Jay Parkhill September 4th, 2008

One of the toughest conversations I have with many startup founders is about salaries.  Founders may come from larger companies that pay them an annual salary and the idea of getting *no* cash for a significant period of time is really hard to wrap one’s mind around.  The argument goes something like this:

“I make $X currently, I know I am worth that much and I really need to get the cash.  I can defer collecting it for a little while, but I need to catch up at some point.”

My humble suggestion is always the same- don’t think about it that way.  You are building equity in a new business.  The equity is your return.  You are unlikely to see your “deferred” salary repaid in that way, so make sure you have enough stock in the business to give the upside you need and work toward making that worth something.

There are really two alternatives to this, neither of which is feasible: accruing a hypothetical salary to be repaid when some large bundle of cash hits the company’s accounts through financing or sales efforts, and taking stock in lieu of cash.

The Extra Cash Theory

The repayment on filling the coffers approach is based on the false premise that at some point there will be “extra cash” available.  This never happens.  Investors put money into a business in order to build structures that will take the business down the road.  Seeing their cash go straight through a company’s bank account is anathema- except when a founder has actually put in cash without getting stock for it.

The revenue argument is probably even worse.  Revenue is hard to come by and most businesses don’t see enough of it to justify paying back salaries on top of current ones and other business expenses.  The idea of generating enough revenue to cover accrued/deferred salaries is a fantasy in almost all cases.

Stock for Salaries

The stock-for-salary proposal is actually much worse than the extra cash idea.  What many founders don’t realize is that the IRS treats stock in that case exactly the same as cash and taxes it at the same rate.  If a founder accrues $100k in salary and collects it in stock she still has $100k in income to report.

The problem is that she has $100k worth of illiquid stock, a tax bill of $35k or so and no cash to pay the taxes.  This is not a happy situation for anyone.

No Deferral, No Salary, Just Stock

The way out of the dilemma is to give up on the idea of taking much cash out of the business in the early going.  Buy your founder stock (for cash!) at a very low price when you start the business.  That is what you get instead of a salary, so be mindful of unnecessary dilution (no “advisory” options to friends and relatives) and work on making that stock as valuable as you possibly can.  You may not see much cash for a couple of years or more, but if you are lucky the stock will more than compensate for the sacrifices made in the early days.

Tags: capitalization, founders, stock, Tax

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Jay Parkhill July 17th, 2008

This post may get a bit wonky.  I’ll do my best to keep it straightforward.

I have talked to a lot of people in my career who get confused by the value of shares of stock in a startup company.  A venture-oriented company has two or more different kinds of shares with different values attached.  Here’s how to keep them separate.

Pre-Money, Post-Money and Per-Share Value
When a company does a financing, it sets a value for the entire company- the “pre money” valuation before the new money comes in.  Let’s say the value is $10M.  If the company has 5M shares outstanding, this means that each share is worth $10M/5M = $2.00.  This is the price investors will pay to buy stock in the company.

If the investors are putting in $5M, they are buying $5M/$2 = 2,500,000 shares.  The company now has 7.5M shares outstanding, and the total “post-money” valuation is $15M.  We can see by the numbers that on a per-share basis (2.5M/7.5M) and a dollar-value basis ($5M/$15M) that the investors now own 1/3 of the company.

Common Stock vs. Preferred Stock Pricing
The part that gets tricky is that investors buy preferred stock, but the company also has common stock that it will issue to employees.  Preferred stock has superior rights, especially including a right to get paid first when the company is sold.  By convention and IRS rules, we are allowed to say that the preferred stock is worth more today than the common stock.  Thus, when we sell preferred stock to investors at $2.00/share, we can give options to employees to buy common stock at a much lower price- $0.30 or so.

This works well for the most part.  Investors want certain rights that employees don’t care about and pay extra for them.  Employees would rather get low-priced options than the preferred rights.  Everybody is happy.

But I Thought Each Share Was Worth $2.00?
The place people get tied up is comparing the enterprise valuation with the common/preferred stock differential. We valued the entire company at $10M, which meant that each share was worth $2.  At the same time, we say that common stock is not worth $2 and is only worth $0.30.  Which is true?  Both.  Here is how and when to use each number.

Enterprise Valuation is for the Big Picture and Financings Only
When we value the company for a financing, we put a value on the whole company as though it is about to be sold.  We take into account all of the economic preferences and assume that all stock is converted to common.  Every share is the same at that point.  In other words, if the pre-money valuation is $10M and the company has only common stock outstanding, each share is worth $2.  The valuation is really forward-looking to an eventual exit.

Common Stock Price is For Employees Today
Until that happens, though, we maintain different types of stock with different rights- common and preferred.  The preferred is sold based on the as-converted valuation, but the common has fewer rights and we can issue options at a lower price.  The company’s total valuation continues to be $10M and each share would be worth $2 on a sale of the company, but before that happens each share of common stock is actually worth $0.30.

The Simple Rule
The easiest way to think about this is that preferred stock is for investors and common stock is for employees.  Be aware that pricing is set differently for each.

Tags: capitalization, Financings, Startups, valuation

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