
Investor Concern Grows Over Founders Cashing Out Too Much, Too Early - ssclafani
http://www.pehub.com/102796/concern-grows-over-founders-cashing-out-too-much-too-early/
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vessenes
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.

~~~
ojbyrne
That last paragraph definitely resonates with me. Especially if your bosses's
names were just above yours on the Series A, and one of them now is an angel
investor with some top tier investments, and the other bought himself a Tesla
and a multi-million dollar home in Mill Valley.

I try not to hate...

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jabrams
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.

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davidu
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).

~~~
kenjackson
_It removes the requisite hunger level which is a determinant for success._

Is this true? I think the hunger is a function inherent in the person. Gates,
Jobs, Zuckerberg, Page, Schmidt -- all of them could have quit years before
their prime, but none did/have.

The people who are hungry because they're broke are the wrong people to bet
on, because if the company is even remotely successful they'll find a way to
cash out. There's just no way around stopping that from happening. But if you
bet on those for which shipping the next great product is what drives them
then giving them some money won't cause them to lose their drive.

~~~
arach
I agree with you. The people you back hopefully have inherent hunger and
achieving some measure of financial success should not slow down their drive.

Do we know about the dudes or dudettes who started a promising company but
started relaxing after sales hit 10M$?

What you could do to keep the incentive: keep the liquidity money in a trust
that is accessible only after (a)a making big exit (b) hitting a key company
milestone or (c) shutting down the company.

This way the founders can make sure it's not a big game of double or nothing
while the VCs can make sure the founders aren't shooting rap videos instead of
kicking ass.

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JoeAltmaier
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.

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esoteriq
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.

~~~
davidu
It's really much more about losing alignment between employees, management,
founders and boards.

The consequences are quite negative, and if I could name the companies I know
of dealing with this, I would. Unfortunately, I'm friends with the founders
involves and can't out them here. Needless to say, they have some very unhappy
employees who have been on board for years and who resent the founders for
cashing out while they keep slaving away, especially in the face of overly
generous offers to buy the company.

~~~
SriniK
Totally agree with you.

Concerned about the whole slew of companies that are in this bucket - Groupon,
livingsocial, fb, twitter, zynga, automattic, digg, etc... which had known
public founder cash out.

It is interesting to see VCs cashing out as well
[http://techcrunch.com/2010/11/19/accel-facebook-chunks-of-
st...](http://techcrunch.com/2010/11/19/accel-facebook-chunks-of-stock/)

~~~
copper
To offer a contrasting opinion: this is very similar to the kind of whining I
used to hear from middle-management about employees who hopped from one job to
another during the boom days.

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3pt14159
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.

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rdouble
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.

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roel_v
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 ;) )

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rexf
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.

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keiferski
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.

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johnrob
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.

~~~
nickconfer
Groupon has a proven model though.

What the article is focusing on are the companies that haven't made large
income or profitability.

I assume the 20m example was probably from a company spending significantly
more than that. Either way if a founder wanted to sell a large stake of
shares, wouldn't that concern you to some extent that they saw an iceberg up
ahead?

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mkramlich
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.

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nickconfer
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.

~~~
dedward
Then they shouldn't have structured things so that the founders COULD cash out
early.... once you're able to cash out, it's YOURS....

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rafaelc
You could see this coming at least 6 months ago:
[http://blog.rafaelcorrales.com/2010/10/markets-upcoming-
reac...](http://blog.rafaelcorrales.com/2010/10/markets-upcoming-reaction-to-
talent.html)

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ares2012
Where's the follow up article: "Founders Angry Over VCs Cheating Them Out of
Equity"?

