The Salary-Equity Trade Off

The Salary-Equity Trade Off

I just had an angel deal collapse because the investors wanted the founder to change the compensation structure of the top management team as a condition of investing, and the founder said “no.” This company provides a good example of the difference in how top management is compensated differently in an externally-funded startup from a bootstrapped one.

The company is generating revenue of approximately $900,000 per year and could triple that next year with an investment of $250,000. A group of angels and micro venture capital funds was interested in investing the $250,000.

When the potential investors looked at the company’s financial projections, however, they showed that the company would experience significant negative cash flow in 2017. The cause of the negative cash flow was compensation. The company had four top managers, including the founder, who were going to be paid a total of $500.000. Most angel and VC-backed startups at this stage would have a top management team of three, paid a total of $180,000. The top managers wouldn’t be making market salaries but would be compensated through a big capital gain from their shares and stock options when the company was acquired or went public.

The investor group suggested that the founder restructure compensation to boost stock options and reduce salary of the top four managers to $250,000 in total. The founder and the team discussed the alternative and turned down the external financing to keep the compensation structure.

This decision illustrates the complementarities that exist between ways of financing startups and top management team compensation. The term complementarity refers to a situation in which the value of something increases the value of something else. In this case, the value of an investment in a startup is higher if the startup compensates its top managers largely through capital gains rather than through salaries.

The Salary-Equity Trade Off

This company faced a strategic choice: It could grow more slowly by paying its top management team higher salaries and not take on external financing or it could grow more quickly by paying its top management team lower salaries (providing compensation in the form of shares and stock options) and taking on external investors. What it could not do is take on external investment and pay its top management team higher salaries.

The founder’s decision to grow more slowly and not raise external capital is a fair strategy. The strategy can’t be criticized.

But the founder did make a mistake in the process of implementing her strategy. She spent a bunch of time trying to raise money from investors. That was an error. If you do not want to compensate your top management team in the way that is appropriate for external investors, you should not waste time talking to them.

A founder’s time has a high opportunity cost. Whatever an entrepreneur spends time on comes at the expense of other activities. In this case, the founder could have closed another customer sale or two in the time she spent talking to investors about an investment that would not work for the company.

The lesson here is simple: Before you think of raising money from investors, think of all the changes that an external investment would impose on your company. Don’t talk to investors if you wouldn’t be willing to make those changes. As an entrepreneur, your time is too valuable to waste.

Time and Money Photo via Shutterstock

Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.