VC backed Startup Founder Advice: Addressing Frequently Asked Questions
I recently read an interesting blog about 25 Frequently Asked Questions, written by Richard Harroch, startup lawyer, entrepreneur, and venture capitalist.
The founder of Y Combinator, a leading seed-stage startup accelerator, explains that “a lot of the advice we give startups is tactical; meant to be helpful on a day to day or week to week basis. But some advice is more fundamental.”
Some of the most common questions founders ask about starting and growing a business include: What valuation should I take? What should the CEO be paid? Is venture debt a good idea? How should equity be divided among co-founders of a startup? How big should a stock option pool for employees be?
Around some of these questions, there isn’t always an easy answer, and as lawyers often like to say, “It depends on the circumstances.” So in this post, I would like to tackle a few of these common issues that founders face.
1 What valuation should I take?
Is it good to get a high valuation for your venture-funded startup? For a founder, it can sure feel good to have the highest valuation possible. After all, you experience lower dilution at a later fundraiser when your company is highly valued. And the press loves to talk about valuations and unicorns. Healy Jones a VP at Kruze Consulting, contributed to an article in Crunchbase about this topic and he said “But high valuations often come with financial engineering: Special preferred stock that gives the VC a lot of privileges that can make selling the company a lot harder. And overly high valuations can make the next round of financing difficult.” Founders need to think carefully about the implications of an overly huge valuation. Being able to meet growth expectations against a massive valuation can put a lot of undue pressure on founders and can make reasonably sized exits—which can be quite lucrative—impossible.
2 What should the CEO be paid?
Mr. Jones also addressed this compensation question, where some schools of thought believe that “founders shouldn’t make any money” and that startup founders/CEOs should be compensated almost entirely in equity.
Mr. Jones stated, “that might be romantic on the surface, but it sets up a poor incentive alignment over time.”
For instance, a founder living off of $30,000 a year in San Diego or the Bay Area is going to feel a lot of personal financial pressure. This leads to poor decision-making and presents a long-term, structural risk to the company.
Founders should give themselves a salary that allows them to focus on the business instead of worrying about putting food on the table. The average recommended salary for a very early-stage, funded startup founder is somewhere between $115,000 and $140,000 a year, depending on the size of the startup.
3 Is venture debt a good idea?
Venture capital is the dominant form of financing for startups, but venture debt — which offers a way for VC-backed startups to raise funding by borrowing money — can be appealing to founders wanting a quick influx of capital without giving up much equity. Venture debt is also a great solution for companies that want to achieve certain milestones before going into funding rounds.
The venture debt market has seen enormous growth as more and more founders have realized that this is an option. Venture debt doesn’t require giving away as much equity as venture capital, which means founders can retain more of their company while still raising money. Startups must pay back venture debt over time — unlike venture capital, which doesn’t have to be paid back directly. Instead, VCs take a significant stake in the company in exchange for capital. Another Y Combinator article explains “ Venture debt is great for financing working capital or operating leverage; it is typically a poor choice for extending runway (i.e. financing headcount, op-ex, etc.).
4 How should equity be divided among co-founders of a startup?
Mr. Harroch explains that there is no single correct answer, but you should discuss it and come to an agreement about it, in the beginning, to avoid any misunderstandings later on. If you are the original founder and brains behind the idea, a good argument can be made for more than 50% ownership. The split should take into account:
- The relative value of the contributions of the founders
- Vesting is dependent upon continued participation in the business (you don’t want to give away 25% of the company to someone who leaves after a few months)
- The amount of time to be committed to the business
- The cash compensation to be paid as an employee
- Whether the founders will be contributing cash as an investment in the business
- Whether one person wants to maintain control over decision-making
5 How big should a stock option pool for employees be?
At some point early on, generally, before the first employees are hired, a number of shares will be reserved for an employee option pool (or employee pool). The option pool is part of a legal structure called an equity incentive plan. A typical size for the option pool is 20% of the stock of the company, but, especially for earlier stage companies, the option pool can be 10%, 15%, or other sizes. Once the pool is established, the company’s board of directors grants stock from the pool to employees as they join the company.
Standard vesting for options is 4 years, with a one-year “cliff vesting” and monthly vesting after that. “Cliff vesting” in this context means the employee must be employed by the company for a minimum of one year before the employee earns any of the options.
Basically, there is plenty of bad advice out there for founders and sometimes there is not an exact answer, so definitely make sure you’re consulting accounting experts when it comes time to make these important decisions.