My VC Nightmare - An Entrepreneur Brain Flip

If you ask 100 VCs what their worst nightmare is, I suspect (after loosing money) you will get a bunch of different answers.

Here's mine: The Entrepreneur Brain Flip (EBF)

An EBF happens when a founder wakes up one day and 'flips' into employee mode.  To me, nothing is scarier then a founder saying "It's just a job." 

This can happen for a number of reasons but the signs are pretty clear.

When you are closing a deal and the entrepreneur negotiates for his/her pay like it's a job, that's trouble. 

When I look at our investment in Healthunity, I point with pride to the co-founders (Jay/Prem). They are passionate, work insane hours, take almost no money out of the company rather took additional equity vs. cash.  Total owners and you know it ten seconds after talking to them. These guys don't talk to me about "market" CEO rates or car allowances, etc. They are the owners and do what's right with the business and then own enough of the company that is matters.

This, of course, brings me to my message:

If you don't feel like you are the owner, jezz, don't take the money; don't close the deal.  If you feel the need to fight over severance in your employment agreement and it runs 30 pages, bad start to the game.  If you worry about ' getting fired ' and aren't thinking about the business, who is right for the business, etc, etc, don't close the deal.

Yes, negotiate value, negotiate terms, negotiate the color of the toilet paper but if you brain flip into this is just a job, that's a red alert, stop the train, issue.   There is an interesting post from Gerald Joseph regarding what seed VCs look for in a seed.

No Salary Expense-Very few Startups can successfully bear the burden of salaries; restricted equity adequately diversifies the risks and rewards of a volatile Startup venture

Everyone Paid With Restricted Equity [Vestment, Performance Clauses]-restricted equity is the only currency that should be used by a early stage Startup to reward founders and employees for sustained, quality performance

I am NOT advocating everybody taking a vow of poverty. What I am saying, tho, is there's a specific mindset around what defines a Start Up and a Founder within the VC community. Make sure it is your definition.

Comments

[Aaron]

Wow. This is extremely insightful. I saw myself slowly over a three year period forced into an employee from an owner. I'll never let it happen again.

[Anon]

I think you are right to say that founders should take equity over salary, but to suggest that we shouldn't defend our sweat equity with protection against termination seems, well, ludicrous.

[sam]

oh man, you're making me depressed to be 29 with a mortgage, family and no $$ (not that the first two aren't good things). wish somebody had told me that this would have been easier five years ago.

[Parand]

Here's a great way to turn an owner into an employee: add new people to the management team at "market" rates. Nothing like collecting 0 salary for a year only to wake up to the new guy collecting market rate and getting significant equity. It may seem like the right thing for the company, but it's as good a founder flipper as there ever was.

Actually, here's a better one: higher new developers at market rate but refuse to adjust salaries of the original developers. A 20% increase in pay for the developer who was there from day 1 might seem like a lot, but it's not if you consider he took 1/2 of what he could've to work there. The guy you hired yesterday getting market is now making more than the guy who was there from day 1. If a founder can't protect the people who were in the trenches from day 1, he'll start thinking employee real fast.

Nobody wants to increase the burn rate, but you either go poverty level for all, or you go market for all. Leave it part way and you'll flip the poverty folks into employees overnight. Disgruntled employees at that.

My point is, the VC is complicit in founder flipping more often than not.

[Mike]

I agree with your views on this, but to a point. While it is true that a founder thinking in employee terms is Not A Good Thing (tm), it is also true that he has probably been working for zero return for many, many hours, and while VC funding is meant for the business to develop, IMHO it is also meant for the founders to be more comfortable in what they are doing.

If a VC comes and says 'look, here are $5 million, now go work 20-hour days for another two years, but hey, here is some restricted equity to keep you happy and feed your children', the founder may be much easier flipped into employee mode, or into leaving the venture entirely.

The founders don't need a Mercedes, a house, first-class flights, paid holidays, etc. - but they need a decent salary that compensates the hard-working hours they put into the company. I find it obscene to have the founders getting paid zip, compared to a high-profile CEO the VC may want to bring in, who will of course ask for a high salary, company car, first-class flights and so on. It wouldn't also make sense to have the employees that come on board after money getting paid a whole lot more than the founders, or employees that were there from day one.

In the end, it is a matter of striking a balance, and I don't believe in going the employee way, but I believe in getting appropriate retribution for one's work. If a VC is not willing to give a salary to a founder, that VC is probably not right for the venture, just the same as a founder asking for the moon just because he gets VC funding is also not right for the venture. The message should be comfortable bootstrapping.

[Ed Holloway]

Rick -

While founder salary is obviously a very situational number, I think everyone (including the VC community) would agree that the founder(s) should be focused 110% on building the business - NOT on how to put dinner on the table or how the mortgage is getting paid that month.

Saying that, everyone needs to have skin in the game in some form.

[Leigh]

I think there are no rules about these sorts of things and it depends upon the individuals. It is FAR easier for a 20 year old to get paid almost nothing than it is for someone with a family and responsibility. If the older person is "worth" the while and important to the end result, than I would have to go with the "sometimes you can't afford NOT to buy".

We tried working with people only for shares and in their "free" time and guess where we ended up being on everyone priorities list? Not that they didn't try, but it's hard to demand of people if you aren't paying them.

That being said, if people aren't willing to work for reduced salaries (some of our guys have taken 20K or more pay hits to come and work with us - but still get paid enough to cover their non-student bills) than they probably don't believe in the product enough.

Like i said, it's a balance.

[Christie]

So, here's what happens when a VC comes into your company. They give you money. Actually, no, they don't. They give the company money. Usually that means that they are giving themselves money because they (depending on the deal) may own a majority share in the company. They expect the entrepreneur to work for inequitable salaries (a small fraction of what they will pay the CFO that they employ to manage their funds, and less than any new senior people coming into the company). They give you shares with onerous vesting rights, which essentially gives them the right to fire the founders at any time, with little for the founders to show for it other than a high debt load built up to put food on the table. They expect the entrepreneur to devote all of their mind to the venture. When the exit opportunity comes (in its many and varied forms), they will pay lip service to the needs of the founders. And they will use the fact that low salaries have been paid to the founders to show artificially high returns to whomever buys the company.

My experience in this game is that a large proportion of the founder CEOs are fired within the first year, when none of their shares have vested, when they have put in many months or years of sweat equity, and where will have taken home virtually nothing from the business. They are left only with the knowledge that they were the originators of the concept that made the VCs richer.

I am not suggesting for a moment that the VCs don't deserve to get supernormal returns on their risky investments, and that they have no management rights, but most of the time the thing that creates an EBF is the onerous conditions imposed by the VC. If the entrepreneur's original intention was to get a market related salary out of the deal they would have found a job. It is certainly a lot easier and a lot less stressful than going the VC route. The point of departure for the entrepreneur is that they want to see their innovation turn into a commercial success.

What needs to happen is that there must be a power balance between the VC and the entrepreneur. If you want me to work at less than market rate now, then give me shares that have vested now - not a promise of shares in the future, which relies solely on the discretion of the VC. This is part of the VC's skin in the game.

Termination clauses are also important to keep VCs honest. VC decisions are often taken too frivolously mainly because there are few penalties.

The most successful (and rarest) VC deals are those where there is a balance of power between entrepreneur and VC.

Talk to 100 entrepreneurs that have been through the VC route. It will add a new meaning to the concept of rape.

[Richie Hecker]

A distinction needs to be made between a company that was earning money pre money and one that wasn't. If a compay wasn't earning money and is now taking on money, why would one expect a big salary? If a company was profitable, even if only a small profit, a decent salary would be justifiable.

Speaking from the entrepreneurs perspective, the goal is on the equity but part of the value in bringing in money is to not have to live off of credit cards and savings so I would want to cover my monthly nut.

From an investors perspective or even from the perspective of a new partner coming on board - low pay = incentive to stay.

With that said, regardless of what compensation model is used it should be consistant across the company;