Ask HN: How do founders end up broke?

Liquidation preference is the number one way that founders end up with nothing. Works like this: VC invests $1m with a, say, 5x liquidation preference then if they company sells for, say $6m the VC gets the first $5m and the remaining $1m is split according to equity. http://www.gabrielweinberg.com/ has some really, really good articles on this kind of thing.

But if the company sold for less than $5m, the founders would get nothing?

Probably ignorance here, but if the company sold for less, say $4m are the founders now in debt for the remainder of the 5x agreement?

So the founders who own majority of the company, can be outnumbered on the board and have little influence over "strategic tactical" decisions etc?

yes at $5m they will get nothing, but at $4m they won't be in debt. 5x is really a rip-off, but 2x (double-dip) is quiet common.

Liquidation preference at its core is an instrument to protect the investor. Imagine the following scenario:

An Investor gives you $1m for 50% of your company. A year later it sells for $1m (because it wasn't a hit). The investor just lost $500k you made +$500k.

Simply put, funding rounds are often a stack. Each round of new money typically moves existing investors to a lower priority.

Founders are first in.

1. If you're in debt because of your startup, then when you get acquired you use that money to pay off your debts, and keep what's left over (after taxes, and all). If you're deeply in debt, then it may occupy a large sum of your money.

2. When your VCs and board own most of the company, they have the right to fire the CEO regardless of his founder status. This can be avoided as long as you keep the majority of shares. Influence varies from VC to VC, but I'd say their influence is proportional to the amount of the company they own. They only take as much as you let them take.

3. Being bought out and/or burned is probably the top reason why founders leave or sell out. When you've been doing a startup for several years and you're ready to move on, and someone offers you a big fat check for your company, it's hard to turn it down unless you're really passionate about your startup and are still willing to push it forward yourself.

"This can be avoided as long as you keep the majority of shares."

This is wrong. A board can hire or fire as it chooses. Holding a majority of common shares can mean very little, as many founders have learned the hard way. Protective provisions and board seat election procedures can, for all intents and purposes, define who controls the company.

Dan can you elaborate? If the board is company leaning with say 3 of 4 seats for the founders and 1 investor, how can a founder be fired unless in the unlikely scenario that the other two vote against him/her?

His point is that owning a majority of the shares does not necessarily imply controlling a majority of the board seats.

Can you elaborate on why not? The board exists to run the company on behalf of the owners. If you are the clear majority owner (51% - heck, let's say 75%) - in what way can the board possibly be stacked against you unless you willfully let it?

A not-uncommon scenario for a post series-A board is a CEO, a cofounder, 2 VCs, and an independent. Any 3 board members can sack the CEO and hire a replacement. To add insult to injury, the CEO seat is often attached to the job, so the replacement gets the CEO seat, and now the sacked CEO and cofounder are left to bicker over one seat.

The board composition is decided by the financing docs, and is one of many things you negotiate in the financing. You're right that you have to "let it" happen (ditto the protective provisions), but unless your round is highly competitive you will probably do that, as the alternative is not getting funded.

Finally, note that the board exists to maximize shareholder value. The CEO's share holdings, majority or otherwise, do not mean s/he is the best person to create value for the company's shares. A board member is supposed to act for the best interests of the company as a whole, not for any one person or share class.

As a side note, this sometimes leads to odd cases where someone - like a VC - will vote in favor of something as a board member, which is clearly in the best interest of the company as a whole, but then vote against it with their shares, which is their right and obligation to do, to maximize the value of their own investment. That could happen, for example, if an acquisition offer was in play that would not meet the VC's goals for the investment.

These definitely happen all the time.

Another thing to watch out for is for unfilled seats that can change the board dynamic. If multiple parties have to agree on the board seat, then an intransigent investor can maintain an advantage by never approving any candidates. Don't put off filling these seats! Ideally, you should agree on a specific person before you sign the docs.

Because board seats are often given to new investors as part of term sheet "package". Shareholders can decide to grant a board seat to an incoming VC because they think the combo of the VC's money and guidance will increase the value of the company. That can lead to situations where a majority of the ownership is not represented on the board.

The US has strong minority shareholder protections.

An interesting (albeit fictional) movie to watch on this topic is "The First $20M is always the hardest". Yes, you have to give away equity to get funded. But if you are asked for a controlling stake early in the game, then you are being setup for a big letdown.

Also, although convertible notes are very fashionable these days, consider your position if and when you need another round of financing. You may very well be forced into a bad deal under the threat of liquidation to pay your creditors with the company IP. On the other side of the table your investors got you to pour your blood, sweat and tears into the company as well as the financing, and they ended up with 100%. This is not to say that all VCs are bad, or even most. Rather, that is the substantial risk of a convertible note.

http://thefunded.com is a great community of founders and CEOs, and includes many bitter people who were burned by investors. I've seen a handful of horror stories on there.

See this post for example, even though it doesn't speak directly to your question of being broke after an exit, because it talks about investor control: http://thefunded.com/funds/item/5822

"From a purely technical standpoint, venture capitalists can't easily 'fire founders' either, yet two thirds of founding teams are eliminated. In fact, most investment agreements have more provisions to force a sale than they do to eliminate a founder. "

That article was very informative.

I still don't fully understand what a VC has to gain by eliminating the founders?

So as long as the board is owned by non-founders, a sale can be forced even though the founders disagree and want to continue operating ... even if the sale will leave the founders with nothing? ... that seems so diabolical!

One of the big things I know about is the being "in love with the technology". Founders get replaced in their own companies because they focus on improving the technology, rather than revenue. There is a balance, but part of the reason VCs and investors get shares is because their financial interests should be represented in the company. If as a founder you aren't representing their financial interests, then of course they will replace you.

There are big dramatic forced resignations, but often there are simple restructures. A founder will be removed as CEO, but stay on as a VP of development, for example. His ownership stays intact, but the executive leadership will be more aligned with the interests of the investors.

>>Also, how do cases like Steve Jobs and Harry Osborn occur where they are removed from their own company?

Check out the movie 'Pirates of Silicon Valley' - its about Apple and Microsoft and shows how Steve Jobs got fired.

0) Desperate 3-man startup needs capital to survival. (gone 4 years w/o salary)

1) After pitching only thing they get is an offer with 'participation'. This means a preset amount is guaranteed back to the investors in an exit event if the % gain doesn't match a specific minimum. I.e. Investors are guaranteed 1,000,000 if their equity doesn't exceed that value.

2) A partner sees the company is weak, knows the founders are rockstars and rolls them up for 1.2 million.

3) Founders get jobs at company X and 200,000 split among 3 of them before taxes.

The term for first-money-out is "preference". Preference terms are almost ubiquitous in preferred stock (the similarity in names isn't entirely coincidental).

Participation means that after the investors get their preference out, they continue to share in proceeds ratably. It is also common, but less so.

The short version is: preference WITH participation means "Your money back plus your share". Preference WITHOUT participation means "Your money back OR your share, whichever is bigger".

Brad Feld's term sheet series explains this well, in depth.

>> I've recently read stories of startups that became successful and were bought out for large sums, but the founders received little from the transaction.

It depends on what startups you're talking about, there are many reasons as to why this could happen.

>> Also, how do cases like Steve Jobs and Harry Osborn occur where they are removed from their own company? Do VC's and Investors really take that much of the company? How much influence do they hold over a company they invest in?

Apple was a public company at the time, and Steve Jobs was forced to resign by the board, just like any other employee can be forced to resign for whatever reason (unless they're in control of the majority of board, ala Mark Zuckerberg). He still owned a large share in Apple after he was fired, which I believe he mostly sold off.

>> Why would a founder continue if they lost their ownership? Why would a founder give up ownership of their company in the first place? Isn't one of the prominent appealing aspects of the start-up world to own your own company?

Most good founders don't want to give up ownership, but if you want to receive funding from investors, as far as I know there's not really any alternative to giving up equity in your business.

There is also something to be said about a founder not being the right person to a grow a company. A techie might make a great CEO to impress a VC and raise a million bucks. But is he able to make the right deals, find good partners, hire superstars, etc? He is invested in the company, possibly more than most so it is in his own interest to let the VCs place a better CEO so he can focus on what he is best at.

Are there a pre-set number of board seats or can new seats be issued as new investors emerge?

How did Mark Zuckerberg maintain control of the board, whilst still receiving huge VC investments? So I imagine it something like, he owns majority of the board but not majority of the shares?

Crazy high valuations—investors are paying huge sums for small stakes. If you convince people your startup is worth ten billion dollars, you can raise a billion yet retain 90% ownership.

Why would a founder give up ownership....

They would give it up because someone offers them money in exchange for that ownership.

As long as you aren't seeking investment capital and are retaining full ownership of your company, you have nothing to worry about with regards to losing your company.. buy if you want others to invest their money - you will likely have to give something up in return...

I've seen cases where one absolutely non-technical partner takes 75% of the initial equity, tells the other not-so technical partner to find technical people and that her 25% has to be diluted if necessary to bring them in. That's a recipe for ending up with almost nothing if the firm ever becomes profitable after a round or three of investment.

Thanks for all the answers ... I also found this which cleared up a few things.

http://www.danshapiro.com/blog/2010/08/vc-insanity-economics...

By not winning.