Early payouts to startup execs a troubling trend
sfgate.com
sfgate.com
If an acquirer offered enough for the company that I personally would make at least 10 million from it, I wouldn't hesitate to sell at that point. My VC isn't hungry or broke like I am, he's just an investor who rationally wants me to go for the billions. My employees aren't hungry or broke like I am, they're earning market salaries and their only hope of a decent equity payout is for me to go for the billions. But I'm just subsisting and I don't have the stomach to avoid cashing out early from an acquisition. We have a problem.
Now let's suppose I raise another VC round and partially cash out. Now I have my millions, just like the VC's. I'm still left with a good stake in the company. Now our interests are aligned; I want to go for the billions now too. I no longer have any reason to sell it short.
Truth be told, I'm not a founder and I've never faced this myself. Maybe even taking a startup to this point requires crazy, dedicated risk-takers who will turn down significant wealth for the promise of absurd wealth, and I'm just not that kind of person. Maybe if I ever invest the time and effort into a startup necessary to get to that point I'll grow the stomach to take crazy risks. But I just don't understand the argument that paying founders a few million in a late VC round makes them less motivated to swing for the fences and build billion dollar businesses. Hungry people don't turn down a decent meal for the promise of a huge feast later on.
But if you're doing well enough to have several employees and funding and stuff, wouldn't you pay yourself a reasonable salary?
It seems hard to believe a company could be doing that well, but the founder would be in dire straits financially.
Imagine you're semi-profitable, you've got enough to pay wages for a few months while you finish off your next iteration/product and bring in new cash. Then your project gets delayed, and all of a sudden you're running out of cash to pay the actual programmers. Do you try to make them take a cut and risk them jumping ship, or do you cut your own salary to close the cash gap?
These sorts of things happen with (from what little I know) quite alarming regularity. The founders are almost certainly taking out less cash than everyone else up until the equity starts being traded.
The same sorts of decisions can occur even if you're not desperately squeezed for cash. Do you bump your personal wage up, or do you use it to hire that kickass designer you just found who can really polish up your stuff and give you a better chance at success?
The whole founder-as-martyr approach explains why they feel justified in taking out early cash, and why there's a general feeling that '1st employee' shouldn't get any early cash - they've already gotten their fair share through their wages up til now. It gets a lot more complicated when your employee is taking a pay-cut to work for you on the hopes you'll succeed, but then it's up to you and them to negotiate some sort of fair compensation scheme when you do get cash in.
I like that some investors are wising up to the reality that you can get better outcomes if you make sure the entrepreneur's utility curve is aligned with the investors'. That said, I do think there's a difference between providing the entrepreneur liquidity and buying him a megayacht.
These companies don't go public because they are not sustainable yet. This is what VCs are for, they take the risk to lose 100% of their investment.
When now the founder cashes out, he is not in the same boat as the VC any more. The investors have to trust you, because they have almost zero influence in the company. When you now cash out then they are asking, why? It is a sign that the founder himself doesn't believe in the valuation. When the founder would be sure that his company will be worth billions, he is loosing money by cashing out. It is simply unfair, because there is a big information asymmetry between the two parties.
There may be exceptions when there is a personal problem, but most of the time a decent salary is enough for everyone.
Anyway, i think this is better than in the new economy. Back then the little guy got screwed and now professional investors. I don't feel sorry for them, they could do something against it with an endorsement. For an outsider it should just be a warning sign not to be too confident in these startups.
On top of that you have to weigh every word you say in public.
In the 90's, people cashed out by taking their companies public. Now, for a variety of reasons including the new burden of complying with Sarbanes-Oxley, founders are waiting much longer to go public. So they are cashing out by selling some of their founder shares to private investors.
This is in the interests of the investors because it aligns their interests with those of the founders. Say you started a company, it's kicking ass, and you face a choice. Plan A is a $100MM acquisition offer. But there's also Plan B, an ambitious expansion. Plan B gives you a 50% chance of $1B in two years, and a 50% chance of failure. If you had no assets before you started the company, the only sane thing to do is to sell out. (Not that I am suggesting that sanity should always rule the day.) But your investors probably prefer plan B. If they let you cash out $5MM or $10MM of your stock, then they make your risk tolerance more like theirs, and you can both get excited about Plan B -- which, assuming your startup is actually producing something of value, is better for the world, too.
And it's probably also better for the investing public that tech startups don't make it to IPO until they are a bit more fully baked.
It's purely observational on my part, but a founder who is sitting comfortably vs. a founder who is not -- I've seen the difference, and it very often comes down to motivation, drive and determination.
Each situation is different, but given the hungry founder (like, actually hungry) vs. the comfortable founder -- I'll take the hungry founder almost every time.
There's clearly a level of financial uncertainty where a founder is LESS productive. But, there are ways (which don't necessarily overlap) a founder could spend "excess" money which don't inhibit drive at all.
Probably the lowest hanging fruit would be to eliminate actual debt (founders may have student debt, credit card debt from earlier in the company, etc.); getting rid of debt probably won't change behavior. Maybe other health-related things. Actually, a lot of this could just be handled as "generous startup perks" vs. payouts; if I knew I could always fly in domestic E+ or upgrade-to-F on my preferred airline, and stay in a decent hotel, I'd be a lot more into taking back to back business trips all the time.
Taking care of someone else's expenses (e.g. kids, parents, or other dependents) probably won't reduce motivation, either. Fixing things which inhibit a founder's productivity (paying for a housekeeper, driver in some cases, closer apartment to the office, ...) seems like a good idea.
It's probably a bad idea to pay someone enough to become an investor, or to buy/build a house (oh god no for BUILDING), indulge in expensive AND time-consuming hobbies, etc.
The gray area is when founders would actually take an outright sale, but are given a choice of $5-10mm now and continue instead; that's enough to possibly reduce drive, but not as much as selling out.
One option might be to put some of the payout into a "lockbox", where it's safe for reasons of diversification, but not accessible. e.g. you sell, get $1-2mm into your 401k, or into an account which is inaccessible (but safely invested) for 5 years. That way, your downside risk is covered if the company tanks, but your lifestyle doesn't change.
Although, anything like this will make Bay Area luxury car dealers very sad. :(
If I cashed out a few million, what would I do with it? I'd pay my debts, buy a respectable place to live, eat healthy meals, buy a car, and buy generous gifts for all the people who've helped me along the way. Maybe most important, I'd show my friends and family I made the right decision.
But a few million is not nearly enough to buy everything I want, and there's no way I'm going to ditch such a high-potential project just for a quick payout. In fact, now that I've tasted wealth, it's more likely that I'll make sure I keep it.
The hungry founder fears staying hungry. The comfortable founder fears becoming a hungry founder and staying hungry - and I think the latter is a much more prominent fear.
Do you have a list?
Also, if living comfortably was a founders goal, why would they start a company instead of getting a steady job working for a comfortable 6 figures at an established company?
This worldview seems completely cynical and utterly immoral, and reality runs roughshod over it in any case. Two words: Steve Jobs.
A) That phrase is a classic copout to try and draw attention from the fact that you're generalizing based on your own biased opinions with no evidence.
and
B) It was immediately followed by further reinforcement that you believe your opinion holds in "almost all" situations.
You didn't actually admit that every situation is different, you used oratorical sleight of hand to try and make people agree with your sweeping and unsupported statements favoring the greedy, self-serving worldview of VCs.
If you can reach that logical summary based on my comment that I trust a hungry founder over a sitting-comfortably founder, then we don't have much to talk about.
BTW, I'm not a fan of the VC crowd -- I'm a fan of the early-stage employee crowd. The one who loses out in this conversation about 99% of the time.
Conversation over.
More realistically, chances are that any contract between them and the founder(s) states clearly that a sale within the first n# of years can only occur if the offered on the table is m%, m being >= 100 (more likely, m >= 120, 150 or more).
If OTOH only a fraction of the offer has been invested, then it is nearly guaranteed that they will be highly motivated to sell.
If the company is growing fast, it is not in the founders' interest to sell themselves so short. In fact, i doubt there exists empirical evidence that would support the likelihood of such a situation. VCs are logically only far less motivated to keep a business operating (after all, likely their only tie to it is financial) than the owners themselves -- whose baby, after all, it is. So when the founders are ready to bail, a sane investor would immediately pick up on the ominous implications regarding the future viability of the business and try to moderate their personal exposure as much as possible.
this is a new phenomenon, at least at these multimillion-dollar levels. And it's a very troubling one in the eyes of some investors.
Not troubling in general, nor even to investors in general. Just troubling to some investors. What's bad about the balance of power shifting toward founders when it was so unbalanced the other way for so long? Let's remember where the pendulum is swinging in from: a few months ago there was a video of Silicon Valley in the 70s with stories of entrepreneurs giving up 98% of their companies in order to raise any money at all. The real story here is the long-term trend.
Is there evidence to support the claim that these deals diminish companies' long-term prospects? There isn't any in the article.
Goldhaber said it sends a signal that entrepreneurs don't believe in the long-term prospects, and makes VCs question whether they should.
Obviously not the VCs who just signed the deal. Seems like markets behaving like markets to me.
Think about the company's employees. Especially the ones who joined early on. They are usually working nights and weekends hoping for an IPO or a buyout. How do they feel about this?
Actually, the trend does seem headed this way. Just as the balance between founders and investors has been shifting, so it is shifting between founders and early employees. Scarcity in the hiring market for top talent is one indicator. It is bound to be exacerbated by the fact that creative people who want to work at a startup can easily just found one themselves. We may see the line between founders and early employees blur over time.
None of this seems very troubling. It looks to me like creative people being rewarded more, and earlier, for value they add. Perhaps it is more troubling if one has nothing to add but money. But even that seems short-sighted. Why not maximize the total value created?
Otherwise, an early employee would have to wait/work years longer for the actual equity event (if it ever comes) to find out how they will be treated.
Besides that, I just don't have any sympathy for founders who don't want to wait a few more years to make their millions. The point of starting a company should be to do something useful for society. It shouldn't be a race to the exit.
Edit: Your tone seems a bit bitter, no? There are many ways to be useful to society. Helping people travel cheaply to cool places, for example. I don't really want to be told why I should start a company, though. Demand that I benefit society and I will probably just play punk rock instead. But damn it there might be social benefit lurking in that too!
I just don't think the trend of having founders being able to extract more millions sooner from their companies is a good thing. It just invites more greed from Wall Street types into the Valley.
Those innocent investors are being taken in by the cruel and shrewd entrepreneurs!!
Who gives a shit?
They're investment bankers.
I'm pretty sure they can handle their own money and don't need investigative journalists to stick up for them.
Find something real to report.
Secondly, if your goal in business is to extract what you can from foolish VCs and run, you're destroying many things. One is obviously investor value. But you're also destroying all the other startups that could've put the money to good use. In which case as a founder or director you're no better than these inside-trading Ponzi-scheming main-street-hating 1% banksters your lot loves to hate.
But hypocrisy is lost on the hypocrite...
So let me get this straight.
You're arguing that, based on ethical considerations, entrepreneurs should go easy in negotiations with investors.
And they should do this for ethical reasons. To help "investor value" and "other startups"
And this ethical argument is important enough that it should be prominently displayed and argued by journalists.
This is some kind of cosmic joke right?
Charity is for poor people.
Personally, I don't agree with the "easy cash-out" strategy, and I think that what you find is that with the REALLY successful businesses, the game changers, money is never at the top of the list of priorities for the founders, its usually viewed as an added benefit. However, from a business standpoint, working long hours and taking advantage of an opportunity to earn some serious cash for your effort can't really be criticized.
The simplest explanation is that someone is willing to offer it to them. Many of the companies the author mentions had very high acquisition offers at some point. Founders and early employees could have taken the opportunity then to cash out, but they didn't.
My guess is that a lot of this is VCs compensating founders for not accepting acquisition offers and instead going for something bigger.
This is perhaps not an optimal situation, but it may be better than acquisitions in terms of creating longer-term value.
If a startup is going to take the shortest path from a well-funded garage op to a mature company, you need everybody on the same side of the table.
"You'll stop looking for who's to blame; instead you'll start asking, What's the system? The concept of feedback opens up the idea that a system can cause its own behavior." - Pg.34 ( http://lnkd.in/kK7hdJ )
Or to joke via P vs NP, always easier to verify a solution than to create one.
Not all deals seek to diversify the founders and there are a number of warning signs:
1. The cash out is too soon. The company is still growing rapidly and in need of capital;
2. Too much of the funding round goes to the founders when the capital requirements of the company are still high. If the company is already profitable then a paying out the founders makes sense;
3. Such offers are only available to the founders rather than all employees.
Two recent deals fall into the highly suspect category: Groupon and Airbnb.
In Groupon's case, the early investors are paid out. Eric Lefkofsky has cashed out to the tune of almost $400 million [1], Groupon has has dubious accounting practices, it is only cash flow positive by screwing merchants and it basically looks like a giant scam.
In Airbnb's case the founders are using a large chunk of the funding round to pay themselves a dividend [2]. Dividends are normally a way to distribute profits to shareholders. Imagine if you take a $1 million loan from the bank, paid yourself a $500,000 dividend and then declared bankruptcy.
What's worse, most employees will see none of this because most of them have options not shares.
So this deal fails the smell test too.
Twitter is a more borderline case. $400 million seems reserved for cashing out employees [3]. If that's open to all employees I'm generally OK with it. If not, it's a problem. That being said, I believe Twitter's future is far from assured. It's unclear how many "real" users they have and what those users do. The large majority seems to just follow celebrities. I'm not convinced it can really go mainstream.
[1]: http://venturebeat.com/2011/06/10/the-questions-about-groupo...
[2]: http://articles.businessinsider.com/2011-10-01/tech/30232499...
In fact, letting the founders sell a little stock early would generally be better for the company, because it would cause the founders' attitudes toward risk to be aligned with the VCs'. As things currently work, their attitudes toward risk tend to be diametrically opposed: the founders, who have nothing, would prefer a 100% chance of $1 million to a 20% chance of $10 million, while the VCs can afford to be "rational" and prefer the latter.
I can understand Groupon and Airbnb, but what about Twitter?
Where funny accounting happens there should be lawsuits, not a general call for founders to stop taking some off the table.
but small payouts do give founders enough security to swing for the fence.
So in summary: We're partying like it's 1999 again.