February 19, 2020
Incentivizing Deal Leading – Lead Investor Compensation
Leading an investor syndicate requires a lot of work and expertise. And quite often the syndicates are struggling to find a volunteer to take the lead. One of the ways to address these issues is to compensate for the deal lead. In this article, we take a look at different lead investor compensation models.
Activities of the Lead Investor
While agreeing on the lead investor compensation several things should be considered, relating to both the pre-deal activities as well as the post-deal activities required:
- What is the amount of work required for the deal lead to coordinate the syndicate, perform the due diligence, to negotiate the deal and to close the investment (pre-deal requirements)?
- And what is the amount of work required for the syndicate lead after the investment is done, e.g. ensuring the communication between the company and the members of the syndicate, representing the syndicate in the board of the company, acting as an advisor for the company, helping the company in future fundraising and helping the company in exit (post-deal requirements)
Many of the post-deal requirements are such that those the value delivered is clear and a separate advisory compensation can be agreed in case the lead investor takes a hands-on role in helping the team. But the pre-deal activities are not, so those are easily left as a pro bono work unless a lead angel compensation is put in place.
Lead Investor Compensation Models
There are several compensation models for the lead investor:
- Lead investor fee
- Lead investor carry
- Board and/or advisory compensation
- No compensation for the lead investor
Lead Investor Fee
A lead investor fee is either a fixed fee or a percentage of the funding round. The compensation can be paid in cash or stock.
This is a model applied in most crowdfunding platforms as well as fundraising advisors. Thus, it is mainly suited in cases where the company engages the lead investor to help in the fundraising. For a syndicate that is formed out of a common interest in a particular startup, this model may not be ideal.
Example on Lead Investor Fee
One of my portfolio companies agreed to compensate for a lead investor with shares worth 2% of the funding round. The role of the lead was not only to lead the syndicate but to make introductions to new investors and participate in the discussions between the potential investors and the company. So he was clearly in this role as an advisor for the company.
Lead Investor Carry
With a lead investor carry (“carried interest”) the lead investor gets compensation if the exit is successful. Thus, the model is somewhat similar to the carried interest in VC funds. A lead investor carry is a good instrument in those investments where the lead investor is committed to driving the investment forward for both as a predeal and postdeal. If the role of the lead is limited to the pre-deal activities, this should be taken into account in the level of the carry.
Carried interest is non-pro rata distribution of profits on behalf of the lead investor. It consists of the carry rate, combined sometimes with hurdle rate. E.g. a carry of 20% with 2x hurdle means that the profits are distributed so that first all investors get their pro-rata share up to two times their original investment. After this level (“hurdle”) 20% of the proceeds (“carry”) are distributed to the lead investor and 80% to all the investors pro-rata their share in the company.
Examples on Lead Investor Carry
In one of my recent syndicates we applied a carry of 15% to the leads. This was divided as follows: 6% to the lead investor, 5% to the administrator of the investment structure (we set up a holding company for the investment) and 4% in three other syndicate members who helped the deal lead as experts during the due diligence phase, negotiations and drafting the investment documentations. In Fiban Follow (a co-investment structure for the members of the Finnish Business Angels Network) a carry of 20% above a 2x hurdle is applied.
Board and Advisor Compensation
Quite often the lead investor supports the growth of the company by helping the founders as an advisor or as a board member. If this work is separately compensated, we talk about the advisor and board compensations.
Advisor and board member compensations can be paid in cash or shares/options. As the compensation is for the work performed by the investor as an advisor or as a board member, it is not so much compensation for leading the deal. I prefer applying for an advisor and board member compensations in cases, where 1) the investor is providing valuable assistance and 2) the investor is not compensated thru lead investor carry. If the board member is only observing the investors’ interest without adding value to the company, in my view the board member compensation should not be paid by the company.
When agreeing on the compensation for the advisor or board member, it is also a good practice to define the responsibilities of the advisor or board member to ensure that the parties’ expectations regarding the services are aligned.
Example on Advisor Fee
The parties can agree that the advisor provides quarterly mentoring to the founds and attends quarterly advisory board meetings supporting the team in strategy, corporate decision and fundraising for two years and in exchange receives options corresponding to 0.8% in the company. It should be noted that the stake in the company depends not only on the involvement of the advisor but on the stage of the company as well.
Having defined board member compensation and responsibilities, makes it easier for the founders to reach out to investors and ask for assistance. In cases where no compensation is paid, the founders may have a high burden to “bother” the investor – defining responsibilities and paying a fee for the board member eliminates this burden.
Quite often lead angel does not get any compensation. And while I have been advocating for the use of some kind of lead compensation, this model is justified in some cases. For example, if the syndicate is small and all the investors are contributing in equal fashion into the growth of the company, leaving the lead without compensation can be justified. Also, in these cases, the value of the investors’ non-monetary contributions should be taken into account when discussing the valuation and other deal terms. Thus, this kind of model works best in early investment rounds when a small group of investors is supporting the founders in the early stages of the company.
As discussed above, choosing the right compensation model for the lead investor depends on the case and the role of the lead investor, both before the deal and after the deal. The different compensation models and roles of the lead are summarized below, which is hopefully useful when considering the lead investor compensation.
- Lead investor is engaged by the company to find investors: Lead investor fee
- Lead investor is responsible for coordinating the syndicate and pushing the company forward with hands-on activities: Lead investor carry
- The investor is not leading the syndicate but has helps the company with hands-on support: Advisor fee
- Founder takes care of coordinating the investors and running the funding round: No lead compensation
- All the investors in the syndicate contribute equally and their contributions are taken into account in the valuation: No lead compensation
Article written by Reima Linnanvirta