Why Deferred Salaries Don’t Work for Startup Founders
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.