Why VCs prefer firing founders

Classic case example: founders A, B, and C each get 2M shares, owning one-third each of the startup; they build value over, say, two years and take in $4 million in VC funding at, say, $6 million pre-money valuation; VCs require them to reverse-split their shares to 4 million, VCs take 4 million at $1/sh, with 2 million in pool, of which 1 million goes to an outside CEO brought in by the VCs; as part of funding, founders have to agree that one-fourth of their shares are vested while the balance vest over 4 years; this means each founder now owns about 1.3 million shares measured against a model of 10 million, or about 13% of the company but only slightly over 4 million (4%) of those shares are vested; arrangement is theoretically "shared control" (4 million to founders, 4 million to VCs, with maybe a board-seat deal of 2/2/1, with the one being the new CEO). Net result: founder who might have built incredible value in the first two years of effort on behalf of the startup finds himself, immediately after the VC funding, cut back from 33% to 4% equity stake, typically with no acceleration provisions for his stock in the event he is fired without cause. In such a scenario, the founder can be highly vulnerable to losing most of his stake in the venture if the VC investors and their favored CEO decide that he is immediately dispensable.

Specifics can go all over the board in different cases but the above example typifies what tends to happen with founder interests in a typical Series A funding. Founders can resist but, if they want the money, they often have to agree to just such terms.

I have seen all sorts of cases where such scenarios lead to bad outcomes for the founders. I have seen many others where things work out great for all concerned. It is just one of the risks of taking in VC funding but it is a very real one for the founders.

Even where a founder has largely vested his interest, or where his termination triggers enough accelerated vesting that he largely vests, he will find himself vulnerable in any down-round scenario. In that case, I have seen VCs (in the most abusive types of cases) do as much as a 100 to 1 "reverse split," reducing everyone in the company to 1/100th of the interest that person held before a new funding, and then inject new funding (at a much-lowered company valuation from that used in the most previous round) that leaves the VCs with substantially all the ownership in the company (they being the only ones with the funds to participate in the highly dilutive round) apart from the employees they wish to keep and such persons will then have their options "refreshed" to give them modest equity pieces as incentives to keep going forward. While the 100-to-1 cram-down is absurdly extreme, many cases will arise of more modest ratios used by VCs that have the effect of sharply reducing the early-stage equity interests in a company and that clear the way for new grants to be made to continuing founders who, because of such grants, will keep something close to their original percentage in the company while a terminated founder gets sharply reduced.

Hate to sound boring with logistical details but these two illustrations are among the most common techniques used.

One way: take in new money at a lower value than the founder would like. There is always a reasonable difference of opinion and majority shareholders can exploit this to dilute the value. They don't even have to take risk. Just make the company cash rich instead of cash poor. That's one reason why early investors demand anti-dilution clauses. But if you are a cash poor founder it won't do you much good.

I'm sure there is a lawyer here around that can help prevent such shenanigans. Anyone?

Yes, the basic idea is that if a founder has, for example, 25% of the equity in the company but is subject to a 5 year vesting they just don't get the shares that would have vested after they leave. If they move on after 2 years, that is 15% of the company that is no longer outstanding equity and therefore everyone else's stakes (VCs, other founders, employees) are proportionately larger.

In the original AVC post he hints about this by talking about doing the right thing and accelerating the vesting in these scenarios, but that could obviously mean a lot of things in terms of actual amounts depending on the situation.