I got a great question the other day which highlights the tension that can emerge in an early stage company between VCs and entrepreneurs.
Company X - which is VC backed – has six months of cash in the bank. Almost every employee could go without a paycheck. The team is on full pay now – it’s a small team of under 10. Not taking salaries buys the company another six months. There is a major launch in about four months.
An option the team is discussing is that if the current investors won’t throw in another million now so they have room to raise money after the results of the launch, they will "self finance" the company by everyone cutting pay if the investors issue a significant additional chunk in common to the employees
What are the issues for the team in doing something like this have you seen it, when not in a "difficult" situation?
While there is no tension yet, here’s a negative view of how this could play out. The entrepreneurs ask the VCs to put up money – presumably at a certain price – in exchange for buying another six months of runway. The VCs don’t like the price the entrepreneurs suggestion (presumably it’s too high) and offer to do a bridge loan with warrant coverage or an equity round at a lower price. The entrepreneurs don’t like this, so they tell the VCs they’d rather go without salary for six months and get stock equivalent to what the VCs would have gotten (at the lower price of course) for their investment. The VCs don’t like this because (a) they aren’t getting money to work, (b) they are ending up with less, not more of the company, and (c) they potentially lose some of the control over the financing dynamics. After much handwringing (and wasted time), everyone comes to an agreement on the amount of stock the entrepreneurs and staff get for going without salary for the next six months.
Wind the clock forward. The entrepreneurs have an “ok” launch, but the valuation for the new round is lower than they expected or there is no outside lead and the VCs start talking about an inside round. The VCs have no incentive to get the valuation up in this case - they are focused on buying up more ownership, so they’d rather have a lower valuation anyway. The entrepreneurs are pissed because they just gave up salaries for six months but didn’t end up in the “better” position they wanted. The VCs aren’t appropriately sympathetic (at least in the entrepreneurs mind) to the situation – the entrepreneurs just made an investment they aren’t getting credit for.
Tension mounts. No one is happy.
While it’s a logical trade, it’s an uncertain one for the entrepreneur because there is no way to predict whether or not the launch will be successful, so fundamentally the entrepreneur is buying more runway, but not necessarily for the exchange of more ownership. Of course, in the positive situation (where the launch goes great and new investors show up willing to invest at meaningfully higher prices) this could work out nicely.
Posted in: QACOMMENTS (7)
It's all about execution. I still think the best thing to do is find some common middle ground. The entrepreneur needs to mitigate risk and hedge against a poor launch. The VC needs to hedge against an excellent launch. Ultimately it's all a bet... the key for me is the status of all of the parties (regarding alignment) after the bet has played out.
Interesting challenge. Perhaps the entrepeneurs should consider fronting the cash equivelent of their salaries over period X, and act like true investors (not staff foregoing their salaries). Seems to me, that would allow all the right financial/interest-level dynamics to remain in place.
, June 16, 2006 4:07 PM
Interesting challenge. Seems to me the entrepeneurs should consider fronting the cash to buy actual shares (board produces more common stock if required) to the tune of the salary they'd forgoe. That way all of the financial/interest dynamics can remain the same; they'd just be arbitrary 3rd party funding sources, with regular, defined, interests. They should act like investors, not staff forgoing their salaries.
, June 16, 2006 4:11 PM
I had another suggestion from someone that I thought was good - have the salary accrue as senior debt that converts into the next equity round at the same price as the financing. There are some tricky compensation / tax issues here, but given the magnitude of the dollars, there's probably a way to figure this out so the employee gets credit for his net salary and the company pays the normal taxes.
, June 17, 2006 2:03 PM
Hi Brad,
There is also the issue of creating a valuation event by trading compensation for common equity. There is particularly tricky in the 409a era. They potentially risk having to price any future options at the same price that they traded their compensation for.
Ralph
Ralph - true - although if the compensation is traded into preferred stock in the next round, the common value shouldn't be impacted by the trade (although it will be impacted by the next round valuation.)
, June 19, 2006 5:58 PM
"While there is no tension yet"
First, there certainly is tension already. If the team is so financially personally viable they can go entirely without salary:
1. why aren't they fronting the salary already, as jvaleski mentioned.
2. clearly, if there's a major launch just months away and the team is quite comfortable taking a fairly large gamble on it while the VC is clearly unwilling to take a comparatively much more modest gamble (probably the VC has soured on the opportunity since initial investment). The team and the VCs are so far apart on the underlying fundamentals of the investment that I would suggest that the relationship is going to be very difficult to continue. (I.E. the team expects substantial near-term positive improvement, while the funder is likely thinking the whole thing is worthless).
"it�s an uncertain one for the entrepreneur because there is no way to predict whether or not the launch will be successful"
But certainly the entrepreneur would be the best possible source of information (or hopefully among the best sources at minimum)on that, and they are willing to put considerable resources on that bet. Again, I think the value here would, instead of trying to structure the deal more creatively, for the entrepreneurs to find other investors more in line with their own views on the opportunity.
As we wind the situation forward, I would suggest that the funder has now likely moved his opinion of the opportunity from "worthless" to "having some value" which really should reduce the gap in expectations between funder and entrepreneur. I mean, if the funder really wants to play the heavy on an investment that's
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