Compensating Employees - Explained
Paying Early Employees
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Options for Compensating Employees
The first option for compensating an employee is to use operational funds. Of course, this becomes a problem when the company does not produce adequate revenue to pay the employee. Also, startup companies generally try to refrain from allocating revenue to operational expenses. Rather, they prefer to invest funds in research and development and marketing. These are the life blood of a startup. If the startup hopes to meet its lofty growth expectations, it will need an excellent value proposition and a strong marketing game.
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Personal and Business Loans
Most startups meet initial expenses by taking out loans. The business itself has little or no value or credit history ing the beginning. As such, taking out a business loan in the name of the business is very difficult. The startup may begin with loans from friends and family, who do not require collateral or personal guarantees. If this is not an option, the founders will push forward with a formal business loan.
To facilitate this process, the company owners will either take out personal loans or co-sign on the business loan. In either event, the rate of interest on the loan can be crippling for the startup. Some startups attempt to mitigate this by establishing an line of credit that only charges interest once funds are drawn out. Nonetheless, the interest rates and required payments can still be stifling for the business.
Outside Equity Funding
Equity funding is a primary method for funding the startup, including paying the salaries of early employees. Generally, equity funding begins with investments from friends and family, as angel investors and venture capitalists are rarely interested in investing in very early-stage companies. Once the business begins to scale, the company may be able to secure funding from angel investors.
Angel investors are generally good for seed-stage financing. The equity investment often begins as a loan (in the form of a convertible note), which is later converted to equity as the company matures. Once the company has scaled to the point of producing significant revenue or having a strong customer base, the business may be attractive to venture capitalists (VCs). VCs generally may investments of $500,000 or more.
Ownership Equity (or Equity Equivalents)
Perhaps the most common method of compensating early-stage, startup employees is by issuing equity ownership in the company. The company will pay a minimal (or no) salary to the employee but supplement the wages with an ownership interest. The equity awarded is generally restricted common shares.
But, it is also common for startups to issue equity equivalents, such as stock options, profits interests, or phantom stock rights. These offer similar benefits to stock awards. In any event, the equity interest is always restricted and subject to a vesting schedule. This makes certain the employees stay loyal to the company into the future.