

Early payouts to startup execs a troubling trend - nradov
http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2011/10/08/BUIB1LESO0.DTL

======
philwelch
I'm trying to take the perspective of a founder here. Let's suppose I have a
startup that's showing signs of success and growth. I'm some combination of
funded and profitable that means I can keep running for awhile. My startup
have the potential to grow into the billions. I'm earning a subsistence salary
and have no significant assets aside from my equity in the startup itself.

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.

~~~
jlarocco
I'm also not a founder, so this might be a dumb idea..

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.

~~~
shabble
The simple answer is: because every single dollar/pound/yen you're not paying
yourself, you could be using to grow your business.

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.

------
geoffschmidt
I don't see this as troubling at all - actually, the opposite.

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.

~~~
jroseattle
That, or the motivational carrot to drive to success has been reduced.

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.

~~~
rdl
It definitely varies per person.

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.
:(

~~~
jroseattle
Well put. It's definitely a balancing act to go down this path.

------
gruseom
Troubling to whom? You have to read the article to find out:

 _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.

~~~
nimrody
If it's only the execs (founders I assume) then this may create unhealthy
tension within the company.

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?

~~~
gruseom
But this is an argument not that the trend is bad, but that it should go even
further and benefit not just founders but early employees as well. I'm
inclined to agree. No doubt investors who feel this way are advocating
strongly for employees' interests while structuring deals.

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?

------
forensic
Oh those poor investment bankers!!!

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.

~~~
wonnage
First off, venture capital != investment banking.

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...

~~~
chopsueyar
I watch all my games on Broadcast.com and pay my local taxes with govWorks
website.

------
kevinpet
This article completely misrepresents the email. Chamath Palihapitiya seemed
to take the most issue with the fact that the deal was structured with most of
the money going out as a dividend. It's not about the founders taking money
out, it's about the founders taking money out without dilution.

------
SurfScore
This reminds me a lot of professional sports...you see a lot of athletes get
criticized for "not being a team player" because they want the huge contracts,
but people don't realize that ITS A BUSINESS. If you see an opportunity to
make something in the tens of millions of dollars, why wouldn't you jump at
that? Its hard not to get sentimental about it, but some people don't view
their companies as more than a venue to make money, and its a FACT that if you
couldn't make money doing it, 99.9% of businesses would not be started.

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.

------
momoro
Apart from suggesting that entrepreneurs are "trying to hit the lottery," the
article does not attempt to explain why founders and early employees are
taking cash early.

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.

~~~
zszabo
That scenario is likely precluded by the conditions that come along with the
investment capital. Nobody has ever gotten rich from signing blank checks. And
while there may have been the occasional, foolish investor to do just that,
everybody else in that position has already internalized the rules of what not
to do if they want to have a hope of hanging on to some of their investment.
If in life there is no such thing as a free lunch, then by extension, nobody
in the position to be directly involved views VC as a free handout.

------
martinkallstrom
The article completely disregards that there is a business interest for the
investors to align the interest of board and management in a startup.

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.

------
Hitchhiker
" Here we meet a very important feature. It would seem as if this were
circular reasoning; profits fell because investment fell, and investment fell,
and investment fell because profits fell. " - Jan Tinbergens

"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.

------
deepGem
As others have pointed out, how is this a problem ? If the VCs are offering
cash out to founders and early employees - it's just to sweeten the bitter
side of a non-acquisition. It's not like the founders will take the cash out
and retire to a private island as the author implies. Money is not a motivator
for most of these founders and if it is - then the VCs are making a bad choice
in not just offering the cash outs,but in the basic investing they are doing
in that company. VCs are not that short sighted or stupid.

------
cletus
Founders cashing out isn't the problem. It's common--even encouraged--for late
stage founders to partially cash out so as to align their interests with the
startup, particularly if they're not otherwise sufficiently wealthy to aim for
the fences.

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...](http://venturebeat.com/2011/06/10/the-questions-about-groupons-
other-founder-eric-lefkofsky/)

[2]:
[http://articles.businessinsider.com/2011-10-01/tech/30232499...](http://articles.businessinsider.com/2011-10-01/tech/30232499_1_cash-
dividend-stock-options-groupon)

[3]: <http://mashable.com/2011/07/20/twitter-8-billion/>

~~~
chopsueyar
Excuse my ignornce, but what is Twitter's business model?

I can understand Groupon and Airbnb, but what about Twitter?

~~~
cletus
Exactly.

------
3pt14159
Provided that a company's financials arn't half baked like Groupons were, an
early diversification of investments is in everyone's interest.

Where funny accounting happens there should be lawsuits, not a general call
for founders to stop taking some off the table.

------
eding
small payouts, yes, to pay down a mortgage or for home/family-development. but
nothing multi-million, especially 8-digits-- definitely not.

but small payouts do give founders enough security to swing for the fence.

------
jpdoctor
> Far too many silly, derivative and pointless companies are cranked out in
> the desperate hope that they can secure just enough press attention and VC
> love to make the founders a few million bucks.

So in summary: We're partying like it's 1999 again.

