Tag Archives: series a

Series A Startup CEO Salary

A startup’s Series A financing shouldn’t be a large liquidity event or salary payday for the startup’s founders. While a startup typically receives millions of dollars in a Series A, if too much of that $$$ flows guaranteed to the founders, various incentives get out of whack.

Not all startup founders understand this tenet.

Case Study

Earlier this year, this issue presented itself when a client was the lead investor in a Series A round of about $2MM at a $4MM pre-money. The term sheet was pretty much a done deal, when the startup’s CEO demanded a salary of $25,000. Per month.

My client countered with a reasonable startup CEO salary, but the startup’s CEO didn’t back down from his $300,000/year figure. You can guess what happened to the deal.

In addition, here’s an example of how a startup CEO’s huge salary didn’t help his startup: CEO’s $500,000 Salary Burns Startup Into Fire Sale.

The Importance of Startup CEO Salary

The startup community focuses most of the term sheet discussion on liquidation preferences and anti-dilution, but startup CEO salary is nonetheless an important issue. According to Peter Theil, Startup CEO salary is a predictor of a startup’s success:

“The lower the CEO salary, the more likely it is to succeed.

The CEO’s salary sets a cap for everyone else. If it is set at a high level, you end up burning a whole lot more money. It aligns his interest with the equity holders. But [beyond that], it goes to whether the mission of the company is to build something new or just collect paychecks.

In practice we have found that if you only ask one question, ask that.”

If a startup CEO’s post-Series A salary is too high, he or she may not have a true sense of urgency to implement and/or create shareholder wealth.

This doesn’t mean a startup CEO must continue to make Costco runs for ramen noodles. But if the startup’s CEO gets a huge salary, the startup CEO could likely view his or her equity stake as “house money” (i.e., even if the startup fails, the CEO won’t feel too bad because he still received got a hefty salary).

Furthermore, a demand for a high startup salary can signal that you don’t believe all those things in your investor pitch.

What is a Fully-Diluted Basis?

The concept of a fully-diluted basis is not difficult. A fully-diluted basis just means the assumption of the highest potential amount of common stock a startup will have outstanding, regardless of vesting provisions and assuming all options and other securities like convertible notes are converted into common stock. That is, assume the highest share count possible.

I’ve seen it defined in legal documents in the following way:

Fully-Diluted Basis” shall mean the assumption that all options, warrants or other convertible securities or instruments or other rights to acquire Common Stock or any other existing or future classes of capital stock have been exercised or converted, as applicable, in full, regardless of whether any such options, warrants, convertible securities or instruments or other rights are then vested or exercisable or convertible in accordance with their terms.

The definition of fully-diluted basis matters especially for founders in financings. Typical VC financing deals will calculate the Series A share price on a fully-diluted basis, and the investors have an incentive to capture as much shares as possible in the definition of fully-diluted basis. The larger the amount of shares calculated by the definition of fully-diluted basis, the lesser the Series A share price.

How to Set Conversion Discounts in Convertible Notes

Convertible promissory notes do not include a stated pre-money valuation. Instead, the convertible note seed investor and startup agree that the pre-money valuation for the convertible note investment will be determined by the pre-money valuation the startup receives at the Series A round. However, the convertible note investor does not receive the Series A pre-money valuation, but rather a lower pre-money valuation as determined by the conversion discount.

The convertible note seed investor gets a lower pre-money than the Series A investors for investing in the startup before the Series A round. Since the convertible note investor made the higher-risk investment in the startup, the seed investor’s reward is the ability to purchase (not by investing new cash, but by exchanging the debt) Series A shares at a price per share lower than the per share price paid by the other Series A investors.

So how do you set the conversion discount in a convertible note?

Conversion discounts are set to approximate the amount of risk the convertible note investor is taking by investing in the startup. In addition to the general risk of investing in an early-stage startup, other factors include time and the likelihood of the startup’s valuation increasing between the convertible note investment and the Series A round,

The majority of convertible note deals I see have the conversion discount set at a fixed percentage somewhere between 10% and 40%.

Occasionally, I have drafted conversion discounts that increase over periods of time. For example the conversion discount may be:

(i) 15% if the Series A round occurs within 6 months of the convertible note investment;
(ii) 25% if the Series A round occurs within 7-12 months after the convertible note investment; or
(iii) 40% if the Series A round occurs 12 or more months after the convertible note investment.

Series A Pre-Money Valuations Down 25 to 50 Percent

Connie Loizos of Private Equity Hub interviewed Bob Ackerman, co-founder of Allegis Capital, regarding the current state of the VC industry. Ackerman made a few quasi-dire statements for both startups seeking capital and firms looking to provide capital, most notably:

In response to the current state of Series A pre-money valuations, Ackerman said:

Depending on the situation, you’re seeing pre-money valuations come down from 25 percent to 50 percent [for Series A deals].

According to Ackerman, there’s bad news for those you planning a Series B or C deal:

Bs and Cs have collapsed entirely because the capital in the pipeline isn’t moving.

And finally, Ackerman made a prediction about the future of the venture capital industry:

[F]rankly a lot of VCs are going out business — I’d say 25 percent of them will disappear.

Read the full interview here.

Preferred Stock: Where “F” in a Class Can Equal Success

If you pay any attention to TechCrunch or Venturebeat, you’ll see stories titled “Startup Raises $X Million in Y-round Financing.” When the “Y” in story is a large number, do not assume that the startup company is tanking. Instead, the startup could be gaining momentum and approaching positive cash flow…but just needs one more round to get over the top.

Rounds of financing are tied to classes of preferred stock. You can name the preferred stock rounds whatever you like, but the norm is to follow the alphabet. For example:

1st round = Series A
2nd round = Series B
3rd round = Series C
26th round = Series Z

If a startup raises its rounds of financing at increasingly higher company valuations, each new class of preferred stock will represent an increase in price. This means that value is being created and progress is being realized at the startup. Thus, a startup may be going through a sixth-round financing (or Series F) simply because the startup needs more time or money than it anticipated.