Investors should not fund a founder's lifestyle

More than a year ago, I wrote in this column about the common traits among startup ventures that succeed.

One of those traits was this: "The founders and other officers and principals take little to no salary from the company in the first one to three years."

About this trait I wrote: "This seems to be a hard lesson for many in Utah to learn. Many would-be entrepreneurs want investors to fund their lifestyle by having exorbitant (by startup standards) salaries for the founders and early officers. This sucks the lifeblood out of the company. Every dollar, whether from operations or financing activity, needs to be pumped back into improvement and growth of the company, not to salaries.

"In fact," I continued, "this tends to be a major red light for me as an investor. If the founding entrepreneurs are taking out salaries beyond rent and grocery money (which I would define as anything above $60,000 per year, though I greatly prefer deals where the salaries are zero for all principals for the first year or two), then I would encourage every investor to run away, run away, run away.

"And, if an investment is made in any deal, especially an equity investment, then there should be a contractual salary cap on all founders and officer-shareholders coupled with a requirement for the company to pay out dividends if cash surpluses become too great. After all, why should the entrepreneur take out a huge salary while the investors sit empty-handed with illiquid ownership? They shouldn't."

Now, more than a year since I wrote those thoughts, I remain just as concerned about the all-too-common insistence of founders of investor-funded companies wanting to earn market rate salaries and compensation packages for management positions. This topic is so important that I want to revisit the subject and elaborate on it a little.

Certainly, a founder starts an entrepreneurial venture with the hope that it will provide for him a spectacular return on his investment, both in hard dollars and sweat equity. We all want that. But, the return should not be in the form of salary from cash flow. If the founder self-funds, then he can pay himself whatever he wants. But investors do not invest to fund a lifestyle.

Founders who want to take a large salary are indicating to their investors that they do not really believe in their company, that they are not willing to sacrifice for the short-term in order to start their company. To me, a request for high compensation signals a lack of belief in the company, a fear of competition, and uncertainty that the end game —liquidity from a stock event — will not arrive. These are all danger signs for an investor.