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Should First Investors Get Extra Compensation?

Our startup financing expert offers tips on providing incentives for your first investors.

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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.

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.

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