The relationship between the founder of a business and investors who back the founder in the early stages is complicated and can easily veer off course. While at first glance, one might expect that unforeseen setbacks for the business would be the most likely source of friction, that is not always the case. Most early-stage investors recognize that there are many factors outside the founder’s control and that there is always a material risk of failure. Investors know this going in and generally size their investment accordingly. The worst that can happen is that they will lose their entire investment, and they are prepared for this eventuality.
Surprisingly, a more frequent source of friction derives from a degree of success. Specifically, founders and investors sometimes fail to delineate in very clear terms the compensation that is being awarded to the founder as a result of their work, and what is deemed to be a return on investment. As a result, when the business begins to produce profits, the founder may seek to increase their compensation and the investors can feel like the founder is trying to “retrade” the original deal. An example may make this clearer.
Jim is desperate to launch a new business, but lacks the $300,000 necessary to buy equipment and fund necessary working capital. Jane agrees to make a $300,000 investment that must be repaid and will also receive a 33% interest in the equity of the business. Jim’s salary is set at $75,000 and he gets to work. Business is pretty good, and Jim finds that, after paying himself $75,000, he has a remaining profit of another $75,000. He begins repaying Jane’s $300,000 investment and after two years, he has paid it down to approximately $150,000. But Jim is straining to support his family on $75,000 and so he proposes increasing his salary to $100,000, reasoning that he will still be able to pay back Jane over time.
In this case, Jim obviously felt that his $75,000 salary was a starting wage that he hoped would increase substantially if the business succeeded. In contrast, Jane may have expected Jim to increase his salary only with inflation, earning any additional compensation through his equity, in which of course she would share 33%.
To complete the example, if Jim maintains his $75,000 salary, Jane will be paid off in two more years and then the $75,000 profit will be distributed $50,000 to Jim and $25,000 to Jane. In contrast, if Jim’s salary is increased to $100,000, it will take three more years to pay off Jane’s investment and, once it is repaid, there will only be $50,000 of remaining profit, which will be distributed $33,300 to Jim and $16,700 to Jane. The value of Jane’s long term equity interest is reduced by 33%.
The lesson is not that Jim’s request is unreasonable, it is that the full nature of Jim’s compensation for his work needs to be set out at the beginning so that the terms of the equity investment can fully reflect compensation costs over a range of expected outcomes. A more fully developed compensation plan might have included a base salary, specific guidance as to when and how much the salary would increase, and a bonus that related to profits, for example 10% of profits. This would have provided Jim a $75,000 salary that might have increased with inflation, and he would have earned a bonus of approximately $7,500 in each of the succeeding years. Most importantly, Jim and Jane need to agree that this compensation package is reasonable and that, if necessary, another executive with similar skills could be attracted by this package to come perform the job at a similar level.
There will undoubtedly be some cases where the business simply doesn’t have the cash flow to pay the founder the full wage that would be required to pay a qualified outsider in the early years. In such a case, the founder may decide that they are prepared to work for lower pay but should advise his or her investment partners of the compensation that should be provided once it is feasible. That way the investors can factor the higher pay into any investment return analysis that they may prepare.
Failure to establish a clear understanding of both short and longer term compensation expectations can be a point of friction between investors and founders. Open communication and reference to the standard of what would it take to attract a qualified third party to do the job can help provide clarity and lead to better alignment for all parties.
- Bob Gould, Executive Vice President, Principal and Vice Chairman of Spinnaker Trust
Spinnaker Trust is a Maine bank chartered as a non-depository trust company. Spinnaker specializes in investment planning, management, tax & estate planning, tax preparation, trustee services, and ESOP trustee services.
MCED Sponsors understand the important role that our organization plays in supporting Maine entrepreneurs, providing ready access to the resources needed to launch and run successful companies in Maine. MCED thanks Spinnaker Trust for their support and sponsorship.