
In our business plan the salaries are on the low side, and 15% of NP is budgeted for team profit sharing. That will give the team the opportunity to make a very nice income, salary + profit sharing, by delivering the profit, so it protects the investors, inspires profit. Strong LEADERSHIP will keep the focus on sustainability. Much of the profit sharing may be in equity options, with the requirement that they’ve got to hold on to it for at least X years, which places an emphasis on long term profitability, so that equity will be valuable.
I believe the investors and entrepreneurs have to have a team, Co-Create partnership. I dislike high salaries, and beleive that those in the postions that have the greatest potential for improving profits, ought to have higher ‘profit sharing codes’; with the overall profit sharing distribution being salary times profit sharing code; easy to explain showing a QuattroPro spreadsheet, than in straight text.
I’ve had some people thinking investors would oppose profit sharing, and MY view is that we’ve got a communication opportunity, to help the investors see how this protects their investment, promotes team performance.
Clearly the accounting, determination of profit has to be honest, audited, with no “creating accounting”, Bernie Madoff style.
John Crockett, CEO
Mother Nature’s Farms
Carmel, New York
http://www.magicsoil.com/success
jac@magicsoil.com
Xavier Montero wrote:
Sorry I’m Spanish, my English was learnt at school. Asking publicly to help other non-native like me when reading:
What means S&U in Robert’s message?
E.L. (Rick) Beets wrote:
@Dr. Smith, very good observation…. Could it be that some (former) CEOs are “once a CEO, always a CEO?” and can’t keep their fingers from touching the buttons? I hope not too many, then, if I can see why not everybody is cut out to sit at the sidelines (less so, when their money is involved).
Luckily some people work up a comfortably-in-the-middle compromise, anywhere along the line of hard-driving entrepreneurial meddling and distant investor attitude, as would be most suitable to each case.
Some VC I’ve been involved with, in these settings, could be comfortable in being just another team player and assuming the roles that their -entrepreneurial- partners had most use for them. That’s basically what I was referring to (Venturepreneuring) … It would seem that everybody’s input is best served if the ideas are taken to market by their motivated creators.
@Robert, those are some great pointers that you give – thanks for a most insightful contribution. I have very little VC experience, myself, and I welcome the explanation.
And, on the whole, there is much valuable learning in this discussion
Robert, Thanks for the comment. I have seen similar approaches work well – particularly with initial angel funding of start-ups and the second round funding from venture capitalists. Both investors and founders were focused on the percentage of the inward investment that went to the founders. The inverse relationship between compensation and equity participation inevitably gets into the mix as well. I also agree with you that the process is best approached openly from the start. Psychotics fretting about eating dog food seldom do well in building relationships with investors. Strutting self-adulators seem to follow the same fate. But most of the founders who approach the investors I work with do it with respect and a willingness to find common ground. They want to be in business and turn their ideas into a going concern. Most investors are highly receptive to this approach. They are in the business of deploying funds with the objective of generating a returns. Dr. Smith
Robert Clark wrote:
1) price your round correctly, with enough near term post money valuation lift to your investors against their purchase price, based on deliverables or milestones;
2) have skin in the game with a long term mutuality of interest with your investors;
3) have a reasonable and justifiable “salaries” line in your S&U that is not in excess 3-10% of your net proceeds – as you approach 10% the line item jumps off the page;
4) have enough capital at your round’s minimum escrow break to reasonably get to your target milestones that will in turn get you to your next round or your B/E point, including the paying necessary salaries that everyone seems to be worried about here, as well as contingency reserves – because something will go wrong.
VC’s want to see a founder scale out the management team and know what salary ranges are today. Quality, experienced talent costs reasonable money, not excessive.
As a founder, you should always focus on the quality of the money, not the checkbook. VC’s will be your biggest ally and best resource for key management, banking, customers and exits. If you treat your VC’s openly from the start, the question of the S&U is somewhat moot if you have done your homework and been reasonable – and “reasonable” does indeed vary by location at the metro areas are extremely expensive.
If you’re uncertain about what constitutes reasonable in any given market for a particular function, or you wish to benchmark your “founder’s salary” against a base line, call headhunters specializing in your industry in your region. They will give you key employee pay package figures for like kind pre-revenue companies, including stock and equity rights.
Ron Fleckman wrote:
Great comment. We are progressing well with our investors and each meeting quickly gets to the use of funds. We have put together a series of pie charts for identifying very clearly where investors funds are flowing Q1 through Q4 with 8 metrics both in color and identified by % along each metric. This gives the investors a very clear picture and confidence and a real opening to answer their questions.
PS. Re founder compensation, maybe we are very fortunate, but the investors that we have spoken to so far are not interested din creating additional stress on the founders. They are truly interested in us being stressed about our performance and our ability to execute on our projections.
Maybe we are just fortunate. But that approach seem to make common sense to me.
Ron
Ron
Dan Cooper wrote:
When you invest with a hedge fund, or a mutual fund, or buy stock or bonds through a broker, do you require them to live on a subsistence wage LOL? All they do is, as we follow the decades old Wall Street Journal game, is lose to random darts thrown at a list of stocks. How much of your investment does a hedge fund take? How well do they live? How have they performed?
This box of investment rules for entrepreneurs you advocate is feasible because entrepreneurs aren’t in the fraternity of self-serving finance people.
I’ve made this point before, but for those of us who have been very successful intrapreneurs, we have been paid very high salaries and perks while building corporate assets.
I’d like to hear from some HR people in this matter. Your let-them-eat-kibble philosophy, and BTW, in New York City, $100,000 a year is the poverty line, does not produce a climate within which best results will occur. That’s probably why you keep failing.
Dr. Dan
Robert Clark wrote:
An investor who objects to pay for experienced management – including a founder – in the Use of Proceeds is displaying more interest in a loan to own deal than investing in a team. I have found that most successful VC’s would rather back the A guy with a B idea, rather than the opposite. Entrepreneurs should be hungry, not starving, and their interests should be both transparent and mutually aligned to their investors.
Dave Scott wrote:
Every situation is different…BUT…some founders (and most investors also) want their cake and to eat it too. In other words, they try to get equity for their “sweat” plus a good pay package on top of that. In general the investor will think these two are see-saw factors that the more of one the less of the other.
Mark Montgomery wrote:
Scott– the issue of martyrs is indeed a problem in entrepreneurism. When so much of society feeds off of the work of the engine that enough fuel and air isn’t sufficient for combustion, then indeed we experience market failure like that of the U.S. today, which of course costs everyone but government and monopolies it seems– at least in the near term — eventually even they pay a severe price.
I am a very experienced investor, having called some of the best in history — perhaps the best track record as an analyst in venturing in terms of dollars earliest in — although I didn’t benefit from most of it, I can tell you with out any doubt that most investors are sheep and fools. Of course at the early stages very little information is available, so fools are in good company, but the broader message is most important.
Personally I could care less what other investors seek as what I seek has proven far more valuable than the best in the world. — MM
Rick, Thanks for the comment. In the late 90′s there was a filtration with successful entrepreneurs who aspired to become venture capitalists. These were people who had cashed out ahead of the bubble burst and found founding a bit too tough in the colder climate that followed. Their track record was spotty at best. Most of them are now out of the business. The main problem seemed to be their tendency to act as a ‘shadow CEO’. They had a preference for weak CEOs and were very intrusive. The model sounds logical but the limitation seemed to be that they were not able to act as an investor who was focused on generating a return for their institutional clients. Dr. Smith
E.L. (Rick) Beets wrote:
It’s a really interesting discussion and, surely, a crucial topic to all considerations of direct investment.
When one (VC, consultant, etc.) looks at any business plan or synopsis that aims to attract investors, one may already have a bit of an idea as to the percentages that will really be allotted to paying the entrepreneur’s lifestyle, etc.
One thing may be, to “cook the books” of incoming benefits from operations, yet quite another, to be robbing oneself by skimming funds that may make the difference to becoming profitable, sooner. But some will go for what seems like “easy money”, to run for the border and forget the business…
For this reason I won’t intermediate or involve myself with any contexts where investors stay outside the company, or, aren’t privy to their management and application of resources.
So, rather than traditional VC-ing, I favor “Venturepreneuring”, whereby entrepreneurs don’t gain “silent” partners but very articulate ones, who must participate with more than their money — their advice from relevant experience with and industry and type of business, active decision-making and hands-on inputs for the best possible use of the company’s assets and opportunities.
‘t Were not only to better help the entrepreneur, also to better protect one’s own investment, improving the odds of success for the business…
Tiara RONDE wrote:
Dr Smith and Xavier Montero, thank you for this great discussion. Both your blog Dr Smith and discussions which invite people like Xavier Montero to respond with such insight comments are much helpful and appreciated. Many thanks, Tiara Ronde
Dan Cooper wrote:
Isn’t it amazing and tragic to see the defensiveness of so many entrepreneurs. It’s the investors who sit on their asses and do nothing. Oh, wait, that’s right. They offer ADVICE! That’s very helpful. I wouldn’t have known where to turn for consulting from people who actually know stuff.
Entrepreneurs out there, it’s OK for you to get a nice fat paycheck for creating a major asset, creating jobs and making money for people who have too much and put some in your custody, sat on their cans and got an enormous return or, heaven forbid, a writedown on their too much money.
I think over-rich investors should consider eating dog food while entrepreneurs drive Mercedes to keep in perspective who exactly is contributing to society.
Dr. Dan
Makes billions for zillionaires and buys castles to live in
John Crockett wrote:
I believe that everyone on the team needs to be appreciated, feel appreciated, valued, in order to deliver their best. YES to goal setting, agreed upon milestones, IF the founders are at povrety level, they cannot perform up to potential, and as someone said early on in the discussion thread, killing the moral of the founders is killing the business.
That does not mean paying a fat salary, but rather something they can live on, provided they deliver value.
I’ve got 15% of NP marked for team profit sharing, with the base salaries on the low side, and the combination, PROVIDED THE TEAM DELIVERS THE PROFIT, is sweet. That profit sharing is paid on the previous period’s earned profit. That means everyone on the team has a vested interest in the team generating a net profit.
We can’t sit in front of the fire place and say: “give me heat, and then I will give you wood”. At the same time, without any heat after putting in the wood, there ceases to be any motivation.
How often do problems come up because of a lack of communication? Intestors and the entrepreneur, who is a huge investor in many cases, need to become a synergistic team, partnership, working together for the common good.
Sweat equity is very real. Many of us Entrepreneurs have bet futures to the point that we’re out of $$$ and emotional reserves, and without a working income we cannot continue to deliver. There is balance, and a need for a healthy working dialogue, communication, respect.
Dave Scott wrote:
Every situation is different…BUT…some founders (and most investors also) want their cake and to eat it too. In other words, they try to get equity for their “sweat” plus a good pay package on top of that. In general the investor will think these two are see-saw factors that the more of one the less of the other.
And…yes…I have started several businesses, including one that sold to Google for a billion dollars. Unfortunately, I sold it to someone other than Google who in turn spun it off to Google for the $1.15 Billion 14 months later after doing nothing but losing money and applying for patents on my technology.
George, that is a lot of hands – most entrepreneurs I know are a bit more decisive. Dr. Smith
George T. Haber wrote:
wow lots of opinions.. have any of you ever start a StartUp ??
I have started 5 successful companies and I could argue either way..
- From one hand people need to get payed to have the family and children insured in order to be able to completely focus on the business aspects ..
- From the other Hand there is no better prof of your confidence in your own business than working for shares !!!
- On the third Hand as long as the VC’s and Investors get payed for their work in adition to the Percentage they take in your company the Founders have every moral and legal right to be paid
- On the Forth hand you do what ever you have to do to make your business successful….
Kevin, Thanks for your comment. The key issue is, of course, balance – balance of the interests of the founders with those of the business. In the run-up to the bubble burst in the late 90′s, we have lots of behaviors like you describe. Founders were driving conspicuous consumption and competing with each other to define excess. The short-term push back was fairly severe – it was almost impossible to get a start-up funded. Now that things are beginning to loosen up a bit, the focus is on balancing the outgo to founders with the needs of the company. I recently was asked to intervene with one company. The CEO had clearly not gotten the 90′s memo. He had a big house, two cars and spent a lot of money on clothes and travel. His company was in the very early stage and was generating very little revenue. Now, he has lost his house and cars and is living in an apartment. The investors are left with a huge loss – most of which was generated by the CEO’s excesses. Dr. Smith
Kevin Curl wrote:
This is just a general comment to the initial post. Investors understand that founders need to make a living wage, now this doesn’t mean go out an buy a new Jaguar or pay off the mortgage, which some greedy individuals do. There is a tremendous amount of stress on new entrepreneurs, this doesn’t need to be multiplied several times over by bill collectors calling to get the past due mortgage or car payment. Prudent investors know that initial growth and development of the venture is built by a very focused founder; so a living wage is entirely within reason. If the idea is real and the potential is there, the big payday will come, and the founder(s) and investors know this.
Chris, The investors that i work with do not try to impose ‘ridiculous salaries’. They have too much experience to even suggest it. The gap seems to come from the entrepreneurs who think that, just because they have started a business and even through it is pre-revenue, they should be paid salaries north of $100K per year. Investors are in the business of putting money to work and reaping a return. They know that founders need an income level that allows them to cover their living expenses. They also know that there should be an inverse relationship between compensation levels and equity participation. The issue gets productively resolved when founders approach discussions about the use of proceeds from inward investment as if every expense, including their own salaries, needs to be justified in terms of an ROI. Dr. Smith
Chris Stewart wrote:
For all, if you have money in the game and work 15hr days to make it work, you should get paid something. Ridiculous salaries are one thing but we all have bills, kids, and obligations. Entreprenuership is hard enough without being paid, we are working too and longer days than most.
An investor will appreciate all efforts by all, incuding founders.
Chris
Brian, I never said that you did. My comment was based on experiences with lots of investors and how they make their decisions. They are very sensitive to the priorities of the presenting founders – they want to figure out where their ‘hot buttons’ are. Some get their lift by satisfying customers and building a business while others want to play the role of a CEO and have all the perks. In my experience, investors are not interested in keeping founders on a subsistence salary – most of them have a far more humane approach to the issue of compensation. Many do not mind higher salaries if it is demonstratively connected to production of value in the company. Many investors see the question of salary compensation as tied to equity participation. They want an inverse relationship that recognizes the sacrifices that founders make. Your last point is a very good one. Investors – particularly ones who have had lots of experience – have built in and highly sensitive BS detectors. They value traits like honesty and integrity. Dr. Smith
Brian Javeline wrote:
Actually I never said “top of the list” since that implies that it is the highest priority. Again, it depends on what amount of money we are talking and where in the process the investment is coming along. If founder salaries represent a large percentage of the investment, then Yes, I see your point. But if the salaries are a small percentage in the scope of an investment lasting a long period of time then I do not see the issue. And another point to make is “what does the founder need?” since a salary can be earned, but perhaps at a (greatly) reduced list price, etc. Too many variables that I would suggest to an entrepreneur to first include it as part of the building process, and negotiate from there. It all depends on your plan, the amount of money you need, etc. Just too generic of a topic to discount, and keep in mind, always be honest with the potential investor and this detail will work itself out.
Brian
Ashok, thanks for the post. Most investors that I work with are sensitive to the balance between salaries and equity ownership by founders. They tend to avoid founders who want both a big salary and ownership percentage. I have also found that investors tend to avoid founders who want to focus on compensation early on. Most are looking to invest with founders who are focused on building a business rather than their bank balance through short-term compensation. Contrary to what the two kids are frothing over, I have never worked with an investor who has insisted that the founders ‘take a breadline salary’. Such straw-men appeal to the feeble minded but adults realize that reductio ad absurdum arguments are just the fluttering of the feeble mind. The serious issue is how the founder approaches the discussion with potential investors and how they tie their ability to produce value in a company with their compensation. A collateral issue is how the propose a balance between salary and equity. None of these discussions are enriched by childish or extremist approaches. Founders who recognize that investors have serious and important concerns about how the funding is used and how that use generates increasing value are a step ahead of those who do not. Dr. Smith
Dan Cooper wrote:
Paul, let’s you and I go to the supermarket and buy some SUSTENANCE! LOL! “Sir, may I have another spoonful of sustenance for breakfast?” “NO Oliver, for you own too much equity!” “But I am hungry, lord. And my idea, well, I can hardly remember it my stomach is growling so loud”. “”You should have thought about that and eaten up before you had an idea, Oliver! You asked for it trying to be a capitalist!” “Woe is me. My dream of employing many American citizens and providing their families with health care, down the drain because … ” Paul…Paul … susten nn . c ….
Paul Fitzgerald wrote:
Maybe I’m missing something here. Why is it that investors who help to fund a startup company, and receive a percentage shareholding in exchange, seem to expect that the founders should only take a breadline salary or none at all, on the assumption that they have equity? Surely it is counter productive to have the founders struggling for cash, and worrying about the bills, when they need to be focussed 100% on the business. Again, I am not suggesting that the founders receive massive salaries, but they should, in my opinion, at least earn 75-80% of market rates – or an agreed amount that allows them to pay the mortgage and put food on the table etc. Naturally, the younger the founder, it usually follows that the less money is needed, but the principle is the same.
Perhaps someone can explain this to me?
cheers,
Paul.
Ashok Deora wrote:
Hi: In my view, salary to the entrepreneur is also a function of % of equity, he or she holds post investment. If the % equity is say 10%, then market rates of salary would be taken.But if the equity % is high, then a sustenance salary may be taken ie an inverse relationship between % equity and salary.
Brian, My experience is that investors avoid founders who seem to have their salary at the top of the list. They are not adverse to discussing salaries but they tend not to think that it should be in the top ten issues to be discusses. Your description of the process fits with most of my experience. Investors like founders who are focused very strongly on building a business, getting customers, generating revenues, controlling expenses and generating a profit. They will generally be more willing to see higher salaries to these types. Dr. Smith
MyOnlineToolbox.comBrian Javeline wrote:
Use of proceeds should focus on the expenses required to increase value towards the strategy. It is too difficult to say that people will be adverse to investing to pay a salary without talking about the salary itself, how much money the entrepreneur has invested themselves before, and how much they can invest going forward. A smart investor wants the business to grow and perhaps the only way to do so is for the entrepreneur’s to have a limited salary in order to survive. Or perhaps the entrepreneur doesn’t need a salary for a limited time to get to the next level. There are just too many variables for this answer to be generic since obviously the first investor for a venture with $0 in the bank will be more agressive in positioning as opposed to follow on investors who may be supporting a further along business that has already had hundreds of thousands or millions invested and now is going to the next level. The issue should not have too much time spent on it when there are other topics that an investor will care about such as “where are we now, where are we going and what will it take to get there”.
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PS. I have gone through all these steps from raising capital from my first two investors through my last two, out of a total of 12 individual investors. Never did it take a lot of my time when it came to use of funds … again, so long as I was clear on the direction of the investment goals.
Leo, Thanks for the comment. That has been my experience as well. Investors realize that founders are taking a big risk and they also appreciate that, as investors, they are better situated to survive a complete failure of the business. They generally avoid the prima donnas who are more focused on their image than building a business. One in particular comes to mind. He was full of himself, always seeking the limelight and posing for cookies from the local associations. He got a lot of press coverage but could not build a business. The investors lost all of their money and this guy is living at the margins. Dr. Smith
Leo Nacelli wrote:
I have found that investors are not against paying a fair salary, however, they will not fund your lifestyle while you try to prove your worth. With that said, once you have shown that you have skin in the game, a lower salary with performance-based payouts is a perfectly reasonable way to get compensated while telling your investors that you undertand their point of view as well.