Entrepreneur Office Hours - Issue #102
Properly compensating your first investor
When most of us think about investors, we tend to think about venture capitalists writing checks for millions of dollars. At the very least, we’re thinking of well-healed angels with a few extra bucks to throw around who can afford to bet some cash on a scrappy young startup. But lots of startups that take on investors — possibly even the majority — get their first capital from friends and family who are writing checks for a few thousand dollars to help cover initial expenses when the startup is more of a nebulous idea than an actual company.
How do you compensate those kinds of investors? On one hand, by being your first investors, they’re taking an enormous risk. On the other hand, if you give them too much equity in exchange for the relatively small amount of money (and additional value) they’re likely providing, you could cripple your company’s ability to effectively raise capital in the future.
In this issue’s Q&A, I help one entrepreneur struggle through precisely this challenge. If you ever find yourself in a similar situation, maybe my answer will help you, too.
Yes, practice makes perfect, but only if you’re practicing in front of people who can give you valuable feedback.
My students are constantly asking my advice on whether they should work for a big company or a startup. Here’s the story of what I told one of them and why I was wrong.
Office Hours Q&A
A friend and I are starting a company and a mutual acquaintance has agreed to give us some initial seed capital of $50,000. However, our company is so early, we’re not sure of the best way to compensate him.
I know we should probably do a convertible note rather than giving him a percentage right now. What kinds of terms would someone in our position traditionally give on a convertible note for a first investor that would be fair to both us and the company down the line when it needs to raise more funding? I know we need to give a discount, but how big? Also, are there any other sweeteners we might add? We definitely want to give our first investor a nice deal because he’s being so generous with us. But we also don’t want to shoot ourselves in the foot.
In general, you’re right that a convertible note is usually the way to go in scenarios like this, particularly if the investor isn’t providing any other value aside from money.
The advantage of a convertible note is, of course, that you can wait to price the round – and your investor’s ownership stake – until after the market has helped price it for you. This is the best way to avoid what’s otherwise going to be, at best, a difficult guessing game in order to set a proper value, or, at worse, a full-on argument that leads to the investor backing out.
As for how to incentivize the convertible note, the main thing, which you’ve already mentioned, is the discount. A typical discount on a convertible note is around 20%. You could maybe go up to 25%, but be careful about getting too generous. I bring this up because there’s a decent chance you’ll need to add additional convertible notes for other, later early investors. If they see a big discount on your first note, they’re going to want something similar for themselves. Also, when the notes convert to equity during a priced round, future investors might be a little peeved about just how big a discount the early investors are getting.
A couple other “sweeteners” you can look at are the interest percentage you’re offering in the note. That’s because the interest on the note also converts into equity. In other words, if you’re getting $50,000 with 5% annual interest, and that note converts exactly one year from when it was signed, then the investor will get $52,500 worth of equity at whatever the conversion rate ends up being.
From there, hopefully you can see how interest can be used as a sweetener. The more interest you give (or the more often it compounds), the more equity the investor will ultimately get. Again, just be careful with this number, particularly because you’d hate to have that note with a high interest rate hanging over your head for too long.
Another, safer mechanism is a warrant. Warrants give investors the right to purchase additional shares in the future at some sort of discount. For example, if your first priced round is at $10 million and you give warrants with a 20% discount, the person holding the warrants can buy in at an $8 million valuation. This can be good for you, too, because it incentivizes current investors to follow-on and participate more in future rounds. Just be careful with the terms of your warrants, and be willing to invest a few bucks into a good lawyer who knows how to do them properly. I’ve seen some poorly worded warrants that unintentionally give investors the right to buy equity at deep discounts or far into the future.
Heck… I had a lawyer write some warrants for me that basically would have let holders of the warrants buy shares at any point in the future of our company for the price of our first round. In other words, the way the warrant was worded, even if our company was about to go public, the holder of the warrant could still buy shares at our first valuation.
Luckily I caught the issue in our paperwork before it ever got to our investors, but it’s a good reminder that the more complex you make your terms, the more room for errors and unexpected loopholes.
My best advice is to stick to standard terms as best as you can. I know both you – and your investor – are probably imagining scenarios where a little tweak to the terms here or there could lead to enormous differences in outcomes, but, in my experience, that’s not usually the case. In reality, even if you 10x that investors $100k – which would be an incredible outcome – you’re still only turning that money into a million dollars. Not that a million dollars is bad, but if the person owns an extra few shares, we’re really only talking about a difference of a few thousand dollars. In the grand scheme of things, that’s just not enough money to get worked up over in relation to the expectations surrounding a startup.
Got startup questions of your own? Reply to this email with whatever you want to know, and I’ll do my best to answer!