Founder Pay (or Welcome to Raw Nerve City)

That last founder brain flip post generated a bunch of emails and some comments. Thank you for the email, I've answered them all but I thought some of the general comments were worth expanding on.

The biggie, Founder Pay.

First, I don't believe in working for free.  There is no such thing as working for free. If you tell me you are working for free at your start up, then your start up is worth nothing.   You are working for equity in the firm and that equity has value. 

This brings up a term sheet/founder equity issue.

In lots of cases (mostly in the seed/very early stages), you will see term sheet clauses that allow for reverse vesting or company buy back of founder shares.  For example:

(It's early on Friday morning so don't yell at me about this simple/easy math example.)

Let's say that we have a seed company and I've agreed to put a million dollars in for half the company. (yeah, greedy, it's simple math, never give up half in real life, etc, etc).  That means the company is worth 2 million bucks with your half worth a million.  Typically, you will see agreements where the VCs insist that the company has the right to buy back your shares, amount reduced pro-rata over time, if you quit or get fired for cause. Cause, by the way, means stealing, getting arrested on a felony charge, etc.  You will see this right reduced over time.  In some cases, it is 24 months others 36 months. It depends on lots of things. 

The reason this is done is the idea/vision/execution is with the founder and if the founder quits, the company's value goes down.  Lots of founders get nuts about this clause and I've struggled with it myself.  In one case, I told a very good friend of mine who came to me for advice on this that, as written, I wouldn't sign it without serious modifications.  The VC in that case wasn't happy with me but it wasn't fair.

 Keep in mind, every situation is different.   Returning to our example above, let's say that the founder has been working on his idea for two years. Slaving away, working at Wal-Mart stocking shelves at night to put food on the table. We agree to a financing.  In my opinion, the founder is entitled/deserves to keep some equity for the work.  How much? That depends.  Let's say that in this case the founder needs my million to finish out the prototype, submit the patent paperwork, etc, etc, but they've gotten this far.  In that case, you say, cool, you've got half the equity. Of that, 75% is not subject to the buy back clause.  Or whatever the number is, point being the founder created value to that point, reward/protect it and reward/protect the future value.

Again, this is just an example but the point of this example is to make clear there is value to the work done and if you get a VC who doesn't recognize the value of your hard work: Run from the room screaming. Oh, and tell all your friends so they will come to me instead.

Second big issue is pay.  I agree 1000% with the email/comments about having the founder work for no pay or 20 bucks only to have the VC fund the company and then bring in professional management at "market salary".

My opinion: Founders set the tone/pace of the company and others join because of the tone/pace, not to change it.

Danger one: VC sends you a person who is trying to impress the VC instead of you. It happens and when you do the interviews with these referrals, pay attention to body language and watch for this. 

Myth one: You have to pay market (or better) to get top talent.  This is nonsense.  People who show up at a start up and want to know about the health club, paid parking, etc, don't belong in a start up. It's about creating value in ownership. I have a number of key data points in the companies I manage that have convinced me I'm right.  I have an incredible women in MusicIP (besides my daughter) that could command 10x the salary she gets but she believes and owns a piece.  At SIRIT, a publicly traded RFID company, the CEO is outstanding, bought tons of the company before he joined and is working 'below market' on the wage scale.  Paolo Boni, CEO of VFMi, is working for less than half of what he was making in his previous life. He believes.  And I can point to many many developers, receptionists, finance people, etc, that all believe.  It is not about "market" when it comes to pay.

[Side note/Story: When I joined Microsoft, I took a pay cut. In the new employee meeting, the game was bragging on how much of a pay cut you took.  I doubt that this conversation is happening today. Microsoft managed for years to keep people believing in the value vs. straight pay. Say what you will about Microsoft, this was a huge accomplishment.]

Important point one: Share the dream.  Stock Options/Restricted Stock is an important, perhaps the most important piece of start up compensation.  I believe that a huge chunk of the company needs to be in the hands of the team creating the value.  People who say, I'm not interested in options, what's the pay, are going to mess up your culture/team.  Hired guns can be consultants, paid for specific tasks and then kicked loose, no problem. But the team needs to have a stake. 

Finally the paycheck itself.  I point you to Jeremy Wright of b5. At 27 years of age, Jeremy is not an experienced CEO and over the last couple of weeks as walked into enough walls, stepped on enough third rails, to prove it. Ah well, youth.  The two reasons while I'll take a bullet for this guy? His passion and total focus on doing the right thing for the business. Jeremy CUT his pay AFTER we had a deal because when he did the budget model, he wanted some additional dollars in place for other things.  When he sold the idea to Mark Evans, Mark didn't have a pay discussion, he had an equity discussion and is now drinking lots of b5 Kool-Aid.

As a founder, set your pay to mirror what the company can afford. It is not about what you need, what you want, what is market, what is fair, etc.  It is about the company. 

Don't work for nothing, don't give away your equity and do the right thing for the company are the three pillars that you should based the discussions around.

Thanks for the email and comments, please keep them coming.

Comments

[Jeff Persch]

Thank you so much for this post. Does this mean I shouldn't have quit my job and should now get a job at Wal Mart until I find funding?

[Rick Segal]

Hi Jeff,

I just walked out of a meeting with two founders. One of them is working at Canadian Tire (Canada's Wal-Mart) in the back room. :-)

So, there you go...

[Matt]

First, regarding the previous post, how does one go about "loosing money"? Second, does your firm follow the "2 and 20" market rule, or do you take a 0% management fee? I think that it is important that all founders understand that they will get screwed at some point during company creation. Equity and passion are both important in launching a company, but a founder also needs to hedge her position. Remember, most founders are holding common stock while investors are holding preferred stock. This means that a founder's 2 years of "sweat equity" (i.e. $60K+ in lost wages) is completely unprotected and that a weak exit could leave her with nothing. Furthermore, keep in mind that "no exits" are more common than "weak exits" which are far more common than "successful exits" – so make sure you budget for a market rate salary after taking VC. If a market rate salary doesn’t fit in the budget, then your company might not be a business.

[Gerald Joseph]

Rick's post is way beyond spot on...his post has inspired me to consider my own views and post some thoughts of my own

Matt, look at it both ways:
If you buy into the philosophy that your sweat equity is either very valuable or invaluable, then you have created preconditions that increase the difficulty of achieving a meeting of the minds with a VC.

Your position incorrectly asserts that your sweat equity has greater value than the post money equity. From an economics point of view this is an impossible assertion.

If you want to increase the value of your sweat equity, then you must therefore pursue a strategy of inflating your company valuation and securing the largest VC deal possible.

Then you may discuss with the VC, whether or not, they will allow you to sell them or an approved third party a part of your equity.

If you successfully execute such a strategy, then you would have succeeded at cashing out a piece of your sweat equity after significant appreciation.

But the conundrum that you face is that without large scale VC funding at a high company valuation, your sweat equity has minimal market value.

[Matt]

: Your position incorrectly asserts that your sweat equity
: has greater value than the post money equity. From an
: economics point of view this is an impossible assertion.

I am not sure that I follow you here. I am highlighting the difference in liquidation preferences between VCs and founders. Take Rick’s example:

“Let's say that in this case the founder needs my million to finish out the prototype, submit the patent paperwork, etc, etc, but they've gotten this far. In that case, you say, cool, you've got half the equity. Of that, 75% is not subject to the buy back clause. Or whatever the number is, point being the founder created value to that point, reward/protect it and reward/protect the future value.”

I am saying that the “protection” in this case is a phantom protection. So, the founder is not subject to egregious buyback clauses – that’s good; however, the founder still has no guarantee of recovering his lost wages in a sub-optimal exit since all his equity is in common stock. Even this might be OK, but to insist that the founder, going forward, is not entitled to a market rate salary is ludicrous. The founder should not be treated as a risk dumping ground.

: Then you may discuss with the VC, whether or not, they will
: allow you to sell them or an approved third party a part of your equity.

Interesting idea, but I am not sure that this happens much in practice. I think that having a founder try to sell a portion of their private equity (especially in a series A round) is more of a warning sign than having them budget for a market rate salary.

: If you successfully execute such a strategy, then you would have
: succeeded at cashing out a piece of your sweat equity after significant
: appreciation.

This is a “BIG IF”. Founders need to understand that VCs do not forgo market rate management fees. This is because VCs are not stupid. In this respect, founders have a lot to learn from VCs.

[Drew Meyers]

I just came across your blog today per a mention from Scoble's blog--absolutely love it so far (only read 2 posts)!!

I'm certainly no expert, but I totally agree with this point you made: "I believe that a huge chunk of the company needs to be in the hands of the team creating the value. People who say, I'm not interested in options, what's the pay, are going to mess up your culture/team. Hired guns can be consultants, paid for specific tasks and then kicked loose, no problem. But the team needs to have a stake."

The right employees will believe in the future success of a company. Giving them a vested interest in the company is the best way to ensure motivated employees. Not everyone is start-up material. In a startup, random tasks are thrown at you every which way. Not everyone likes that hectic environment--some people just like to show up at 9, know exactly what to expect for 8 hrs, then go home (that's not me). If I was doing the same thing day in, day out--I'd be bored out of my mind. I am lucky enough to work with a great team at Zillow that believes in the vision of the company, which I believe to be one of the most important factors to a companies success (tho I only have limited experience to make such a statement). If people are just working for a paycheck, chances aren't the right type of employee for your startup.

[Robert Scoble]

I'm paid, and paid well, but it's Friday night and I'm sitting on my couch with Chris Pirillo and we're both working.

If this were just a job I'd be drinking merlot at the Ritz. :-)

[Matt]

"Cause" means different things to different people, is the thing.

A VC that isn't willing to value "sweat equity" is, to my mind, a potential knife at my back, in my hypothetical capacity as someone who used to be an entrepreneur and is now just another employee. (Sorry, but when someone you didn't choose gets the authority to fire you, you're not an entrepreneur anymore no matter what percentage of the profits you still have to pay taxes on.)

On the other hand, if Rick is right about belief being an economically-viable substitute for cash, I'll never need outside money since I'll never have to pay my yet-unhired employees a competitve wage.

I mean, I'm sure Rick's a great guy. He certainly seems like one here on the blog. And no such great guy would actually structure a deal as lopsided as the typical VC term sheet. But all I see is more confirmation of the whole VC ethos of "as of today, half the profits you've been paying the mortgage with are now ours forever, plus most of the remaining half is also ours -- but we promise to gradually give that latter half back to you in installments over the next N years, assuming you never make a mistake or disagree with us during those N years, and that you from now until the end of time divert a significant fraction of the attention that used to be spent on keeping _customers_ happy and spend it instead on keeping _us_ happy...oh, and if we allow you to pay yourself a salary at all, it'll be way lower than you made as an ordinary sysadmin 15 years ago when your career was first starting out, but you'll have to keep working your ass off like an owner...at least as hard as you did to build a profitable business in a hostile climate with no outside help before we got here, but probably harder because now we can fire you for spending Christmas with your family...and in exchange we give your company (not you), up front, as much cash as you personally would have taken home in three years if you hadn't accepted our investment". In other words, under the typical VC terms (surprisingly defended by well-known-good-guy Rick) the founder is an owner when it comes time to take financial, personal, or reputation risks, or to work marathon shifts performing tasks he never willingly signed up for (in other words, in the contexts in which being an owner can suck pretty hard), but an employee in all the contexts where being an owner is a really sweet and wonderful thing that's really worth all the risk and sacrifice and extra work...and he's not an especially trusted or valued employee at that.

But the founder shouldn't THINK of himself as an employee, because that might demotivate him. Right. And I've got this lovely bridge to sell you...

Thinking those terms are a bad deal doesn't reflect a lack of commitment and belief on my part. IMHO, when a VC thinks that a company founder should accept such terms, it's the VC who lacks commitment and belief. Which is fine...if the VC had as much commitment and belief as the typical founder, he'd be an entrepreneur instead of a VC. But I'm disinclined to be lectured on _my_ level of belief by people whose behavior shows all that clearly that their only belief is in leaving all the risk and all the costs with me, while keeping half the profit and all the power for themselves.

Again...not necessarily including Rick in this group. I've never pitched to him. With luck I'll never have to pitch to ANY VC ever again, but if I did he'd probably be the one I'd want to work with. But as someone who's done the dance with Rick's professional peers, this is what "work for belief, because people who quibble over paychecks shouldn't have startups or work for them" sounds like. I worked for faith when my company's only resources were faith and code. Now that there's money as well, I expect to keep getting some of that too, and if there's an infusion of investment cash, I expect to have the right to use it to hire people to do the things needed to grow the business that I'm not personally good at. It'd be nice if those people believed as strenuously in the vision as I do, but frankly if they did, they'd be current competitors rather than potential employees. From my perspective, having the money to hire good people is the only good reason for a web-based technology company to ever get outside investment in the first place.

I'm fairly certain Rick doesn't intend that the co-founder he referred to above should have to CONTINUE working at Canadian Tire once the investment money comes in, should the deal he co-pitched get done. Nor does he seem like the type that would insist the guy quit his day job and yet not accept enough salary being paid to allow him to do so. But that's the vibe one gets from a lot of VCs, and Rick's general rhetoric here (if not his specific actions with actual founders he works with, which we don't know and aren't entitled to know the details of) purports to justify their behavior, while declaring that anyone who disagrees isn't really committed enough.

[Rick Segal]

Hi Matt,
Thanks for the long (and thoughtful) comment. I would expect somebody working at Canadian Tire that got funded to get paid enough to stop working at Canadian Tire, yes. I would further expect that founder to present me the budget which included him/her getting that pay. The point is that the founder should be driving that process, not me.

As for this notion of not valuing sweat equity, keep in mind, this reverse vesting stuff only applies at the earliest of seed stage companies as I've seen it. I've never seen the buy back in later stage deals. And, as I've said, I don't particularly like it but understand the why behind it.

In a case, by the way, where the VC does not have majority control, I am not sure I would agree with your employee comments once a VC money comes in. If I own 20% of the company, I can't unilaterally fire the CEO/Founder. I don't own the majority of shares so there is a practical issue. And, in general, first couple of rounds, I don't have massive blocks of ownership. In one 'let's see if it works' deal, I have a board seat and 6% of the company. The board seat for such a small amount is unusual but I have an excellent relationship with the team and they wanted my input.

Thanks again for the long/thoughtful comment. Always a pleasure to have you stop by.