Paul Graham has a provocative suggestion in his post, “The Venture Capital Squeeze” [via Kevin Burton]: as they fund the working capital of a startup, VCs should consider acquiring a small portion of Founders’ equity in order to provide them with a (sometimes much needed) bit of cash. Paul’s thesis is that this would make “early take-out” offers from large companies less interesting:
Whatever they say, the reason founders are selling their companies early instead of doing Series A rounds is that they get paid up front. That first million is just worth so much more than the subsequent ones. If founders could sell a little stock early, they’d be happy to take VC money and bet the rest on a bigger outcome.
So why not let the founders have that first million, or at least half million? The VCs would get same number of shares for the money. So what if some of the money would go to the founders instead of the company?
Some VCs will say this is unthinkable—that they want all their money to be put to work growing the company. But the fact is, the huge size of current VC investments is dictated by the structure of VC funds, not the needs of startups. Often as not these large investments go to work destroying the company rather than growing it.
The angel investors who funded our startup let the founders sell some stock directly to them, and it was a good deal for everyone. The angels made a huge return on that investment, so they’re happy. And for us founders it blunted the terrifying all-or-nothingness of a startup, which in its raw form is more a distraction than a motivator.
If VCs are frightened at the idea of letting founders partially cash out, let me tell them something still more frightening: you are now competing directly with Google.
Founders’ buyout is typically happening in late stage deals, such as eHarmony or Webroot, in which company founders were able to cash out substantially. It also happens when founders of a company about to IPO sell a portion of their shares in a private transaction in order to diversify their risk, and get a limited liquidity before they are bound by lock-up provisions of the public offering.
Would such an arrangement be palatable to early stage founders ? Absolutely, especially first timers who, for example, start having family responsibilities (hey, this happens). And it is true, having had these conversations with some founders, that selling early to build their initial asset value is tempting. So would a partial cash out. Especially if they live in Silicon Valley, which is the one of the best places to start a company, but also one of the most expensive.
How would this work ? An early stage startup raising its initial round of financing will typically get a pre-money valuation of a few million dollars – let’s say $3M for argument sake. A VC investing $1M will get 25% of the company’s equity, and will ask to create an option pool (assuming there was none) of say 15% in the pre-money, diluting founders’ ownership by 40% and theoretically valuing their ownership at $2.4M (60% of the post-money of $4M). How much of that equity could they sell to 1) be meaningful to founders, and 2) make sure that their ownership in the business is still a source of motivation ? I’d say 10% to 15% tops. And obviously, the higher the valuation, the easier the maths.
Why don’t VCs do this then ? Because they are investing to build the company, not the personal wealth of the founders – at this stage of the game. Obviously, if the company is successful, both investors and founders will strike it rich. But until then, they want to be aligned on incentives and risks. A partial buyout changes that balance.
Now comes the wrinkle: early stage take-outs that allow founders to make “meaningful” millions of dollars upon selling early, instead of raising financing and executing in the long run – foregoing the opportunity of building a much bigger company. The current thinking is that most of the companies selling early were not VC deals in a first place, but what if exits start happening with companies that have a VC potential (Flickr comes to mind) ? Will a partial buyout clause make their way into early stage VC termsheets ? I would say no, but then – there was a time when you had to give away percentage points of your company to find new digs… just because there was a lot of competition…
Update: Greg Linden in the comments suggests that a partial payout would somehow make up for the opportunity costs incurred by the founders during the bootstrapping period. The common view is that these bootstrapping costs (both opportunity costs and hard cash invested in the business) is what makes up the Founders’ equity.