Paul Graham on the Venture Capital Squeeze – or will founders be able to get VC funding AND partially cash out ?

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.

  • Greg Linden

    Rather than think of this as a cash out for the founders as if it was some kind of windfall, VCs might want to think of this as covering the founders’ opportunity cost.
    At self-funded startups, the team often works for unusually low or no salary for the first couple years. In effect, they are funding the company with the difference between their startup compensation and what they would earn at a normal job.
    By acquiring a small amount of the founder’s equity, VCs can cover these opportunity costs. It is little more than paying back salary and benefits to the founders, but it does make it much easier for founders to consider taking on additional risk.
    Even for a small company like Findory, the opportunity cost of the time spent building the company can be substantial. I would estimate ours at between $0.5M – $1M.

  • Ol’ Dirty Programmer

    Graham also says that VCs are competing with Google. Do you think that’s true?

  • Greg Linden

    Jeff said: “The common view is that these bootstrapping costs … [make] up the Founders’ equity.”
    Yes, Jeff, but the pre-money valuation of a startup bears little relationship to the sum of the opportunity costs and the cash invested. And it is the pre-money valuation that matters for a cash out.
    Getting back to the point here, a partial cash out puts the founders back in a position to take on risk. You want the interests of the VCs and the founders to be well aligned. The founders will not have the same attraction to long-term risk that VCs have if the founders just recently depleted their personal assets.

  • Ol’ Dirty Again

    Jeff — your remark about the founders cashing out a bit, and being able to take more risk, is exactly what Graham mentions. It makes a lot of sense to me: once I’ve gone from my measly savings to (just) half a million, I’m a lot more willing to stomach more risk.
    But, as Graham mentions, VCs want the guys they give the money to to be as desperate and controllable as possible. Which makes sense, I guess; if I was giving you money, I’d want you under my thumb.
    Also, Jeff, you make the point that “pre-money valuation” doesn’t bear much relationship to the costs — and indeed that is true. Anyone who argues otherwise is trying to deceive you (or he’s dumb).
    The value of anything is not dependent on its costs. E.g. I find a dollar. It didn’t cost me anything to find it. But it is still worth a dollar. Or I buy a new car, and demolish it. The cost of that is the cost of the car and the cost to demolish it — but it is just worth scrap at that point (maybe more, if you can market it as “modern art” — but again, it is just worth what folks will pay for it).

  • Metavalent

    > 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.
    While this is historically true, the all-or-nothing risks of founders in today’s society are so high that this historical definition is no longer accurate. Some early cash out is absolutely required by any pragmatic economics in order to bring the formula back a bit closer to that ineffable and eternally unattianable ideal: equilibrium. Far too many of the experts that characterize and quantify the amount of founders risk have never felt the real life pressures that founders face. Also, the previous experience that many founders gain in FAILED ventures, which often make it possible for them to be successful THIS time, are not quantified in the traditional formulation of Founder’s Equity. Am I saying that founders should be rewarded for those past failures? Yes, in a sense, because of the extraordinary focus and fortitude demonstrated in bouncing back from those failures and making YOU rich in the process. If you haven’t been through it in your own life; been out on that limb, perhaps multiple times, you can not even begin to imagine the costs. Ten to fifteen percent early cash is more than fair, and just a little bit Closer To Truth.

  • Eric

    Speaking as a potential founder, the early buyout offers from the big players look awfully tempting. Graham’s right: The first $500,000 to $1,000,000 is worth a lot more than all the money afterwards.
    Sure, going double-or-nothing two or three times could result in crazy huge money, but the incentives just aren’t there. If VCs want to grow companies to valuations of $50-100 million, that’s cool, but it’s not a risk for founders to take unless they have cash in the bank.
    Another thought: Would buying stock from the founders–and giving them cash–make it easier to ease them out later on, if the growth of the business required it?

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