Q: What costs are considered reimbursable to the founder of a start-up company? More specifically, if the founder has been boot-strapping his company since inception, and he agrees to a series a term sheet with a VC firm, are the operational costs incurred by the founder between this time and the closing of the round reimbursable to the founder? For example: The founder of a consumer product company and a VC firm agree to a term sheet in July. The round doesn’t close until October or November due to raising additional capital for the round, attorney delays, etc. In the interim, the founder continues to self-fund the day-to-day operations of the business – packaging design, inventory, PR firm, etc. What expenses can the founder expect – if any – to get paid back out of the series a funding?
This varies widely and is fundamentally a negotiation between the new investors and the founders who have incurred the expenses. The four variables are:
- Amount of expenses
- Amount of funding being raised
- How the expenses have been accounted for
- Attitude / style of the investor
As the amount of expenses increases, the willingness of the investor to reimburse for any of them decreases. This is directly linked to the amount of funding being raised. For example, if $1m is being raised and the expenses are $50k, an investor will likely be ok with 5% of the funding getting paid back to reimburse the founders. However, if $1m is being raised and the expenses are $500k, it’s unlikely that an investor will be ok with 50% of the proceeds going to paying founders back for expenses that have already been incurred.
How the expenses have been accounted for also matters a little, if only for optics. If it has been treated as debt advanced to the company by the founders and is documented in an arms length transaction, it sometimes has more impact on the investors. The issues of amounts far outweighs the structural issues, but the structural issues sometimes signal that there was an intent to see the money get paid back at the close of the financing.
Finally, the attitude and style of the investor matters the most. Some investors are adamantly opposed to the idea of paying the founders back any expenses and view this simply as contributed capital to the business. Other investors will view this as part of the investment required by the founders to justify the pre-money valuation. Other investors will simply not want any of their new investment to pay for past expenses. In contrast, you’ll run across other investors who are more flexible, or who are happy to get a little more money into the company at what they believe is a relatively low valuation.
Ultimately, there is no rule – it’s just part of the negotiation.