Concern Grows Over Founders Cashing Out Too Much, Too Early

Six months ago, economist Paul Kedrosky found himself in a curious situation. After being introduced to a new service, along with several other potential investors, the founder of the service announced that as part of any seed-stage deal, he expected immediate liquidity for up to 25 percent of his shares.

Kedrosky, a seed investor in the investor information service StockTwits among other companies, quickly passed. “It wasn’t just an alignment issue; it just shows terrible judgment,” he says. Still, the deal was done, and Kedrosky says he’s right now looking at three angel deals and that all have involved discussions about founder liquidity. “It’s been astonishing.”

The trend appears to be growing. Citing a company he wanted to fund “as far back as 18 months ago,” venture capitalist Mark Suster says that he also abandoned the idea “because its founders were taking too much off the table, too early.” The entrepreneurs had founded the company just three years prior and the startup was producing less than $20 million in revenue, yet the team asked for $20 million during a follow-on financing round, and they got it — just not from Suster.

“They were doing really well, but how can you tell me that $20 million isn’t going to change the lives of some twentysomethings?” says Suster of the founders, who are now selling the startup.  “I definitely feel like so much money was a disincentive. It could have been a billion-dollar company.”

Providing liquidity to founding teams isn’t new, of course. Union Square Ventures is one of many firms that have long given their blessing to entrepreneurs once they’ve achieved “something meaningful,” says Union Square cofounder Fred Wilson. Ideally, “meaningful” means “more than [that they’ve just gotten] a product out into the market that lots of people are using but [also] built a business, a team, a revenue model – maybe even become profitable.”

Wilson says he isn’t receiving onerous demands by Union Square’s startups, or seeing them from the prospects with which he meets.

But others say that a frothy market is changing things across the board, and that the days of providing entrepreneurs with the kind of “modest but significant” liquidity that Wilson sanctions — enough to “change founders’ economic situation for the better – by letting them buy a house in the Bay Area, or an apartment here [in New York], or helping them raise a family,” he says – are fast receding.

The best-known liquidity cases, unsurprisingly, involve some of the hottest Web companies on the planet right now, including the daily deals services LivingSocial and Groupon. Half of LivingSocial’s newest $400 million round was used to purchase employee and early founder shares. Meanwhile, Groupon investors have twice returned money to founding investors and employees, including last April, when Digital Sky Technologies led a $135 million round and again in January, when Groupon raised a staggering $950 million from eight firms, including DST. Indeed, a filing showed that just $377 million went to the company and that the rest was used for shareholder liquidity.

Yet even startups far removed from the big leagues are making employee liquidity a competitive provision, according to one high-profile investor of a billion-plus-dollar fund, who asked not to be named.

“A few years ago, someone with a profitable company might say, ‘I want $500,000 or $750,000 so I don’t have to worry about my mortgage and can pay for my kids’ college education. Then it shifted to breakeven, where you’d get requests from entrepreneurs who’d kind of proved their business. Now they’re saying, ‘I want $5 million to $7 million in liquidity’ before a company is even proven and its model fully established,’” he says.

How big a problem is it? It’s hard to know. No numbers exist yet to suggest that early and more employee liquidity impacts a company’s performance negatively or positively. Years from now, it may still be impossible to identify liquidity as the driving factor in whether certain companies made it or flopped.

Still, investors do not think it’s an auspicious trend – even while they feel forced to play along.

“To some degree, entrepreneurs are in the cat bird seat right now and they’re able to drive up deals to terms that don’t make a lot of sense,” says the investor. “Liquidity is one of them.”

“It’s the equivalent to dot.com IPOs, where founders took out companies that weren’t producing anything meaningful to get liquid,” adds Suster.

“Mark Zuckerberg could take $500 million off the table and no one could care,” says Suster. “He’s proven he’s in it to build something big. But other founders should not be cashing out before they’ve created any value.”

And to those investors letting them do just that? “I have two words,” he says. “Caveat emptor.”

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3 Comments

  • Once again, the VCs are acting like spoiled little kids. They just want to take their ball and go home when they don’t get it their way.

    Private equity folks do dividend recapitalizations all the time to repay themselves. When management want to do the exact same thing, they don’t like it.

    How hypocritical.

    David

  • I noticed this trend also, a while back, and posted a little observation on the trend on my blog:
    http://www.nicholasdewolff.com/2011/02/growing-is-forever/

    While I agree – with reservations – with the previous comment about early VC liquidation being at times a parallel of the very complaint being made in this article, my experience has been that most solid VC ventures will seek to leverage their investment well beyond the seed stage, until the venture in question has grown to provide ROI far beyond “quick cash out” levels.

    The challenge here is not so much that founders are seeking liquid remuneration, which is well-deserved, but that they are possibly seeing their ventures as less about building something great, and more about getting rich quick. If you want to get rich quick, go to a Casino and gamble with your own money. Don’t, however, gamble with the careers of your employees and partners, the portfolios of your investors, and the good faith of your clients or customers.

  • There are few “hot” companies (eg Groupon, Facebook etc..) that can command rapidly escalating valuations and provide both the founder and the investor with comfort that taking some “chips off the table” will have little impact on the trajectory or the company and the return on the investment. The rationale from the investors perspective has to be the same as a secondary public offering where a significant portion of the proceeds goes to the existing shareholders and not to the company.

    The other phenomena that I see is the repeat (aka “serial”) entrepreneur becoming more risk averse the second and third time around and wanting to invest less themselves upfront and re-cap out their investment earlier.

    The challenge for investors in these types of deals is weighing how critical the success of the venture is to the entrepreneur, and how far is he/she willing to go to make it succeed (provided that the entrepreneur is critical to its success). If the downside to failure for the entrepreneur has been decreased significantly, how far will they go before they throw in the towel and lose everyone’s investment?

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