One of the most common questions we get about our Shared Earnings Agreement terms is “what’s the deal with the Salary Threshold?”
To address the most common misconception first: it is not a salary cap. As the founder(s) of your business you have full control over setting your own salary.
With that aside, let’s dig in a little deeper. First, remember that the entire point of the SEAL is to align us as the investors with founders who want to run a profitable, sustainable business. A common source of mis-alignment is that founders can pay themselves a salary or dividends or hold cash in the business (retained earnings) and pay themselves salary/dividends out of that any time they want… while preferred equity investors only get a share of dividends. This works reasonably well for large publicly traded companies, but in private profitable companies, things get out of whack very easily.
The primary way we recoup our investment is by sharing in a percentage of Founder Earnings. Founder Earnings are broadly defined as the economic value that goes to the founders (in the form of salary, dividends, retained earnings, etc). Basically, we earn a piece of whatever the founders earn, kinda like a small non-controlling co-founder.
So why don’t we just have a flat arrangement that we get XX% of Founder Earnings?
We invest very early in companies and if the business is only generating $30k in Founder Earnings we don’t want to start taking our percentage and cutting in on the minimal earnings of the business. So we set a threshold, and our percentage only kicks in on the amount above that limit. We know you need to live off what your business earns and the threshold is protection for the founder in the early years of the business.
Two important clarifications in how the salary threshold affects Founder Earnings (both of which we hope you’ll agree are the most founder-friendly ways to
- It works like marginal tax rates and only affects the amounts above the threshold. If the threshold is $50k and the founder draws an $80k salary out of the business that year, there’s only $30k of Founder Earnings (and Earnest would be entitled to some agreed % of that).
Onlysalary that is generated from the operations of the business counts toward Founder Earnings. For example, if the business only nets $40k for the year and the founder decides to top up their salary by drawing down another $30k from the invested capital from Earnest yielding $70k in total compensation to themselves. Even if that is over a salary threshold (let’s say $60k) the Founder Earnings calculation would be $0 owed to Earnest. We don’t want to get paid back with our own money and so Founder Earnings only applies to salary (and other kinds of founder compensation) that come from the operation of the business.