Investor Concern Grows Over Founders Cashing Out Too Much, Too Early

I have read few articles that made me as angry as this one did in recent memory.

Let me get this straight -- investors are complaining that entrepreneurs are outnegotiating them on liquidity terms? And their concern is that the entrepreneurs won't keep doubling down to get to a billion dollars once they have some reasonable fraction of the investor's personal net worth?

It takes the arrogance of the very rich and highly dominant to complain that they're unable to keep their top employees poor enough to stay motivated. To also kvetch that they're getting outmaneuvered at what, fundamentally is one of their only advertised skills, negotiating terms-sheets, would be laughable if the tone of the article wasn't so earnest.

That said, davidu raises good points here about company alignment; it is hard to watch your boss get rich if you don't. You'll probably end up hating them. One nice thing about an 'exit' is that your boss will leave, so you can hate him or her remotely. I'd say the solution is fair incentives up and down the chain in the company, a circumspect attitude to spending, and just keeping quiet about how the deals go.

Unfortunately this article ignores the reasons that pre-exit liquidity for founders is so important. The average founder of a VC backed startup typically only owns around 10% of the startup at exit, and is actually not even likely to still be there at exit time in many cases.

Between first funding and exit, the startup may go through a cram-down recap that washes out founder equity or at least a highly dilutive down round. This is much more common than the company simply going out of business. Another issue is that VC backed startups often raise too much capital and sell for less than the overhang of the liquidation preference. Noam Wasserman from Harvard Business School studies founder issues and says that 4 of out 5 founding CEOs get fired from their startup. Even if it's half that, it's still a sobering statistic.

When startups sell for less than the liquidation preferences, a carveout is often given to current management to close the deal, but that may not include the founders. Founders also often work for sweat equity for years, and then get paid less as CTO or founding CEO than they would working at as senior engineer at Google (in contrast to many VCs who get multi-million annual salaries from their management fees even if fund performance is poor).

All of the risks above is why the book "The Illusions of Entpreneurship" claims: "Even successful founders usually earn 35% less over 10 years than they would working for others. The typical, median, right-smack-in-the-middle entrepreneur is a failure. You have to hit the top 10% to have income as an entrepreneur better than what you would have gotten working for other people."

The reason that pre-exit liquidity is so important for founders is because the chance of making money AT AN EXIT is so low, and because raising tons of venture capital often reduces the likelihood of a founder profiting from an exit.

Update: I also forgot to say that VCs can usually block a sale, another big risk for founders.

I totally agree with this piece, and anyone who knows me knows I feel this way.

Giving an entrepreneur $250K-$500K to pay off credit card debt and give them a bit of comfort cash, is one thing. Doing so helps make sure they are invested in the long-term success, without making them eager to sell too early, but giving someone $1mm+ before driving a business to major traction, revenue and profit is dangerous for the long-term success of the company. It removes the requisite hunger level which is a determinant for success. Moreover, it actually disincentives selling at the right time, because founders who have pulled $1mm+ off the table are likely to discard even the best offers at a time when reality would dictate the should take the offer (see: digg.com).

I guess you could chain the founders to the wall and feed them gruel too - that would keep alignment.

Kidding, but wanting a guaranteed return after years of struggle is sensible. Witholding that because you like to seem the founder "hungry" is not nice, and certainly nobody's business but the persons involved.

I can guess that it will sometimes blow up in everybody's face. Yet in the end, the founder has the leverage in a bull market.

Admittedly, I'm a cynic, but I'm a bit suspicious of the investors' motivations behind their alleged concern.

Sure, it may loosen the founders' ties to the company, but it also loosens the founders' ties to the investors. Investors cannot influence founders with more liquidity (by say, diluting the founders' shares if possible).

Then again, I am a bit of a cynic.

I have a simple rule when it comes to this stuff. Liquidate the founders out of a years worth of projected profit if they stopped hiring right away. "Less than 20 million" could still be $15 million and when you've been grinding for a while sometimes you just want that damn sports car and cottage. Comes back to the fact that every additional dollar is worth less than the one before it. Throw some risk and 1x liquidation preferences and the founders have a really legit reason to just sell to Google for $20m and start something else.

After watching the history of Silicon Valley video which told of the raw deals old school founders got from their VCs, it's hard to have much sympathy for the investor class. Mark Zuckerberg cashing out enough to buy an Acura TSX probably isn't going to raise eyebrows about future liquidity terms. However, the recent Slate article about Sean Parker chartering private jets and buying a $20M carriage house might be what's really causing investor concern.

Maybe a bit OT, but when I read articles like this, I look at the VC scene here in Europe and feel sad. It's hot here (amongst MBA types) to be able to say that you're affiliated with a VC-, 'innovation-' or 'seed' fund (leaving aside that many of these are funded at least in part themselves by public money) but the sort of talking in this article is widely foreign to the type of people who typically get the reigns in such organizations. Over here, they don't see 'founders' as such; tech people or people who actually build things for customers are seen as commodities who just execute simple rote tasks and who are really just employees that don't need to be paid a salary until the point the company is bringing in money and then they get paid (x years times double or triple median salary). 'Liquidity event' for founders in an investment round? They'd look at you as if you had gone nuts if you proposed something like that over here.

(again sorry for OT and the above may come from observation bias - I'm just bitter today I guess ;) )

This is an interesting issue.

If founder(s) get a liquidity event, are they no longer fully committed to making the business successful? Definitely depends on the person.

Also worth a look is where the company is at success-wise. It makes more sense for a successful/profitable company (like Groupon) to give founders a liquidity event than a startup trying to get to breakeven.

I think the bigger issue is the types of companies this line of thought promotes. How is your company going to change the world when you're planning on cashing out 3 years in? No wonder there are so many trendy and knockoff startups.

The investors are looking at this the wrong way. If buying employee equity doesn't seem like taking candy from a baby, then perhaps they should not be investing in the deal to begin with. I'd gladly buy shares in Groupon if the price looks right; and if the sale happens because employees want to buy a house then great - distressed asset sales are great buying opportunities, and that's what this is.

I think one's perspective on whether it's smart/dumb or right/wrong for founders to seek liquidity "too early" is going to depend a great deal on whether you yourself are "post FU money" or "pre FU money". If you've achieved FU money, meaning you don't really have to worry about money or working a regular job ever again, then it's hard to imagine what an early $100k or $1m liquidity event can mean for another person. And it may not even be the case that the founder wants it for bling-and-hookers reasons: he may want it for health reasons, or to help out family members in some way, where there's not really an option to put it off another 5-10 years. Now add to the equation that founders may very well be underwater on a home mortgage, may have debts racked up, unpaid college loans, etc. and early liquidity, even if it means a smaller potential total payday overall, starts making a lot of sense. Emphasis on potential -- the future is not set in stone. And no deal is real until money hits your bank account.

I can see the investors side on this. Its one thing to be concerned about general finances but if your founder is asking to become a millionaire before making a business viable, and is willing to sell his shares before his company reaches its true potential, it makes you wonder how much the founder actually believes in his own company.

You could see this coming at least 6 months ago: http://blog.rafaelcorrales.com/2010/10/markets-upcoming-reac...

Where's the follow up article: "Founders Angry Over VCs Cheating Them Out of Equity"?