May 16 2007

Compensation in Venture-Backed Companies Before They Raise Money

You’ve started your own business and you hope to one day get funded by a reputable VC (yes – there are a few of them.) You’ve got a great idea, your business plan is almost drafted, and you’ve self funded the company along with another co-founder out of savings and credit cards. You think you’ll build out a small team, create a prototype over the next six months, and then go out and raise venture capital.

In the meantime, how much do you pay yourself? Will any of this affect your ability to raise money? By now you should know the answer is “it depends” but what decisions you make here can affect your ability to raise money, so let’s look at factors that one should consider.

First of all, don’t be greedy on cash compensation. There is nothing that turns off a VC more than seeing a pre-revenue, pre-funded company where the employees are making market salaries. You might think that you are setting a compensation floor prior to a VC financing, but more likely you are just sending a confusing message about the relative importance of short term cash compensation. Since you are funding the company yourself, it also isn’t very tax-efficient as you end up paying ordinary income tax on money you have invested in the business (which you presumably already paid taxes on once before.)

Often we see founders and early CEOs not take any cash compensation until the company achieves a funding event. Remember, your previous level of compensation at your last job is not really relevant when you are just starting out a company. Theoretically – in the pre-funding stage – you are providing “sweat equity” (anyone out there remember when that phrase was fashionable) – generally VCs respect the macho entrepreneur who says “current cash comp isn’t nearly as important to me as owning more of the company.” This usually goes a lot further than “but at my last job I was earning $200,000 a year.”

What about the first few employees? Many early team members can’t afford to not get paid anything – the reality of families and mortgages exist for many startup entrepreneurs and early employees. Our experience is that the pre-funding salaries usually settle into a discount of 25% to 50% from post funding salaries (so an engineer making $100k should be willing to work for a period of time for $50k to $75k in exchange for additional equity. Of course, this presumes that the company can afford to pay anything, which is only possible if the founders are providing startup capital or an angel round has been raised. If you are really pre-funding (e.g. pre-angel round), the salary number is often a lot lower (and often approximates $0.)

After an angel round, salaries often increase, but our experience is that the best entrepreneurs keep their comp as low as possible and allocate the incremental cash to adding a few additional people to the team. Everything above applies after the angel financing and before the venture round – especially the signal that you are sending to your future investors.