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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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Jack, I have found that differed compensation schemes are often very useful. They can easily be integrated into earn-in agreements and also can be set up as convertible instruments which can give the founders a choice – to redeem the compensation as cash or take it in additional equity. Dr. Smith
Jack Jiang wrote:
Philip’s well-taken point does not help rid of the mentality of today’s investors, which was accurately stated in Earl’s initial question. Investors do understand that entrepreneurs are also humans, and that humans need to eat to survive so that profit can be made for the investors. However, when talking about money and returns, investors tend to ignore the human aspect of the business for understandable reasons. I think the compromise is for the entrepreneur to ask for a reduced salary, IOUs, and/or equity positions. The alternative will be to buy a ticket for this week’s Mega Million.
Ruth, Thanks for the comment. How would you approach the question of valuation of a pre-revenue start-up? also, how would you handle the balance between the salaries paid the founders and their equity participation? Dr. Smith
fundingroadmap.comRuth Hedges wrote:
Which ever way you want to structure this critical piece of your business.
You will find it much easyer to make these determonations using http://www.fundingroadmap.com online business plan and due dlilgence reporting system where all of these compensation schemes can be played out both ways in our virtual business plan ,due dlilgence report and proforma financials and see the best way to satisfy both the founders and the investors, which in the end is the only way you will launch a successful venture together.
Happy trails,
Ruth
Anil, Thanks for the comment. Could you either post something about your strategic investment model or, if you would prefer, we could take the conversation off-line. Use my e-mail address: DrSmith@Dr-Smith.com. I would enjoy a chance to talk to you about it. Dr. Smith
ANIL KUMAR wrote:
Dr. Earl – This is exactly one of the key components in our Strategic Investing model.
Xavier Montero wrote:
Dave, nice to meet you by here
Dr Earl: About the company “slipping” from the founders as they underperform…
Well, I think that there are 2 approaches: The one on which either part wants “the maximum” despite what belongs to the other part (which inevitably will create tension between parts) and the one on which each part assumes its responsibilities, and in this second case, it is worth that if the entrepreneurs do not match expectations, their % dips.
I strongly feel that the best deal is when each part agrees that his % will be “the proper one”. This is why when I start dealing, as soon as the valuation issue comes over the table, I always say the following to the investors:
“I’ve calculated this value into the business plan. It is clear for me that you, as investors, will want the value of the company go as low as possible to buy cheap. I AGREE WITH THAT provided a single condition:
I have done my homework and I have not placed a single ficgure in the business plan without justification. The value is substented not only in “believings” but also in press-notes of similar companies, in other performance metrics of my team in other companies, etc.
So if you want to lower the company value because you don’t see my calculations I will accept your proposals PROVIDED that you justify each change with solida data.
If you demonstrate me that the value of the company is just the half, I won’t have any problem in giving you the double percentage.
But, the first time that you “try” to lower the value without justified data, just “trying to push without arguments” then your credibility as “good investor” will drop for me down to zero.
And I only want to deal with professional people.
But I am sure you are professional. So I am sure that when you will want to negotaite the value, you will bring me solid arguments sustented in press-releases or whatever”.
Said this to the investor, I just only add:
“Do we all agree that the % will come just after agreeing the company value?”
They cannot negate this last one, so really if my % is strong is because I have good reasons and if I have weak reasons it is normal that my % dips.
NEVERTHELES….
I think that there are ways for an entrepreneur to “re-gain” percentage. For example: As many investors are willing to be in just for a certain period of time, you can “pre-agree” a “re-buy condition”. A clause like this may be a clue:
“If after 4 years, the investor wants to get out, then the entrepreneur will have PRECEDENCE to re-buy its shares at the closed price of “investment + yearly-composed 20% IRR”. Plus an additional clause saying “If that is the case, the entrepreneur will decide it the re-buy oiperation will be done personally or via auto-stock of the company or leveredged, oer whatever formula he decides”.
1) If the entrepreneur under-perfomrs at the beginning, so he looses %, but later he over-performs then it will be “easy” for him to re-buy the loosed share.
2) If he underperforms at the beginning and also underperforms later, it is “natural for me” that it is “hard” for the entrepreneur to re-get the % he lost. If the entrepreneur under-performs ALWAYS it is to be clear that he is “not very good” so things turn harder. Rather normal.
In any case, always pre-agree all the “EXIT CONDITIONS” so everybody knows the rules.
I have a sentence of myself (I don’t know if it will ever become a “well-know quote” but ir works for me in ALL areas). It says:
“It is easy to make things work. What is really really difficult is make them not fail”.
The equivalent in software is to only code the positive side of an “if” sentence, or also code “all the “else” possible cases”.
Iamgine a lottery system that has to print a prized ticket. But… what if the ticket is redimed by another terminal before it is printed? What if the printer is out of paper? What if power-off while in the middle of a print? The same in an Startup.
Dave, Thanks for the comment. What do you think of Xavier’s suggestions and my responses? I am working with a number of investors and want to find a way to deal creatively with this issue. Your thoughts would be most welcomed. Dr. Smith
Dave Scott wrote:
What I have done as full time (and then some) CEO is to accrue a deferred compensation equal to a low but reasonable pay. I don’t take it out in cash at this time but if/when the business is sold, it is paid to me off the top. Then we will figure how much “the company” made and divide based on our equity in the biz.
Craig, Thanks for your comment. I have received a lot of very good responses to this discussion – mostly in another Linked In group: Venture Capital. If you are not a member of that group, you might want to join. The discussion has been very active and largely productive. Dr. Smith
Craig McCord wrote:
Dr Smith-
Very interesting, and a clarion call for reflection and disappointment. I like the effort of weaving a picture of the answers if you take only the 2nd layer of conflict options. Thanks for the effort and for sharing
Craig McCord
c_mccord@msn.com
Xavier, Thanks for two great additional comments. I like your analysis very much but have a question – what is the approach that should be used to arrive at a valuation for a pre-revenue company? The valuation is the key to your structure. I have taken the position that the proper valuation for a pre-revenue company is the sum of the inward investment plus some small amount for the founders. But that approach envisions an aggressive ‘earn-in’ ability for the founders based on achieving or exceeding performance metrics. The more traditional approach, fabricating a valuation based on expectations which assume the achievement of these metrics had several major problems – the biggest of which is the founders inability to perform up to expectations. This can occur because they are simply not up to teh job. but it can also occur because of unforeseen developments or obstacles. The normal solution to this frequently occurring situation is increasing conflict between the investors and founders and often results in an aggressive cram-down of the founders – particularly if additional inward investment is required. My experience is that, once this process begins, founders see themselves as being under siege and their company as slipping away from them. The relationship between investors and founders becomes strained and the good faith that was there at the beginning can erode. One of the reasons that I started this conversation was to explore better ways of setting expectations and agreements. What would you suggest as an approach to valuation and structure that might accomplish this? Dr. Smith
Xavier Montero wrote:
About the performance metrics, I think that the optimum should be take just 2 or 3, at most 4 “key values” on the plan. In my case, we sell advertising of thirs party FM radio stations.
As an example, my current metrics are “number of stations”, “number of comission-base salespeople in the street” and “monthly sales”.
A way to include the % of share as a function of it is the following: Split the investment in 2 parts. Say investment of 200.000 can be done in 70.000 + 130.000 for example. The investment is done in a private document, and the first money from the investor is placed as “debt” for X months. After that time, an “evaluation is done” and the investor chosses to make the follow on (put 130.000 more) in the case you “perform or over-perform” or decides not to continue (in the case of underperform).
At that moment you “officialize” a total of Capital Increase of 200.000, 130k of which go “against cash” and 70k go “against debt” so the debt disappears and all the 200k get “equity”.
Nevetherless as the “officialization” is delayed X months, then you can “adjust” the performance and say “the new 200.000″ are in exchange of X new shares or Y new shares adjusting the % of equity the investor takes.
Also if you inderperform, the investor takes less risk: On one hand only puts you 70k instead of 200k (more attractive to him) and even if the company goes bankrupt, his is “more senior” at taking anything from inside the company (he still was not not upgraded to equity). This is a very attractive formula to investors while helps you raising capital really warranteeing the investor you’lll do everything in your hand to get the performance you promised.
This formula is based on my personal experience in my current Startup. This is how I am currently closing my second round (to be announced in the next week or two).
Xavier Montero wrote:
Hi again. For me it is rather easy the tradeoff with 2 simple effects, one calculable, the second subjective:
Key 1) The % of the entrepreneur is nothing else but the reminder of the result of calculating the % of the investor. You, as entrpreneur, do not negotiate “I want a 78%” what you negotiate is “I’m going to give you a 12% as investor”. The 78% is the consequence.
Key 2) The % for the investor is not “a rule of thumb”. It is a function of the business plan. If you agree with the investor the figures in the business plan, you and th einvestor are agreeing also a “value” of the company probably calculated as a “discounted cash flow” over the projections. Say your “company value” is said to be 750.000 money units. Say the investor is putting 150.000 in this round. He will get 20% as 150 is 20% of 750. Suppose the original salary is planned as 40.000.
Key 3) If you modify the business plan so the CEO salary is “less”, the expenses are also less, so the net cash flow is higher, so the total company value increases. Say that by reducing the salary from a generous 40.000 to a simple 30.000 the company value grows grom 750.000 to 900.000. As the investor is putting 150k the new % is 150/900 = 17% so the entrepreneur “wins” and extra 3% in his share raising from 80% to 83%.
Key 3bis) On the counterside, is the salary was first planned at 40k but the entrepreneur after that thinks that it would help to earn 60k to avoid “family pressure” and therefore increasing its focus on the company, the businessplan must be modified. The expeses increase. The monthly cash-flow decrease. The “discounted cash flow” yields a more poor value. Say it decreases to only 400.000. Now the investors % is 150/400 = 38%. So nearly doubling from 20% to 38% the entrepreneur falls from 80% to just 62%.
This is effect 1.
Effect 2 is that lowring or raising CEOs salary and yielding a greater or poorer results also may affect the “internal return rate” so when the investor is not only looking at your opportunity but also to other projects, you may be loosing competitivty or winning force.
Key 1) Lowering CEO salary, empowers company value but also the most probable result is that you raise the IRR of the investment. So if you were first delivering a 20% of “profit” and you are now delivering a 30% of profit you are eliminating competitors that were offerring a 22% or 25% as internal return rate.
Key 2) On the other side, if the CEO wants too much salary, IRR may frop from, say, 20% to maybe only 12%. In this case the investor may also drop his interest in the company because other external investment instruments -not only companies, might for example be some kind of bonds or wahtever- might give him 15% or 17%.
Therefore, my suggestion is that when the entrepreneur builds the business plan, he should “play” with the salaries ranging from “what minimum I need to live” from “what I would really like” and pay a close attention to the results. And offer a solution to the investor that matches the investor’s expectations beforehand. If your investors are expecting 25% of IRR, do not plan a salary that gives them 22% because that would mean making the deal impossible.
Then “agree” that the investor understands that the salary is what agreed. And NEVER increase the salary until:
a) A next round, when you can do a new financial planning.
or
b) You have OVER-accomplished objectives. If your sales were told to be 500.000 and you did 800.000 then you might tell the investor what if the financial plan is reviewed.
or
c) You had planned an increase into the initial plan: Say you assign yourself X until “sales get 100.000 per month” then you raise Y. If this “was” planned, it was calculated into the IRR and % of shares, so it is also ok.
Phil Parkinson wrote:
Dr. Smith,
I think obviously the majority of the proceeds should be used to fuel the growth of the business. An entrepreneur does need a salary to sustain a living to some extent. They do deserve it since they are trading in ownership for financing and do need some sort of stream of cashflow to keep them engaged.
Regards,
Phil
Xavier, Thanks for a well thought out and very useful comment. I think that you have a very good idea on how to set compensation levels. Most investors have experience with levels of compensation in start-ups and at least some experience with what has worked and what has not. I completely agree that the compensation scheme needs to be embedded in both the business plan and financial projections and that at least part of it should be performance contingent. One of the issues that comes up is the balance between compensation and equity participation – the higher the salary, the lower the equity participation. What are your thoughts on that? Also, how would you approach the challenge of developing performance metrics to drive both the compensation levels and equity participation? Dr. Smith
Xavier Montero wrote:
The key to the answer, for me, is strongly simple:
Which amount should the business pay to a third person if the entrepreneur gets ill and must be replaced (at least for some time)?
Let’s see more:
If that replacement can be put for 30.000 then pay 30.000 to the founder. If that replacement can be put for 60.000 then pay 60.000 to the founder. Once assigned that “the amount is ok” then let the entrepreneur to freely balance if he is withdrawing that amount or he may choose, for example, take 50% and let the other % inside the company to allow “more growth” and increas the value.
3 keys:
1) The salary of the CEO is an expense that MUST be calculated inside the business plan, and the amount should be “the market” salary.
2) Entrepreneurs (like is my case) may have children to take to the school. I cannot pay the school with “future cash” neither I can buy in the supermarket the food for me and my children in exchange of “some shares of the company” so it is absolutely necessary that I can take a “reasonable” salary to pay, at least, the livin expenses, otherwise I would die. And with me died, the project will die too.
Nevertheless I am conscious I will not get a “very large salary” until I get sales of several milions and EBITDAs of some few hundreds of thousands.
3) The revenue for the “work” is “salary”. The revenue for the “risk” is “sahre value increase”. Entrepreneurs not only take risk. Also work. The difference with any other worker is that our risk is times higher, so we do not only get “salary”, but also company value. The difference with pure financial investor is that he is only taking risk, but is not working in the company. This is why he is only bound to company value and is not getting salary.
NEVER FORGET:
Any investor removing any monthly payments to the entrepreneurs is killing the entrepreneur and thus killing the investment done.
Unless the entrepreneur is allowed to have multiple “focuses” (for example run the startup but also work in another incoming stream). This way the entrepreneur has less dependence to the Startup income. But also the Startup will run half speed. This is a possible solution when invested money is rahter low.
Shahbaz Ali wrote:
Dr. Smith, you comment on business planning and projections is so true. This is where operating experience matters for an investor. Unfortunately, in the last decade of VC “gold rush”, the firms are full of young B’School MBAs. While they are very smart and dynamic people, lack of operating experience makes it difficult for both entreprenuer and investor to fully appreciate the business requirements. Generally speaking, use of proceeds is a very difficult subject and also depends on many factors including business requirements, leadership team (there are lot of people who always work for venture backed companies and it is a lifestyle for them – those do not compromise on compensation) and finally funds who are backing you – may have reserved X amount of dollars to be invested in Y years. We hope that this will change now. On the otherhand if there is a right angel with operating experience, one may find, that small money can add a lot bigger value than traditional VC model. We are seeing more of those changes in venture funding.
Shahbaz, You bring up a very good point. My experience is that the normal, adversarial approach to building investor/founder relationships is much more time consuming than the one I am advocating. The result is that the senior team spends most of its time in the money chase and the company suffers because of that. If the focus is on a business plan and projections designed to ‘sell’ the investors, the relationship is tainted from the start and almost never recovers. Dr. Smith
Shahbaz Ali wrote:
Dr. Smith, I totally agree with that. Enterprenuers need to start on low salaries and get bonuses and pay rise as the business achieves its objectives. We are in times where super bootstraping, managing KPIs and organic growth planning is what we need. This also means that any form of funding MUST be used to generate more $$$ for the business. In my experience many startups funded on Angel / seed funding have spent lot of time (> 50% sometimes) on raising money from bigger VC firms and fail to do justice and pay attention on the business objectives.
Dan, Your tendency to leap before you look – to say before you comprehend – continues. I asked you what should be the basis for compensation of founders and you resort to “here are people out here who have earned millions and billions of dollars for others running launches, and who are stepping out for themselves”. What has that got to do with my question? Are you saying that, because some have successfully created wealth, all founders should be compensated uncritically.
Perhaps you suffer from a malady that makes it difficult to actually read and respond to a specific question. So, in the spirit of fairness and to compensate for whatever disability you may suffer under, I repeat, ‘OK, I would ask, well compensated for what? For just being? For promising and not delivering? What constitutes a fair and equitable arrangement?” and please, no irrelevant polemics this time. If you do not have a reasoned opinion, please keep it to yourself. What constitutes a fair and equitable arrangement?
I work with a great many investors. They have all invested with founders who have been successful and have enjoyed the experience. They have also encountered founders with the sense of ‘entitlement’ that you seem to be advancing. “It is a privileged to invest with me – you ought to bend down and kiss my feet for allowing you to.” But these investors know that bending down has its risks and the body part that the kiss is intended for is seldom the feet.
As for me, I have had experiences with the whole range of founders and been a founder six times myself. I have celebrated my successes and with the successful and dealt with the losers – in one case, helping to introduce one to long-term accommodations with the State of New York. To lump all founders, as you do, into some blameless – nay, exalted – group is fatuous.
A discussion of the best approach to one of the largest allocations in any use of proceeds table seems prudent to me. Not only does it represent the real world of negotiations between investors and founders, it is one of the areas where the most difficulties – both pre- and post-investment – arise.
Dr. Smith
Dan Cooper wrote:
Earl, you have a powerfully negative attitude about founders. Have you made some terrible choices?
You ask “compensated for what”. Well, there are people out here who have earned millions and billions of dollars for others running launches, and who are stepping out for themselves. It’s a privilege to invest in them.
I think you have a problem of due diligence.
Sundar M wrote:
I feel its part of your negotiation which you are going to agree with the entrepreneurs. If you feel the effort they have put in is good enough to get a reward and that is within the limits, you should go ahead provided the investment is really worthy enough to take that much.
7-8 out of 10 people would not agree to that proposal. Please do understand that they are short of cash and that was the sole reason which pushed them to go seeking venture capital. So I think it would be a fair deal to make it.
Dan,
Reductio ad absurdum arguments seldom result in meaningful discussions. Nobody is suggesting that anybody should be a slave or be forced to eat cat food. See my response to Paul. The questions is how do you balance the interest of investors, who want to make sure that the funds they provide are sued in ways that maximize the possibilities of success and protect them from the possibilities of founder incompetence or malfeasance, and those of the founders, who have all the ‘real world’ obligations that all humans have and need to be able to meet them. You make the statement “founders should be very well compensated” – OK, I would ask, well compensated for what? For just being? For promising and not delivering? What constitutes a fair and equitable arrangement?
The truth is that only one in ten companies make it to their fifth anniversary. That means that investors are writing off nine out of ten of those investments by that time. That number got much worse during the bubble burst during the late 90s. Sure, some entrepreneurs are the ‘engines of capitalism’ but most of them are a waste of resources. So, you see, the questions are a bit more complex. Entrepreneurs are not all ‘engines of capitalism’, their companies do not always ‘create wealth for investors’. In the real world, things are a bit more complicated.
Dr. Smith
Paul Fitzgerald wrote:
Also, I was told over many years, and have given this advice to others – “always pay yourself first!”
Paul, The problem with extreme statements like ‘I disagree entirely’ is that they are almost never true. The point I was making centered around the use of proceeds from inward investment. Its basic premise is that investors have a right to tie the use of those proceeds to the meeting of performance metrics. This, in the face of experiences during the last couple of decades, is increasingly normal practice with most investors. So the question isn’t should a founder be receiving $500K of the investors money per year without performance metrics. It is, ‘how should investors approach the question of allocations within the use of proceeds table’? For instance, if the inward investment for a start-up is one million, how much of that investment should go to paying the salaries of the founders? This is a critical question as it directly effects the length of the runway that the company has. If the answer is half, then only $500K will be available – if it is 1/4, then the runway will be half again as long.
The issue of founder compensation has increased in importance as investors have experienced founders who were great at promoting their business as an investment but terrible at implementing and monetizing the business plan. I have been brought into companies where the CEO was earning $10,000 to $15,000 per month and producing absolutely nothing. So, if you “disagree completely”, your position has to be that all compensation to founders should be non-contingent and unrelated to any performance metrics. Is that what you are suggesting?
Finally, you make the statement, Also, I was told over many years, and have given this advice to others – “always pay yourself first!” I would point out that that is probably a good idea if it is your money or the funds come from revenues that the company has generated. But the situation I am describing is different. Pre-revenue start-ups that receive inward investment are not dealing with either of these sources. Your dictum would seem to break down if it becomes “I will always pay myself first with your money – even if I cannot demonstrate that I have earned it.”
Dr. Smith
Paul Fitzgerald wrote:
Gents,
I disagree entirely! Just because an entrepreneur starts a new business, doesn’t mean that the existing financial committments go away – e.g. mortgage, school fees, eating etc. I think it is totally unrealistic to expect the founder/s of the business to live below the poverty line just because a “wealthy” investor has provided money to a business. Perhaps if you are just out of college, then you can live on the smell of an oily rag, but I know that in my case, having just turned 50, I have financial committments that will not go away. In the same breath, investors seem to expect that any “blood” money already provided to the business (which typically doesn’t include living expenses) is not a “real” expense or contribution to the business, and therefore is discounted from the value of the business. At what point does the entrepreneur actually get to make a salary? If the directors of the business are worried about how they are going to pay the mortgage next month, feed the kids, and have a spouse griping about money, then they are not going to be focussed 100% on the business – and surely as an investor, that is what you want!
I am not suggesting that a founder should be drawing $500K, but a reasonable salary, factored into the financial plan, with performance based bonuses (agreed and measurable by the board) is not an unreasonable thing to expect.
cheers,
Paul.
asalliance.com.sgasalliance.com.sg
Ken Jacobsen wrote:
Here’s a couple of them. Art’s doing quite well with this model in Asia where some of the governments have accepted his model as a bona fide financial investment vehicle. In the US I am guessing it would be done with bonds. Look him up in Wikipedia.
http://carolinanewswire.com/news/News.cgi?database=columns.db&command=viewone&id=477
http://www.asalliance.com.sg/news_shariafinancial.html
John, I’ll start with your last point. It is one that is overlooked and critically important. The traditional approach to funding start-ups almost dictates the behavior you mention. Founders feel that they have to ‘sell’ the investment to potential investors. They put together a business plan that is more of a sales document than a business plan. The projections are designed to show a ‘hockey stick’ of rapidly increasing revenues after an initial period of relatively little income. Most management teams know this is a fiction but they do it because, in the adversarial approach, the objective is to gull the investors into providing the funding.
My number for contingent payment is far higher than 10%. I believe that the better arrangement is to construct a ‘likely’ projection that meets the needs of the investors but is prudent and then tie compensation to meeting it. Certainly entrepreneurs should not be starved during the early months but cash is going to be in short supply and any of it that goes to salaries will not be available for other uses. Start-ups are an either/or animal. Either we pay this or that. Those decisions need to be carefully thought through. Getting them wrong can condemn the company to failure no matter how good the value proposition is. Dr. Smith
John Wells wrote:
I like the fact that milestones must be met by a certain time frame. I would go so far as to say for each week the milestone isn’t met, you lose 10% of your pay. When I consult, if I don’t meet milestones that I’ve promised, I don’t get paid at all until the milestone is met. I would have it both ways so that when milestones are met ahead of time, there is a little perk (maybe additional options.) It’s key that everyone that’s part of the startup knows they have to succeed—failure is not an option. By that statement I mean that everyone is giving everything they have to make this startup successful. If not, they don’t belong to be part of it and all this should be verbalized upfront so they know why they are being let go when they stop performing.
I see it like this. The investor believes this could be a winning investment; otherwise, it makes no sense for the investment in the first place. The investor probably has partners that have put money into the pool and are trusting the #1 investor knows what he/she is doing to help all of the investors make some money on this deal. The employees of the startup will get salary and options. The options are their prize if all goes as planned. The salary is their life thread during the startup. The salary, in my opinion, should be market rates because you want people to stay with you for the duration. (It takes a good deal of time to get someone else up-to-speed when you have replace people half-way through the project—how much is that worth in lost time.) I think options can be dealt out upon meeting milestones and after each n-months of staying employed with the company. That way you earn your options along the way instead of at the beginning of the project. If you stay the entire time, make or beat your milestones, and turn the idea into a reality, you get well rewarded at the end-of-the day.
I cannot tell you how many companies I talked with (at least a 100) during the .com era where hundreds of thousands of options were promised at the beginning of the project for lack of salary. It makes no sense to me other than the idea must not be that good or one that doesn’t have a known finish line and someone is trying to make a buck on someone else’s sweat.
One last point is that investors and the key executives seem to be very secretive about the plans for the startup and I don’t think that’s a very good idea. For one thing, if it’s a generally good investment, the competition shouldn’t have time to catch up once the project begins, so it’s not going to matter who knows and when. Secondly, it’s important for everyone to know all of the items that will be in place to take the company public, sell the company, or create a large revenue flow. Too many startups begin knowing what they hope for, but no finalizing every step of how they will get there and how to get to the finish line with the product.
Orrin, thanks for the comment – I agree that founders should think very hard before removing money from the company to pay themselves. This is particularly true when those funds have been provided by investors. Dr. Smith
Orrin Xu wrote:
Startup founders should never pay themselves since they own equity in the business. At most the startup should get enough to get by but nothing more. Instead, all surplus money should be reinvested into the company.
Essentially you are investing in the future. If you take a salary, in my opinion you are putting yourself before the business and setting yourself up for failure
Ken, Could you post a link for the readers? Thanks, Dr. Smith
Ken Jacobsen wrote:
You should check out Art Lipper’s latest take on it… he is promoting what he calls “royalty participation certificates” where the investor takes a cut off the top until a certain ROI is achieved… no equity.
Ken, From my perspective, you are correct about valuations with one significant correction. The build up to the bubble bust in the late 90s was driven by your formulation – “Valuation is a calculation of the future value of an investment as a ROI”. That is, in fact, not correct and the danger of using that approach is clear in the minds of most active investors who suffered through those, and more recent, times. A valuation should be based on present value – the willingness of an individual or company to pay a certain amount for the company as it is. In this post-bust world, investors are far more interested in providing funds on that basis and allowing the entrepreneurs to build up very significant equity positions by meeting or exceeding agreed upon metrics. I have seen very successful entrepreneurs end up with 2/3 of the equity in a company by doing just that. Investors also tend to take salaries into consideration when negotiating the performance metrics and ‘earn-in’ formulas. If entrepreneurs want to take a hefty chunk of the invested cash, they will find it harder to earn a large equity stake. Dr. Smith
Ken Jacobsen wrote:
Valuations are not as simple as you state–”A valuation of a million dollars will yield a forty percent equity exchange for four hundred thousand.” Sometimes… sometimes more, sometimes less. Valuation is a calculation of the future value of an investment as a ROI. “What % of the company do I need to own to get the return I am expecting when I think I will be ready to exit?” The primary question for an investor is “how much do I believe the projections, and how much do I discount that for risk?”
Phillip, An interesting perspective – but most entrepreneurs have to have some way to pay the bills. How would you establish an appropriate minimum level? Also, how do you think the balance between salaries and equity participation should be managed? Dr. Smith
Phillip Bautch wrote:
If the entrepreneurs job is revenue generation why should they not get paid?
Many investors own stock in companies that lose money yet the CEO gets paid.(GM, Chrysler, BOA, State of CA, etc)
Jas, Thanks for the comment. How would you approach the challenge of balancing salaries with equity participation? Also, what would you think of establishing a base compensation and a formula for adding to that as performance metrics are met or exceeded? Dr. Smith
Jaspreet Dhillon wrote:
Dr. Smith,
I think that is and always will be an important consideration for any investor. Even when an individual’s money is sitting in a bank account, one has to wonder how is the bank using my money to offer me a higher ROI in terms of the interest generated….perhaps that question is not voiced as strongly given our weaker economy of late and any interest is preferred over zero.
On the flip side, without paying salaries, there is no revenue growth. Its that balance between the two demands that is so crucial. I would refer to it as a structured and balanced business growth plan where not all the profits are dumped either into payroll or future revenue generation. These two are not mutually exclusive concepts rather tied into a symbiotic dance that can either spin a company into a Fortune 500 or run it into the ground. Just my two cents!
Interesting topic; thank you!
–Jas
John, Thanks for a very well thought out and interesting comment. I suspect that we would agree on the need to pay talent adequately. My approach is to establish a base and then allow the entrepreneurs to build on that by meeting or exceeding metrics. What do you think of the idea?
One of the risks for fixed compensation is that a company can turn into a kind of country club – where the income to the entrepreneurs is increasingly justified by excuses for not performing. I do a lot of work with investors and that syndrome is much more common than you might expect. I have also seen entrepreneurs keep up the buzz long after they came to the conclusion that the company was not going to make it. One team managed to keep the checks coming for almost a year and induce the investors to put in additional funds to cover them.
One of the more difficult questions is the correct balance between salaries and equity. How would you approach that one? Dr. Smith
John Wells wrote:
I have worked for 3 startups and was directly involved with the investors with each of them. One of them is still running the same business today and the others went their own ways. What I appreciated were investors that knew employees had to build the business and allowed them to be paid for the value they possessed to the startup venture. For the companies that pushed options for lower salaries, they either got employees that were rich enough to work for peanuts, or incompetent employees that talked a good story but offered little value to the company. I believe the best approach is to invest in good people that “will” get the job done, “pay” them to make that happen, and then let the revenue generation being.
This all sounds too easy. Many investors will go after very smart people only to find out those people don’t do a good job at running the business. The new venture needs a balance so that competent business managers can protect the investors’ investment while pushing hard to get to the point where revenue can start being generated. In some cases, it’s not the revenue, but the ability to become purchased or go public. If you have competence on the top and the bottom, continued management/investor meetings to keep the focus, and paying the employees what the idea is supposed to be worth, the idea will have a much higher success rate.
What good does it do to determine the investment amount based on employees that won’t be paid well and hope they stay long enough to get the idea off the ground and into a profitable state? What happens after a few months is that employees start to get disgruntled over low pay, management/investor decisions, and the lack of progress on the project. It’s improbable to think the projects will be done fast enough to avoid this—a lot of these projects will probably take years before they become complete enough to think about the profits. Focus on few employees that are higher paid, will work hard, waste little time, and stay focused for the end windfall, but be paid enough to stay the course.
In the end, the investors will generate the most income for themselves because they have the highest amount of risk. The rest of the staff will just put in a good days work for their paycheck and not walk away with much more. Yes, there will be options that will amount to something, but in general, it will be just a job for the long haul with each person trying to support themselves throughout the journey.
Todd, You and I agree on the core principle. Investors are entirely too expensive for pre-revenue companies. Too many entrepreneurs write a business plan and then embark upon the money chase. They have little but the plan. They then attempt to inflate the valuation of the company in order to keep a large percentage of the equity. For me, this is a recipe for failure – both for the investors and for the entrepreneurs. Their initial agreement is based upon a sort of swindle and, when metrics are not met, things can unravel very fast. I also agree with you on the contingent nature of compensation. See my earlier response to Shahbaz. Dr. Smith
Shahbaz, Thanks for the comment. I agree that compensation levels should be adequate to cover the living costs of the entrepreneurs. I also suggest that compensation should be based, at least in part, on their meeting or exceeding performance metrics. The problem is not just the level but the basis for being compensated. Too many investors agree to fixed salaries independent of results. I am a fan of allowing the entrepreneurs to exceed their base compensation based on performance. What do you think of that idea? Dr. Smith
Todd Kleperis wrote:
Hopefully you never need investors. My goal from the start was to be profitable and then seek outside investors. I think way toooo many times entrepreneurs are lulled into a sleep walking pattern of Angels / Friends and Family or the proverbial VC who never appears. Get your business off the ground and Entrepreneur up. Now unless your some new bio-tech company, the next greatest pharma company or other highly capital intensive company. More people should learn how to use your own money or a select group of customers money and build out your business. Worse case – bring on another companies product as your first, sell it for a while to generate cash then invest in yourself. How’s that for radical thinking.
Shahbaz Ali wrote:
Entreprenuers and Founders need to focus on the business success and EXIT which is the ultimate goal when they get paid just like investors. Business development priority is a simple one. However there should be sufficient consideration to enable them to pay their bills. Its the last thing you want in operation – An stressed out leader who is shouting and stressing team members. Teamwork and Trust is important between Investors and founders. If those two elements dont exist, no matter how much money you invest, it simply doesnt work.
Bruce, Thanks for the comment. You make a useful distinction. My question was raised after being called in on two different start-ups with similar compensation schemes. In both cases, the entrepreneurs were taking home very substantial salaries – $10,000 per month in one case and $15,000 in the other – without any performance metrics attached to the payments. Both companies had run out of money and were facing closing if additional funding was not arranged. My recommendation was that, without a significant reduction and refocusing of the compensation of founders, additional investment was unwise. In fact, I recommended an increase in some of the areas you mentioned. In both cases for instance, the developers were being asked to float their invoices while the founders’ checks were still clearing. The core of the question focused on the compensation of founders in pre-revenue situations. What do you think is appropriate there? Dr. Smith
Bruce Hudson wrote:
While focusing on where the investment funds go is very important, most competent investors realize that a portion of funds may in some cases go towards salaries. For example, an enterprise developing a product, that have all the materials they need, but are running out of funds due to an unforeseen protraction of the development time-line, may seek venture capital to fund the finishing of the product development. Most of the investment funds in that case would go directly to salaries. Of course there will need to be pointed questions on how the circumstance came to be unforeseen, and an assessment as to how reliable completion forecasts are. More important (particularly in this example) is to assess the profitability of the enterprise and the timing and amount of the returns on investment.
My take is that each investment is unique. The most effective use of funds is dependent on the enterprise needs.
Chris, Great observation and an approach that investors genuinely appreciate. I have seen pre-revenue start-ups where the CEO was drawing $10,000 to $15,000 per month – and without any performance metrics. The results of overpaying and not connecting compensation to results are always disastrous. Using the scarcest resources – cash – to build the business is one of the areas that investors and entrepreneurs should agree on. Your suggestion is right on point. Thanks, Dr. Smith
Chris Kirschke wrote:
Negotiate a “suffucient to survive on” salary depending on how much in proceeds you take in then tie increases to revenue or strategic milestones and performance….