Jul 2015
(Based on an Office Hours)
“If the film is a hit then everyone shares the success. If it is going to be a disaster then it might as well be because of me, not because of somebody else.”
– Salman Khan
“To me, spirituality means ‘no matter what.’ One stays on the path, one commits to love, one does ones work; one follows one’s dream; one shares, tries not to judge, no matter what.”
– Yehuda Berg
It’s always impressive to see a founder who doesn’t want to sell any shares and is so invested in their companies long term success that they refuse to cash out anytime beforehand. They so believe in their companies that they want to see their shares have the most value they can. It is like someone who is going all in on a hand of poker albeit with significantly better odds. When they pull it off and their company ends up huge, you can’t help but be very impressed with them.
But empirically these people are the outliers. For the most part it is always safer to take some money off the table in earlier rounds. In fact, I advise that. Always. The benefits are implicit. If the company crashes and burns. The founders still walk away having at least been compensated for their time, even if it is at some really sucky rate.
Many a successful company has been taken out by something as left of centre as a lawsuit, market shift, preference change, algorithm change or natural disaster. A company that relies on Twitter or Facebook or Google gets totally wiped out if they change any aspect of their services. And in these situations if the founders and early employees never took money of the table, they will walk away with nothing.
But taking money off the table is actually a transaction. It’s a sale. The founders are a different entity from their business and they are selling their shares. Many inexperienced people actually believe that this means just taking company money and giving it to themselves which is totally wrong. If they literally just took company money and gave it to themselves, then they’ve just committed fraud.
I don’t believe anyone should ever walk away from a company having been burned by it and having lost money. If that happens usually someone became really greedy and screwed other people or the company was mismanaged. One of the ways to hedge in the failure prone world of startups is by making sure you reduce the times you have a negative rate of return.
The moments in a companies life that shares are cashed out and money is taken off the table should coincide with either a financing, liquidity event or a significant profit milestone. If a business is generating huge amounts of profit or raises a large amount of money, it can either invest all of it in growing or it can give some back to its shareholders. But how much to give is an often debated subject.
The broad rule is about 10% of whatever is raised in any given round or is in the profit reserves. And an absolute maximum of 20% of the amount of money raised should be used to sell the stock of earlier shareholders if the founders are in a place in life where they need the money. At the earliest stages, this goes really nicely with intentionally reduced salaries, sometimes even nothing at all.
What is really unpleasant to see is when a high flying corporate executive decides to start a company and then wants to pay themselves similar rates to what they were earning at the big company. Similarly it creates an instinctive negative reaction when I meet founders who are both earning a very large salary, own a vast majority of the shares and also don’t have a growing product yet.
Personally, in a pre-series A company I don’t believe that founders should be paying themselves a big salary with investor money. In fact, the maximum a founder should pay themselves as a salary is about $100,000 per year in the early years of their company. It’s a number that is highly correlated with successful startups.
Most of the monetary compensation is supposed to be stock, not in salary. The stock is why people go into startups. The salary is just the cost of doing business and to survive until the shares have value, which only happens when a meaningful company has been built. So you win when everyone wins and when the company wins. If the company doesn’t win, is why the practice of selling shares early even exists — to protect everyone from the downside risk of losing all their money and time.
I suspect the practice started from burnt out founders who were tired of walking away burned out from businesses that cratered and died. And investors liked it because they found that ambitious, motivated, happy, well compensated and financially healthy founders start interesting startups, grow them into great companies and provide better returns.
Mostly the way founders and employees earn money for startups are the following.
Method 1: Share Buy Back
This is where the company buys back the shares of shareholders. These shares then join the option pool of the company, the total number of shares doesn’t change, and these shares are now owned by the company and can be reallocated to people at a later date.
The company either sets a price and how much it wants to spend buying the shares then it offers that share sale price to all of their shareholders. It is an an equal share buyback whereby all shareholders are notified and allowed to sell stock back to the company if they wish.
To do this in Australia means filing Form 280 with ASIC and requires at least 75% shareholder approval.
Method 2: Share Cancellation
This is where the company simply cancels shares it has issued previously and pays out to the shareholders the value of the shares it wants to cancel. If you own a share the company is cancelling, the share will suddenly become worthless but you will receive in money what the shares were worth. The difference between a share buy back and share cancellation is that cancelled shares can never be re-issued or allocated to anyone ever again. It is effectively taking the shares off the market entirely and the total number of shares the company has is reduced.
To do this in Australia means filing Form 484 with ASIC and requires at least 75% shareholder approval.
Method 4: Share Sale
This is when early shareholders sell some of their shares to new investors. When the company is public, they are doing this through a broker or stock exchange. When the company is private, they are doing this directly with another person or entity. Usually when an investor wants to invest in a company, if they are good, they will offer some of the founders the ability to sell their stock to them.
To the investor it makes no difference since they are buying the same amount of shares anyway. But to the founder this can often be life changing. It gives them the safety net to really go for it and take a huge number of risks and try and build a juggernaut unicorn huge company. It obfuscates the downside and great things happen when a person has no downside and the ambition to maximise the upside. The investor will often get an even better return when they do this. It is penny foolish, pound wise.
Some investors actually think that by allowing founders to cash out some of their shares, they’ll then go run off and have no reason to continue. This is wrong. The founders started the company for a reason. Providing them with some degree of financial security actually makes people more motivated, not less. The ones who were going to screw you, probably would anyway and they’re just the kind you shouldn’t do business with ever again.
To do this in Australia means filing Form 484 with ASIC.
Method 5: Liquidity Event
A liquidity event is also a share sale but bigger. When a liquidity event happens, it implies all of the shares or a controlling number of shares are being sold because the entire company is actually being sold, usually to a bigger company or to the public on the stock exchange.
Big companies often buy smaller more innovative companies and buying their shares is the primary way they can take ownership of them. When a bigger company buys all the shares in another smaller company. The bigger companies have acquired the smaller company. This is an acquisition.
In an acquisition, usually all the shares are sold and all the shareholders walk away with real money and now need to pay capital gains tax on their profits. This is the promised land of why people even start companies to begin with.
Method 6: Dividends or Profit Sharing
After a company has reached a certain size and has large growing profits. It may want to spend some of its profits by giving it back to its shareholders and employees in the form of dividends. So each person is given X% of the profits usually evenly spread by the number of shares owned. So X% of the profits are paid back per share. The more shares a person owns, the greater their share of the profits will be.
Most people when buying public stocks will take the dividends into account. Shares that both pay large dividends and grow quickly are the holy ground of stock investing and are very special companies indeed because they are both generating a huge amount of profit and are growing quickly.
Dividends or profit sharing should never under any circumstances be done at a tiny startup. It is almost exclusively done by large public or private companies that have been in business for a very long time. Small startups that payout their profits back to shareholders and not use it for growing are making a colossal mistake. And investors who demand dividends from small startups are just being dicks.
Method 7: Salaries
To do this, all shareholders sign employment contracts with the company which then pays them a salary. They still own all their shares in addition to the salaries. Salaries are also the primary way non-shareholders are compensated by a company. These are the people who do all the work of the company and are called employees. The founders are really just employees of a startup.
Because it is encouraged for early startups to pay for as much as possible using its shares, thus protecting its cash which should be used to increase the startups lifespan and grow faster, the salaries are and should be significantly lower at a startup. But salaries are where a lot of the fighting in early stage companies starts to be introduced.
You see this all the time. Founders are happily working along for equity, but the moment real money gets introduced they start all freaking out and turn on each other, fighting over small amounts of money. I don’t believe salaries should ever be the motivational device in startups. Startups that compensate using large salaries, instead of say using large equity packages, are doing a disservice to themselves and setting themselves up for failure because their costs were too high.
If a company raises $250,000 or less. I don’t think they should be hiring people or paying themselves large salaries. They should instead use it to pay for the founders living expenses and little else. Paying for the living costs of a handful of founders alone, $250,000 could last 5 years. More than enough time for them to build a revenue generating business and bring it to profitability.
It genuinely amazes me seeing companies who have raised $500,000 or more only a couple years later having burned through all of it hiring expensive engineers or sales people and ramping up their costs without the revenues to back them up.
Startups win by being cheap and by not dying. People get rich when the company wins. The only time founders should ever be paying themselves large salaries is from the earnings of their company.
Companies that are profitable and generating a large amount in earnings are the only businesses where the founders should pay themselves large salaries. It is the only exception to the rule.
Summary
I don’t believe in founders earning a large salary using investor money at the seed stage. That should happen only at the Series A and it should never exceed $100,000 per year. They should prioritise living costs only until the business is generating substantial earnings and can pay them from the earnings. And if they want to take money off the table, it should come from selling their shares of which 10% – 20% should be done at every round of financing or major profit milestone so if the company fails, nobody gets burned. Everybody wins. Always.