Should founders accrue payroll before VC funding?

This particular scenario has happened in startups. You’ve started a company. You were used to getting a regular paycheck at your previous job, but right now there’s no money to pay yourself, but hopefully there will when you get funded. And at that point, you feel that you could “reimburse” yourself for all the paychecks you missed.

So you decide to start accruing your hypothetical salary. You basically say, “Hey, I would normally get $10,000 a month, so I’m gonna put $10,000 in the books as a payroll expense. However, that accrual just means you’re creating a liability, and there will be a liability on the balance sheet that says $10,000 per month. That will add up over time.

Accruing payroll can cause problems

There are some problems with this plan. One problem is the amount. While you may think your salary should be $10,000 a month, you haven’t gotten that approved by a VC board compensation committee. It’s a number you picked, not something that was authorized. But there are also other issues.

The liability can discourage investors

A bigger problem is the liability this creates. If you’ve done this, and you’re talking to investors, you have to disclose this payroll liability. If you don’t disclose it, and try to spring on them right before the funding, that’s will be a huge red flag. And your funding could very easily fall apart.

The size of the liability is important here – if you’ve only been doing it for a couple of months, and it’s $10,000 or $20,000, that isn’t as big an issue. But if you’ve accrued $300,000 or $500,000 of payroll, and you’re raising a $2 million seed round, that’s a very big problem for an investor. They aren’t going to want to invest that much money just to see a big chunk of it go out the door right away for work that’s already done. The investors want you to build value and make progress from where you are when they invest in your startup. Essentially, they’re not paying for past performance.

If you disclose this payroll liability after you’ve raised the money, they will probably say no and not let you pay yourself that money. Or maybe they’ll negotiate a much smaller amount, but that will also hurt your credibility with the investors. And credibility is the ultimate currency. You need these people to help you, you need them to introduce you to other investors, or do a bridge round, things like that. So don’t destroy your credibility on this.

The accrual can cause tax problems

Another problem is that it’s “funny money.” You’re making an accounting entry, but you’re not actually paying yourself. Doing this could potentially create payroll tax problems with the IRS and any state agencies. Technically you’re saying this was payroll. Particularly if you run it through your payroll system, which isn’t a good idea either. Identifying this accrual as payroll will trigger payroll taxes, which you should be paying to the IRS and any state agencies where you have tax nexus. But since you’re not actually taking a salary, you don’t have the cash to pay these taxes. However, the taxing authorities don’t know that. They just know you’re accruing payroll.

So these agencies could come after you for unpaid taxes. And one of the worst things to have as you’re trying to build a startup is have the IRS or a state agency sending you notices that you owe them payroll taxes. The government takes payroll taxes very seriously, because it’s one of their primary sources of revenue. So you could be subject to penalties. You will certainly end up paying your accountant a lot to fix this payroll problem.

It’s possible the IRS or state agencies might never know about this or may not care because actual cash didn’t change hands. But that outcome relies on their interpretation, and it’s a risk you just don’t want to take.

What can founders do instead?

One option is to request a bonus during your funding round. When you’re talking to the investors and the rounds coming together, explain to them, “I haven’t been taking a paycheck and I’m going through my savings. Would you be open to paying me some sort of bonus or let me pay myself a bonus after I close the round? Here’s the dollar amount I’m thinking.” And make sure it’s reasonable so you don’t alienate them.

A lot of investors are okay with that. They know you’ve been scraping by and you built something that they’re investing in. They want you to make good decisions. They don’t want you to be so broke that you’re making poor decisions. Calling it a bonus and asking their permission is very different from accruing a large amount and presenting it as a liability. That liability will have to be paid, and your investors probably won’t want to do that.

Carefully track any expenses you paid personally

Another important thing to do is make sure you track any company expenses that you’re putting on your personal credit card during that time, and get reimbursed for your expenses. And again, you need to make sure these are reasonable. These do have to be disclosed when you’re raising money as well. But often, founders have hosting services and Google apps and other business expenses on their person credit card. As long as those expenses aren’t crazy, it’s a good thing to create an expense report. Make sure it’s documented, make sure you have all your receipts, and make sure you’re audit-ready in case you do get audited someday about these expenses.

Then present that to the investors in the same way you would a bonus. “Hey, here’s what happened. Would you be okay if I reimbursed myself this amount of money?” And most investors will say yes, as long as it’s not too big. And really when you’re raising money, it’s all about having a very honest relationship with your investors.

We don’t recommend founders accruing payroll

The bottom line is that you don’t want to surprise your investors, and you definitely don’t want to alienate them. You don’t want the IRS or state taxing agencies to think you may not be submitting payroll taxes. So accruing payroll isn’t a good idea.

If you have any other questions on startup payroll, startup fundraising, startup accounting, or taxes, please contact us. You can also follow our YouTube channel and our blog for information about accounting, finance, HR, and taxes for startups!