Although it's not often discussed or disclosed, it's
quite common for entrepreneurs to provide extra incentives to their
first investors to help kick-start their fundraising efforts. Why
should you consider doing this? First investors are often critical
to a business' success because they can provide credibility for
your company and make introductions to additional investors and
partners to accelerate the growth of your startup. But paying
investors can be a minefield for the inexperienced entrepreneur. To
provide some guidance, this month's column reviews some
effective ways to navigate the minefield of compensating early
investors.
1. Be wary of "special deals." Investors in
startup companies are thrilled when they hear the words
"special deal." By nature, many early-stage, private
investors are used be being treated well and pampered by the world,
so many of them have come to expect being compensated for their
willingness to be your first investor and the introductions that
they'll make. If you're willing to provide them with extra
compensation, be wary of calling it a special deal; you'll need
to disclose it to your future investors and it may get in the way
of future fundraising.
Rather than calling it a special deal, you should structure it
legally with a written advisory agreement and set of deliverables.
For example, rather than letting your first angel investor
informally pay a lower share price than your second angel investor,
it's better to offer all investors the same terms and then
create a separate advisory agreement with your first investor to
provide him or her with additional compensation. In effect, both
approaches provide the same financial result, but the written
advisory agreement is much safer than a wink-wink oral agreement
with the first investor.
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2. Don't let your investors' pay get in the way of
your business growth. There are a wide variety of ways to
provide extra compensation for first investors. For example, you
could pay them a fixed amount of cash; you could pay them a fixed
amount of equity; you could pay them an hourly or per-diem wage; or
you could pay them in deferred compensation when you close a round
of fundraising. In most cases, first investors will do whatever
makes sense for your company and avoid getting in the way of your
future fundraising and business progress. Those investors who are
too selfish to approach compensation this way should be avoided at
all costs.
Since you're in control of determining what's best for
your company, you should think carefully about the precedent
you're setting by how you decide to pay them. For example,
don't pay them in equity if you think your company is unlikely
to be sold or to generate dividends for shareholders. And don't
pay them in equity if you're building a lifestyle business. In
either case, you and your investor are headed for a rocky
relationship if your interests are not aligned.
In my view, you should pay your first investors based on the
value they generate for your business. If they're introducing
you to potential investors and business partners, then they should
be paid for the value they bring.
3. Pay them at the end of contract. Like any vendor
relationship, it's best to include a payment at the end of the
term of the agreement rather than pay them everything at the
beginning of the term. This will increase the likelihood that
they're paid for the value they generate rather than just for
their initial investment. This is sometimes challenging to
negotiate because you have limited bargaining power with your first
investors. However, you can justify this practice by indicating
that it's your corporate philosophy to structure all agreements
in this manner or that the payment at the end of the term is a
"bonus" payment; everyone likes to receive a bonus even
if not everyone likes delayed compensation.
4. Agree to a schedule for periodic update meetings.
It's notoriously difficult to "manage" relationships
with advisors who tend to be very busy and not particularly
concerned with how you evaluate their performance. In one of my
previous columns, I outline how to recruit
an advisory board and work with it effectively. When you're
negotiating the terms of your agreement with your first investors,
get them to agree to a periodic schedule of update meetings or
phone calls. This will allow you to ensure that they make the
introductions they promised to make.
Even though paying investors is quite common in startup
financing, following these tips will help you do it without
breaking the bank or jeopardizing your future business growth.