Wall Street Journal’s article ( http://online.wsj.com/home-page), “Obama Seeks to Jump-Start Stalled Plans”,(WSJ, Jan. 29, 2014) summarizes the President’s initiatives to raise the minimum wage from $7.75 an hour to a whopping $10.10. And I, of course, pondered the impact of the new hourly rate on startups.
The Financial Times (www.ft.com/reports, January 23, 2014) describes a very somber picture where the global under-25 unemployment is 75 million, almost 38% of the global unemployed. The unemployment rate for the Spanish youth is even higher than that. One Spanish woman had graduate degrees in law and business, she spoke several major European languages. And still she remained unemployable.
Under conventional macro-economic theory, higher hourly wages decrease potential employment. This relationship concerns many economists and policy makers. Where can the young, employable youths find work and opportunities? Are startups the solution?
Then I ask myself : does entrepreneurship invest in the young and many have been wildly economically successful. But can the youth from the lower rung in the socio-economic strata latch on to such success as well?
When one does the math regarding the difference between an $8 minimum vs a $10.10 an hour wage, the annual difference is about $80 weekly, about $350 monthly. On the margin, that is not an insignificant difference. If that person has a spouse, double that to about $700 monthly.
Startups require self-motivated workers, usually with the specialized skillset and experience; it is not very likely that a tech startup will have use for these truly minimum-wage workers, except perhaps in the service sector, such as restaurants.
An extremely successful California VC managing director claimed that entrepreneurship allowed him to live in the coastal Shangri-La. But during his early startup stage, while the company did not pay a salary for months, his wife, a professional with a graduate degree, supported the family until his newly created company was capable of paying a salary. When the company took off, he cashed in his equity, and has ever since enjoyed the Shangri-La. Today he, and others like him, believe that entrepreneurship is a wonderful thing, and that it generates wealth and supports a wonderful lifestyle. When one looks around the startup Mecca around Silicon Valley one sees thousands of well-educated youth striving for the pot of gold. Only a small number will make it, and get rich, as well as make their early investors even richer. The rest will have learned lessons that may help them succeed at later attempts at entrepreneurship, or will forever chase the rainbow.
I recently encountered a Los Angeles startup company where the two co-founders financed the startup with enough capital to rent an office and buy hardware/software to develop a Groupon-like product. None of the 7-8 programmers were receiving a salary, as in many other such situations the salary is deferred. I wonder how these “employees” were capable of living in Los Angeles; perhaps only by borrowing from wealthy parents, or living extremely frugally. Whether they were unpaid independent “contractors” or employees, I predicted that their dedication would last one or two months at the most. After that period, that firm would fall apart and it did.
Entrepreneurship is a romantic notion, but there is one very important reality: people can only live with cash. Sweat equity can last only so long for workers without financial lifelines. And founders should understand the plight of those employees. Therefore I am very critical of that approach.In my blogs I metaphorically describe cash flow as the life-blood of a company. And a body without blood cannot survive long. In the case of the LA company, the founders kept funding it for a while, and, as far as know, it didn’t survive. Why? I surmise that the unpaid programming team worried more about paying bills and making their rent or mortgages than solving the business problems creatively. It is hard to focus on the work when that unsalaried worker is concerned about financial survival
Many West coast companies, I observe, expect substantial sweat equity from their employees instead of adopting a debt structure to fund operations. And that sweat equity can be dangerous in the long run if that funding never arrives and the mortgage payments need to be covered. In that case, that employee has not even seen the minimum wage.
My observation is that startups on the East Coast generally fund their company’s operations with convertible notes. These notes convert to equity when the business is successful enough to raise a traditional equity round. For the investor, debt offers the best tax deduction if a company files for bankruptcy, since debt holder have superior priority rights over shareholders in the event of liquidation. Investors with convertible notes can deduct the loss for debt defaults within the first year, while equity losses can only be deducted over time.
And these East Coast companies with convertible debt are usually well funded so that the company can cover salaries and other expenses over several months or even a year.
Then there are those companies where the founders are supported by family (garages) or relatives (investments) or universities (incubators). There is even a Latin American program, www.startupChile.com, which incubates foreign and domestic startups in their country, perhaps in the hope that entrepreneurship creates economic boom.
Then I hear of poorly managed startups that waste their recently raised capital. Last week I heard of a medical device company that burned through $19 million by its senior management with inflated senior management salaries and expensive business expenses. Or a natural language technology company that failed to monitor its burn rate until the $2 million bank account hit bottom without a commercial product being ready for revenue
In some cases there is no alternative to raising external funds, in exchange for equity, but most often revenue and margins are the best source of funds a startup can have. Early stage spending must be focused towards development of products, and customers, which will generate margins. This is usually also the highest risk stage in the life of a startup and any external funds will be very expensive. Once a startup has revenue traction, the valuation rise, and operating capital for growth becomes a lot cheaper. In this situation the founders keep a much larger stake in the venture. And that traction can be best achieved faster and more efficiently with paid employees.
And the most important reality for any startup company is having cash to finance their operations from the get-go, a difficult feat for founders previously working under minimum wage. First, companies should be funded enough to cover not just office equipment but also budget reasonable labor costs. Companies are more efficient with cash compensated teams. Second, senior management must monitor the burn rate and cash in the bank every day. Third, the marketing team must focus on sales-revenues. That is, develop products that “bring in the bacon” very early in the life cycle. Fourth, create economic value for the company quickly that reduces the cost of future capital. That means developing a strong team with a menu of commercially available products.