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Giving Up Salary for Equity After VC Funding

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. 

June 16th, 2006     Categories: QA    
Brad Feld

Hi, I'm Brad Feld, a managing director at Foundry Group who lives in Boulder, Colorado. I invest in software and Internet companies around the US, run marathons and read a lot.

 
 
 
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