The Founder Note Receivable, BigRedCar
October 11th 2018
Big Red Car here musing about how founders can get paid for the uncompensated work they do in launching their business.
A startup may cycle through bootstrapping, friends & family, angels, syndicated angels, seed VC funding, Series A/B/C/D funding.
At some time, they will be able to pay themselves some kind of living wage – the question is when?
Today, the Big Red Car shares an idea whose time has come: the Founder Note Receivable.
The Founder Note Receivable, Big Red Car?
This is not a novel thought though I did support it the first instant I heard it.
A company which was generating a positive cash flow was raising money and the investors were studying the finances of the company as part of their due diligence.
I was advising this company – coaching the CEO, actually – and we’d had a conversation about how much work went into founding the company.
This came about because there were two unequal founders. One had gone hammer & tongs 24/7, while the other had maintained a real job because he had a wife and kids. Their comparative work contributions were about 5:1 while the equity split was 50-50 (There was a 10% option pool which we shall ignore for the purposes of this discussion.)
They were trying to rectify their unequal contributions and after some trial and error decided to compare their contributions by putting together a faux comp plan.
They did not have the cash to pay themselves, though they were just starting to generate positive cash flow; so they agreed to retire their accumulated, but unpaid, compensation when they raised some funding.
That day came and they were sitting there with an analysis and no place to go.
They were raising a considerable amount of money. The founder notes receivable were $500,000 and $100,000 respectively for a total of $600,000.
So, they agreed to put those two amounts on the company’s books as notes payable by the company (a note receivable to the founders.)
So, let’s review the facts:
1. Two founders worked their butts off and were on the verge of a big success.
2. Company starting to generate meaningful amounts of cash.
3. Neither had taken a penny from the company.
4. One of the founders was all in while the other was working part time. Equity split was 50-50.
5. When they got the funding, founder #2 was coming into the business full time.
6. There was a group of investors finalizing their due diligence.
7. The founders put something called a Founder Note Payable (Receivable) on the company books as an obligation of the company to compensate the founders for their sweat equity.
8. The notes ended up being $500,000 and $100,000.
What happened then, Big Red Car?
The investors saw the notes payable and said, “What is this?”
They were told it was the accrued, but unpaid, compensation owed to the founders. They were told that by a finance pro who was acting as the Chief Financial Officer of the company. He would come on full time when the new funding materialized.
The investors nodded and nothing was ever said.
At the closing, the notes were both paid in full and nothing was ever said again.
Come on, Big Red Car, really?
Yes, dear reader, but there is another example I’d like to share.
Almost identical situation, but the investors balked.
They said, “Retire these obligations over the next three years of operations, so our new money is not diluted.”
Same result, the founders got paid for their sweat equity, but over time.
Bottom line it, Big Red Car
There is a lot of cash out there, dear readers. If you are financing growth, you owe it to yourself to evaluate the value of your sweat equity.
Creating a Founder Note Receivable — admittedly a new gambit and one which has to come to life with things like positive cash flow — is something you might consider.
One other point — always make damn sure you have an Employment Agreement with solid “change of control” and “termination-not-for-cause” provisions which protect your interest.