Zerodha founders’ salary: Let’s cut through the noise

There are regulated bodies such as banks where the regulator or institutions like the Reserve Bank of India (RBI) will have a say in the compensation paid to the management. Otherwise, it is completely the prerogative of the company board and shareholders. In this case, as a closely held company, the shareholders, the board, the management, the founders are all the same people. They decide and can take any salary, including borrowing and paying themselves salary. This incidentally is not the case here, as Zerodha is an insanely profitable company!

There are three distinct ways in which promoters / founders can reward themselves and take out money from the company which is a distinct entity.

1. Salary to promoters: As salaries for the work being done; just as anyone who is employed would be paid. This is taxable as salary income and in the highest tax bracket. This would mean 43% tax with surcharge, etc. To the extent the salaries are paid, the profit before tax (PBT) of the company would come down, so less corporate tax will be paid by the company though individuals will get taxed.

2. Dividend to shareholders: As dividend, the company can, out of the profits, pay corporate tax, then distribute dividend. The corporate tax rate of 25% and then individual tax on dividends of 34.5%, would mean effectively a tax rate of 51% by the time it comes to individuals.

3. Selling shares of the company at a premium to other investors in private placement or through an IPO: The taxation depends on short-term or long-term capital gains, based on how long the securities have been held. Assuming it's more than 24 months, the tax would be 20% with indexation benefits. Typically for a five-year holding, would mean roughly 17% tax.

Let’s take an example: say, the closely held private company wants to distribute or reward the founder with Rs 100 from its coffers. Under each of the three options, the founder would receive following amounts:

1. After 43% tax, he/she would get Rs 57.

2. After the corporate tax and individual dividend tax, he/she would get Rs 49.

3. Assume the valuation the company gets is 20 times PBT, for 5% of the company sale, he/she would get Rs 100, after 17% effective tax, Rs 83 in hand. Though they own less of the company, the Rs 100 is still in the company and can be used for further growth.

You can see the attractiveness of this.

So, it’s really left to the company board and shareholders how to compensate the promoter by a combination of the above.

Typical challenges and misuse of promoter / management compensation

While this is blown out of proportion, let’s see what the other angles or misuse of the options available are:

1. Promoters/management taking high salaries while the company is languishing, taking more and more debt, selling core assets, destroying shareholder value while their salaries are out of whack. The board of directors that approve this don’t raise their voice as they have been appointed by the promoters and management. The shareholders, in
many cases the minority shareholders, have no say in this.

2. Promoters driving up the valuation, the share price, so that they can encash, either through IPO (initial public offering) or private placement while the company is struggling for sustainability. Often driven by investors who are looking to mark up their investment or exit in subsequent rounds.

3. Promoters harvesting the business by dividend distribution or salary withdrawals to maximise short-term returns rather than invest in the business, diversify, grow and ensure long-term viability and growth of the business.

Founder compensation: How much is too much?

Since we are on the topic, questions often get asked about founder compensation, especially in startups that are VC funded and yet to achieve profitability. There are several factors here:

1. Should the founder/ CEO be paid as per market norms or is it ok for the founder-CEO to be paid much less than his direct reports?

2. At seed or series A B stage, how much should the founders salaries be, given there is limited funding and runway?

3. Given the founder has only a minority stake in the company, and would be able to monetise only after many years, how much haircut on salaries can he/she take and for how long? What is fair from everyone’s point of view?

There are no easy or correct answers and a lot depends upon the position the company is in and the founder’s situation. Let’s try to understand some of the cases.

1. Founders’ basic need: It is normal to expect the founders' running expenses - including EMI for house, car, if any - are met from the compensation. Founder dipping into savings to meet personal cash flow will create a lot of unnecessary pressure.

2. Stage of the company and funding: If the company has raised sufficient funding for next 24 months burn, and the salary is a small portion of the total funding and will not change the runway significantly, it is fair to be more liberal.

3. Market comparisons: Benchmarking to market salaries is a slippery slope as there are no real benchmarks if you want to compare apples to apples. Salary in a MNC without significant equity stake is not comparable. Salary in a social sector or old economy company that typically pays much less is not the right benchmark. We, as founders, choose to be entrepreneurs and are prepared for the pressures and pleasures of entrepreneurship. We are not looking for the best monthly take-home salary. The risk and potential rewards are well known.

4. Profitable companies: For companies that are profit making, have huge reserves, obviously sharing the wealth creation is important. If the founder owns a minority stake and dividends are not company policy, salary/bonus/ incentive are the ways to compensate. A judicious mix of capital appreciation benefit and salary benefit needs to be done, keeping the long term sustenance, growth objective, founder motivation, investor and other shareholders interests in mind.

5. Signalling: From the founder's point of view, signalling frugality, startup mentality is important. In India, everyone knows other people's salaries. It’s difficult to lead a team and expect startup frugality, if you set your compensation to market levels. Also, vis-à-vis your investor and board, I have always felt, it’s better to be in a position where as the CEO and founder your salary compensation is much lower than market as long as it is not impacting your monthly needs and cash flow.

Lessons from Zerodha model

There are strong lessons here for entrepreneurs and founders worth learning from Zerodha’s stellar success story. In a VC-fuelled start-up ecosystem, it is heartening to see strong profit making business
models that can create wealth for shareholders and employees while bootstrapping. This is an alternate model. IT services firms have shown that multi-billion dollar companies can be built without VC money, without high cash burn, without buying growth and market share.

Employees can make money from Esops even when the company is closely held. The company/founders can create attractive liquidity options for their employees. We have heard about Azim Premji, in early days, buying employees’ vested options when they left or wanted liquidity.

Even bootstrapped businesses, without any media hype or glamour of mega fundraising and valuations, can build very attractive unicorn valuations. Gratification and recognition takes time but being the fastest to get unicorn valuation is not the only metric: Zerodha has shown that building a product or service that customers love, solving a big pain point, creating a disruptive business model (zero commissions), can create a huge
success.

What not to infer from Zerodha model

While acknowledging the many good learnings from the Zerodha model, I am concerned at the bashing the VC-funded, high-burn, valuation-driven tech-based business model is receiving. Let’s understand it from the right perspective.

Zomato and Paytm have IPO plans in India which is a welcome development. They were loss-making B2c companies, dependent on large rounds of venture funding and have been consistently losing money for more than a decade. Technology sector is the largest and fastest growing sector in all major stock markets of the world. In India, we have had
banks and FMCG dominating the stock market, and are being valued much higher than their global peers. The future in a country like India is tech and Covid has accelerated this. Tech platforms are large, powerful and are building whole ecosystems. Globally, huge monopolies are being created like Amazon, Google, Apple, Facebook, Alibaba, Tencent and other mega corporations. India is the third largest consumer market in the world, under-penetrated, with huge problems to solve. So, the cash burn that companies are incurring, is really an investment – consider it like building infrastructure like roads and power and water supply in old times. These would require large capital, high burn and made operating losses for many years. They look inefficient in the short term.

The smartest investors in the world are valuing these high-flying startups and betting on them. When they become big, they will grow the market dramatically, become even bigger and become trillion dollar companies. So, while bootstrapped, always profitable, slower growth business models are one method, the alternative is also very attractive and not to be sniggered at.