How to structure a startup founder’s pay, remastered

Revisiting the nuts and bolts that makes up a fair discussion on founders’ pay

The worst thing that you want to happen is to end a good friendship over a failed business decision. No, just no. If there’s one thing that often breaks a relationship — that’s money. So, let’s talk about it.

Despite the strong economic pullback brought by the pandemic of our generation, startups continue to flourish. Even with frequent lockdowns, we’ve seen strong growths in cloud kitchens, full-chain ecommerce, tech-enabled logistics, and other startups that simply make our lives easier.

Several years ago, I wrote how to structure a startup founder’s pay in Tech in Asia. The article outlined a short concept on how founders should be paid for the work they do and the investment they bring in, if any.

The concept hasn’t changed.

Regardless of financial capacity, founders should be compensated for work they do and the investments they make for the business.

In this rehash of the original article, we’ll be diving a bit deeper into the framework on how startups can find a fairer way to compensate founders.

Compensation

Agreeing on compensation and its structure is the most difficult discussion in closing the deal. Either creating a startup with a cofounder or recruiting a cofounder later on, compensation discussion can make or break a partnership.

There’s one important rule that startups should not break when it comes to working with a cofounder — agree on compensation before working together.

The elephant in the room needs attention.

Startup founders tend to shy away from compensation discussion and agree-to-agree the compensation later on when the business is doing well. Nope. The difference in the perceived fair compensation can change dramatically when the business is doing well or doing hell — a heaven and hell difference. The fairest agreement should be done at the point of handshake, fistbump, or glass clinks — whenever you agree to work together.

Then there’s one important concept about compensation that you should always remember, compensation need not be paid today, at least as a founder.

Getting compensated ≠ getting paid.

It is common for startup founders to be paid meager to no compensation at its early stages. That’s understandable. The hustle, the bustle, and the fasting — that’s normally part and parcel of starting up a business. However, the ability to pay is independent from value contributed by the founders to the business. Agreeing on the value of the contributions is key to determining the true break-even point for a startup. We’ll discuss the concept of break-even in the future.

After getting through the most important rule and concept of compensation for founders, we’ll start looking into a conceptual framework on an ideal way to agree on a fair compensation.

The structure of a compensation is directly tied-up with the value contributed by the founders. This is nothing unique from how we compensate our people. The only difference is — we can agree not to pay cofounders their compensation until “when able” without getting into potential labor issues.

With this, let’s begin to discuss in detail the key components of founders’ compensation — work and investment.

Compensation for work

Obviously, we talk about compensation because there’s work to be done.

Founders tend to wear several hats throughout the lifecycle of a business or, in this article, a startup. From developing the product to pitching an idea to investors or breaking the awful news of failure to your people — there’s so much scope of work expected from startup founders. So where do we begin?

Compensation for work is about setting a starting point for the compensation.

Opportunity cost is a good starting point — how much are you foregoing to join the startup?

We need to have a baseline before anything else. The baseline compensation for any meaningful conversation is the compensation that you’re giving up to join a startup. We just have to respect the laws of demand and supply — it is just not acceptable to have a compensation lower than what you are foregoing.

Adjust the baseline accordingly — what’s the commitment looking like?

The baseline compensation accounts for the skill set of the founder in a job market. However, the role and commitment of founders can be a lot more diverse. Some founders are committed part-time while others have to take on extra responsibilities — these adjustments should be taken into account. However…

If there’s one thing to avoid — that’s assuming that you should be compensated like an executive of a startup that is far more successful than you are.

While the compensation that we’ve been discussing so far is a conceptual compensation, that does not mean setting yourself up for an outrageous compensation package. Our objective here is to agree on a fair compensation and not to draw a number in the air.

If there’s one helpful framework that I’ll recommend — that’s the negotiation pie. If this is the first time that you heard about the negotiation pie, this Yale course on negotiation explains it well.

Compensation for investment

While it might be counterintuitive to say think of compensating for investment, it might be because you are thinking of investment in terms of money brought-in. But investment actually means much more, it’s actually the plethora of capital that founders bring into the business. In economics, it’s what you call opportunity cost.

Compensation for investment is about the direction of the compensation.

Time is probably the costliest investment of a founder in a startup.

Joining a startup is one of the biggest odds you’ll bet in your career. The outcomes are oftentimes binary — a grand slam or a bankruptcy. Moreso if you’re joining in as a cofounder. In the context of compensation, time is best accounted for by a continuous increase in compensation through time.

If time is the costliest investment, network is the most valuable investment.

What really distinguishes a founder from an employee is the network. Technical skills, financial wizardry, and other dance moves your cofounder can bring in — can be… hired. The network that founders can bring in can massively increase the odds of success if the network is fit for your business. Compensating for the network value can be very difficult to determine, but a good starting point is through performance driven compensation.

But of course, actual monetary investment is as important to keep the startup running.

Cash investments into a business is the easiest to be compensated for. If you’re cofounding a startup, then you’re splitting the equities based on your investment; if you’re joining a startup as a cofounder later on, then you’re getting the equity based on the valuation of the business. There’s a whole rabbit hole on this topic — so let’s leave it for now and get back to it in another article.

Compensation structure

We spent a lengthy discussion explaining what we need to consider in determining a fair compensation, but now, we have to think about the tools to compensate. There’s quite a lot of levers available when it comes to structuring a compensation, but we’ll not jump too deep into that blackhole.

When it comes to structure, the compensation can range from salaries to equity with so many options along the way.

The right compensation structure should always be geared towards driving the right behavior.

Before getting too deep into the technicalities of compensation, the end goal of a fair compensation structure is to drive the right behavior. The structure should not be driven by liquidity or tax constraints (important too, though) — don’t waste such a powerful tool to address issues which can be easily addressed outside the structure of compensation.

So now, let’s talk about salaries, equity, and somewhere in-betweens.

Salaries

As a starting point, salaries are good compensation for work. Salaries are a good extrinsic motivator as our good old organizational management textbook teaches us.

Salaries provide a known amount of compensation rather than a floating value.

In any compensation structure, salaries form the baseline compensation that serves as the minimum amount of compensation without all the other variable elements of compensation. When we talk about compensation that can be paid or unpaid — we’re normally referring to salaries rather than anything else.

Equity

Getting a fair share of the future of a business can be really attractive especially for a promising startup. Equity for investment is straightforward, but equity for work is a lot more complex.

Equity can be the most motivating compensation, or the most meaningless.

Startups often attract cofounders with generous equity promises for joining their journey in several ways. Some pay-up a large amount of equity upfront while others adopt a vesting approach. However, let’s face reality. With the odds of success for a startup, the value of the shares is only as valuable as how much your cofounder believes in the business.

Equity is a complex tool when it comes to compensation for work. While it will not impact the liquidity of the business, it can deteriorate the value of a company in the short- and long-run. Without diving too deeply into the concept of signalling theory, granting of equity as a means of compensation for work can give out the following sample impressions:

• Positively. If equity is granted to industry prominent cofounders, accepting equity-based compensation can provide the impression that the cofounder believes in the future value of the company, hence, the equity.
• Negatively. If equity granted to cofounders is deemed excessive or unnecessary as this sends out a strong impression of liquidity-related problem or dire need of technical expertise from another cofounder.
• Negatively. If the equity granted to cofounders significantly affects the governance mechanism in place for the business such as decision making, board directorship, and electoral rights.

Signaling theory has long held a prominent position in terms of capital raising strategy. However, the same applies in the context of a compensation structure.

In-betweens

The range of structural solutions to compensation is limitless and normally falls somewhere between salaries and equity. Here, let’s introduce a few of these common structural tools that you can use to create a better compensation scheme:

Share-based compensation is a good way to motivate founders — intrinsically and extrinsically.

We often hear about employee share options in the world of startup compensation. While straight-line vesting is the common approach, there’s a lot more flexibility to it. A few of the common levers that should be considered can include time horizon, vesting mechanism, vesting conditions, performance, and triggers.

Profit sharing as a variable payment mechanism can be a double-edged sword.

Depending on the stage of the startup, profit sharing mechanisms can either work for or against a business. While it motivates founders to hit profit targets, it can be meaningful for early stage startups with minimal profit prospects. Further, profit targeting for startups can be quite inappropriate when aiming for growth as profit targeting has long been a signal of short-termism or management myopia.

There’s a lot more options in between when structuring compensation. But again, most of it will just fall somewhere in between.

Why the hassle?

Before we leave this off, it’s worth repeating that compensation for founders is a lot more flexible compared to compensation for employees in terms of payment mechanism and structure. What’s really important is that a fair compensation is set at the start and revisited so often.

Without true compensation, you’ll always be in a state of artificial profitability.

Having an agreed compensation is the most important starting point in working together. Outside the qualitative aspect to it, having set a fair compensation is critical for any meaningful financial and business analysis. As a starting point, it can provide a false sense of profitability (or a smaller loss); as a point along the way (since I started with starting point), it can break years of friendship just because of… money.

Unpaid compensation though should still be dealt fairly — one way or another.

While founders’ compensation need not be paid, it needs to be dealt fairly. Either a proportionate amount of unpaid compensation or in-exchange of equity along the way, don’t let financial worries become a preventable nightmare in the future. Deal with it, fairly.

Finally, before ending this long-winded discussion on compensation structure, the most important message remains — agree on terms before even getting started.

About UpSmart

UpSmart is the premier financial consultancy firm in the startup, SME, and social enterprise industry. UpSmart specializes in strategic finance (e.g., structuring and restructuring of legal entities, valuing and modelling companies, serving as chief financial officer of companies) and operational finance (e.g., optimizing business processes and controls, accounting and bookkeeping support, financial reporting and analysis).

About Filbert

Filbert is the co-founder and managing director of UpSmart. He leads the consulting practice of UpSmart and specializes in handling corporate structuring and financial transformation projects. He was previously a consulting manager at Ernst & Young in the UK. He writes for Tech in Asia, Business Mirror and serves as a mentor at The Final Pitch on CNN.