

Ask HN: How do founders end up broke? - Sohum

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.<p>How does this happen?<p>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?<p>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?<p>Yes, i know i used the green goblin as an example. On an unrelated sidethought, it would be fairly interesting to see the corporate dynamics of LexCorp and Wayne Enterprises interact with one another ... surely they would have corporate take-overs etc.<p>Sorry for all the questions ..... any thoughts would be great.
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3pt14159
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.

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Sohum
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?

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

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jmonegro
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.

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danshapiro
"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.

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trizk
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?

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

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dedward
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?

~~~
danshapiro
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.

~~~
SemanticFog
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.

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trizk
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.

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bravura
<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. "

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Sohum
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!

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phamilton
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.

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webstartupper
>>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.

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henryci
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.

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danshapiro
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.

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Stevenup7002
>> 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.

~~~
Sohum
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?

~~~
prodigal_erik
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.

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dedward
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...

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ChristianMarks
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.

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Sohum
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...](http://www.danshapiro.com/blog/2010/08/vc-insanity-economics/)

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flacon
By not winning.

