I earlier wrote a post on hanging deferred compensation. You can view it here. The overall theme is that deferred compensation is messy and very difficult to get paid once you get VC funding. The VCs view deferred compensation that has accrued prior to their investment as “not my problem” and will generally not want their investment dollars being used to pay it. Rather, they want their investment dollars used for growing and operating the portfolio company going forward. To me this makes perfect sense and is justified. To put it bluntly, why should a founder, who knows that he/she will have little salary when they start their startup accrue the “lost” salary on the company’s books? It is part of the startup routine, prior to fund raising, to bootstrap and be super frugal. Enough said.
There is one solution to hanging deferred compensation (other than having it evaporate) that can work, however. Let’s suppose that Joe and Mary are the founders of Startup Z. They have raised some money from 12 friends and family (let’s assume the friends and family have purchased common stock). Mary and Joe own 60% of the company and the friend and family own 40%.
Because Joe and Mary received barely any salary for the past year, the financial statements of Startup Z show $50,000 of accrued salary for each of them. They are out raising a round of VC dollars and the topic of the accrued salary comes up in due diligence. Always a pleasant discussion (kind of like talking about adult chicken pox, which I had when I was 41 — that was a terrible experience).
Faced with the issue, the VC could give Mary and Joe an alternative to having the deferred compensation vanish. Alternatively, the VC could say “Joe/Mary, you all deserve recognition for your efforts over the past year and that recognition should come from your current shareholders for whom you have worked hard with little pay. So, talk to them about adjusting the cap table prior to our investment – have the board grant you stock options (to avoid a tax issue) prior to our investment to compensate you for the deferred comp.”
The impact of such a stock option grant to the VC is zero because it would be done pre-money and simply factor into the pre-money valuation and share price calculation. You would call this solution part of “cap table clean up”, a topic I just realized I should write about soon. After the stock option grant, Mary/Joe might own 65% of the pre-money cap table. Startup Z can use the VC’s term sheet pre-money valuation to figure out the right amount of options to grant to Mary/Joe to compensate them for the $100,000 in total.
Hope you all had a great holiday weekend.