Pay Yourself First

One of the most important rules of successful longtime business owners, right after “Cash is King”, is “Pay Yourself First.” After all, you do not know what the business will be like in a year or two or ten, so don’t shortchange yourself. Of course, you need to invest in your business’s growth as well, but don’t live in poverty because every penny of profit is plowed back into the business.

Highly recommended for even more insights into running your own business with “Street Smarts” is Norm Brodsky’s “The Knack“.

What do you do, though, when you aren’t the sole owner? In other words, when you have investors? What about when you haven’t raised enough cash to “pay yourself first”?

Dave Linhardt had a great, frank post about his experiences getting the short end of the stick on a business sale, along with getting messed up by an inexperienced lawyer. Anyone involved in corporate financing, especially venture financing, must read his post in its entirety.

Two years after raising $50k, the company is being sold for $225k. The problem is his investor has a 2x liquidation preference plus a guaranteed 10% annual return on his investment. That means he gets his money back, double, plus 10% per year (compounded, of course), before anything else gets paid.

  • Dave invested $150k of his own money in the venture before raising the $50k.
  • Dave borrowed $89k between credit cards and a personally guaranteed line of credit.

As Dave explains in his post, the proximate problem was a 2x liquidation preference for his investor, plus 10% guaranteed return.

How can that situation be handled differently? What can the next person learn from Dave’s miserable experience?

First, it is important to understand that many investors ask for liquidation preferences, i.e. they get their money back before anyone else. Most of the time, these are not totally unreasonable; investors want to protect against their downsides.

These are usually traded off against other rights, most commonly participation. An investor can take  either liquidation preference or proportional rights in the proceeds, but not both. If a VC put in $1MM for 10% of the company, and has a 2x preference and participation rights, and the company sells for $25MM, then both together means that the investor gets $2MM (2x preference), plus 10% (the equity stake) of the remaining $23MM, for a total of $4.3MM, leaving $20.7MM for the founders and employees.

On the other hand, if the investor has liquidation preferences or participation, then they can choose either the 2x liquidation preference for $2MM, or the 10% of the $25MM for $2.5MM, but not both.

Of course, that only helps if the company is sold or goes public for a high amount. What about when the company is sold for a song, like Dave’s company? The liquidation preferences will still overwhelm the remaining shareholders!

What could be done here?

  1. First, the lawyer: if your lawyer ever puts in terms that benefit your counter-party at your expense without being asked to do so, fire them immediately. Personally, I believe that Dave’s lawyer violated his fiduciary duty to his client, and could be liable. I don’t expect Dave to sue – I have only ever contemplated suing an attorney once, and am glad I did not do so – but this is an unforgivable mistake by his lawyer.
  2. Negotiate hard on liquidation preferences. Did the investor deserve a 2x preference? Maybe he only deserved 1x preference, which would have changed the payout. Do not expect an investor to forgo some form of liquidation preference entirely.
  3. Your investment is valuable. It appears Dave looked at the private equity investor as his first real investor. In truth, he was the second, and a small one at that. His first cash investor was… Dave. He put $150k of his own cash, plus $89k in personally guaranteed debt, into the business. Dave’s investment was $239k, Todd’s was $50k. Even with liquidation preferences, Dave could have converted his $150k into preferred stock with its own preferences. If anything, he should have had higher payout solely by virtue of the larger investment.
  4. Dave had another investor: Dave again. He worked four years in the company. That should either be paid out of revenues, or treated as deferred salary, debt the company owes him. The amount of that debt would have been subject to negotiation between him and the investor, as well as its seniority vis-a-vis the investment’s liquidation preference, but should receive some treatment.

As Dave is pretty honest about, he looked at himself as a founder, and thus accepted terms that subordinated his equity to his investor’s.

In truth, he played multiple roles:

  1. Investor, to the tune of $150k in cash.
  2. Lender, assuming $89k in personal debt on behalf of the company.
  3. Founder, for which he received common equity which was, and should have been, subordinated to the investor’s preferred stock liquidation preference.
  4. Employee, working hard for 4 years.

Each of these needed to be negotiated under separate terms.

  1. As investor, his $150k in cash should have received preferred stock and liquidation preferences roughly equivalent to what his external investor received. Even though the external investor came later, it was a pittance compared to what Todd himself put in.
  2. As lender, his $89k should have received the highest priority, being assumed directly by the company.
  3. As founder, he received common equity, which was, and should have been, subordinated.
  4. As employee, he should have received, and apparently did, a reasonable salary. If the cash isn’t there to pay it, then some of it should be treated as debt senior to the investor’s equity; others deferred. Note that not all investors will agree to these terms. Some will insist that none of the prior imputed salary is payable. This should be negotiated in exchange for other equity preferences, if you can afford it.

The advantage to this structure is that it cleanly delineated the roles and financial impacts, while still leaving the investor his preferences. Even with a 2x liquidation preference, the outcome of a $225k sale would look like this:

  1. Start with $225k offer.
  2. Pay off $89k in straight debt, leaving $136k.
  3. $200k in outstanding preferred stock all has equal 2x liquidation preference, and thus will get split evenly, each receiving 136/200 = 68% of his original investment.
    1. Dave gets $102k back, a loss of $48k.
    2. Todd gets $34k back, a loss of $16k.
  4. Done.

The lawyer never should have put the liquidation preference clause in. Even if the investor insisted upon it, a good lawyer should have insisted on at least equal rights for Dave’s much larger $150k investment, and seniority for the credit card and line of credit debt.

Summary

Dave Linhardt is a great person for having shared such a personal story to help us all. The best advice one can have is: get great advice.

About Avi Deitcher

Avi Deitcher is a technology business consultant who lives to dramatically improve fast-moving and fast-growing companies. He writes regularly on this blog, and can be reached via Facebook, Twitter and avi@atomicinc.com.
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