This is part of my ongoing series “Start Up Advice” but I’d really like to call this post, “VC Advice.”
If a company has reached a level of success, has been around for a few years and you believe the company has potential to break out into a much bigger company then you should let the founders take money off of the table. It’s that simple. Only then are you truly aligned.
Not FU money, but “feed the family” money. And to be clear – I believe it is also in the VC’s interests. I’m not trying to open Pandora’s Box and suggest all founders should be able to cash out – far from it. But the handful who are building something of substance need to be able to take the pressure off in a way that creates a similar objective to the VC.
I think too many VCs simply don’t understand this. When you’re too far removed from renting a house, driving an 8-year-old car, worrying about how you’ll put your kids through college or coming home to a spouse who wants to know why you don’t just get a “real job” then it’s hard to identify.
I know this is a controversial topic. No matter what I say some people are going to believe passionately on the other side of the argument. On a panel that I sat on with a prominent VC in 2008 he stated that there were no circumstances in which the founder should take money off of the table. I believe this is wrong.
Let me start with a couple of stories.
A friend of mine is a serial entrepreneur and is running a high-profile, early stage company in NorCal. He’s been at it since 2005. We trade emails on the topic of entrepreneurship often. We exchanged ideas when I was an entrepreneur along side him in NorCal in 05-07 and my point-of-view on founder / VC relationships hasn’t shifted even 1% since I went to the dark side.
We were trading emails on a recent rant posted on The Funded about founders’ equity and here is what my friend wrote to me in our exchange (printed anonymously with his permission):
Actually FWIW I think at least in cases of folks like me (and this seems also to be part of what Founders’ Fund tries to do), many of the challenges of working with my VCs would be eliminated if the investors would support partially liquidity for founders after X years. The VCs basically have liquidity in management fees along the way, in the sense they get paid decently along the way. Founders however are asked to take low salaries and never really get back the time they worked for free. At some point, this breaks if their isn’t an exit or IPO. I think it breaks for most people after 3-4 years.
The net effect for [my company] for example is we are now doing reasonably well. We should end the year with a few million in fully recurring revenue and we’re projected to double next year. We could do more in 2010 with more VC investment; the doubling assumes only ratable increase in marketing spend to achieve profitability. But more spend = more viral opps = more revenue down the road. >50% of our revenue in now viral.
However, without any liquidity at all for my cofounder and me, it makes more sense to grow more slowly and be profitable next year and stay there.
My investors don’t seem to understand this, yet it will materially impact their ROI IMHO b/c the absolute return to them will be lower …
The are in a delusional world where every founder just works for a pat on the back, forever. For a while but not forever.
I agree 100% with my friend. I couldn’t have said it any better. VC’s who don’t get this are naive. I’m not being Pollyana-ish for the sake of being nice. I know that eventually if your company is out of cash and you need the money you’ll take it even on punishing terms. It’s your baby. It’s what makes you a missionary CEO rather than a mercenary CEO. But the day after you’ll wake up and see yourself more as a manager than an owner. It happens slowly and subtly. You start leaving the office earlier. You work less weekends. You stop catching the early flight. You lose the dream. And importantly you start thinking about your next gig. That’s when the VC has lost.
I know because I’ve been there. In my first company I had to raise money in April 2001 or die. I took money with a 3x participating preferred liquidation preference with 8% compounded interest annually. Coupled with my participating preferred from 1999 and 2000 I had more than $55 million of liquidation preferences. Ironically our business started to perform very will by 2004 but by then management had lost the dream of a huge upside. We managed the business because we felt responsible since we raised money. But there’s no doubt we took the edge off.
Fast forward to my second company. I founded it in 2005 at the age of 37. I had just moved back to the US from living in Europe for 11 years. We had never purchased a house in Europe because we always knew we’d move home at some point. When we moved to Palo Alto we rented a place. I raised $500k in seed money to start the company. The very modest salary that I drew didn’t come anywhere near meeting my monthly costs so I had to eat into savings. I had a 2.5 year old boy and another one due in 1 months.
The company did well in 2006 as we delivered a phenomenal product that got much industry acclaim at conferences and with initial customers. Many term sheets ensued. By then I was still on the board of my first company but it hadn’t yet sold (it ended up selling in 2007 to a publicly traded French company). So by this point I hadn’t had an exit. I had some diversity – 2 companies – but not nearly the diversity of a VC.
So here’s my question, along the lines of my friend’s comments above. How on Earth would any VC think that our incentives were aligned? They had their nice salaries and I was approaching 40 and still living on a modest salary with good savings over many years but no big exit yet. It was all on the promise of a potential exit down the road and sometimes you don’t end up with that even with the best of execution or intentions. They vacationed at 5-star resorts; I saved up my frequent traveler points and traveled free.
And then the offer came in to buy my company. I had that against the backdrop of several term sheets. The offer wasn’t FU money but it was enough to change my life forever. This made me think hard about the relationship between VCs and entrepreneurs. VC’s have diversification and management fees. Entrepreneurs have much more immediate upside but often all-or-nothing outcomes. If a founding team could take enough money off the table to take the pressure off at home or as I sometimes call it “feed the family” money but not take too much money off of the table then incentives would be aligned.
The entrepreneur would be free to “swing for the fences” with the VC’s. I truly believe it aligns incentives. But it is clearly not warranted in all cases. I think the following circumstances warrant consideration, but there is no doubt it is deal specific.
A strawman set of rules (or for my UK friends, “a starter for 10”) 😉
- Founders need to have been in the company for a few years. Probably a minimum of 3.
- Company needs to have achieved some significant early milestones. Probably revenue based. I think a few million of revenues is probably a reasonable goal. Let’s say, $2-3 million minimum – maybe more?
- The company has to have the potential for a break-out on the upside down the road. Otherwise, what incentive exists for the VC to put in more capital or to have the founders earn money. It can’t just be a gift. The VC is hoping that by buying your shares they will be worth more in the future. You’re hoping to derisk your life.
- There has to be a degree of lock-in for the founder to make it quid pro quo – there are easy ways to do this.
- It should be enough money to take care of basic needs but not extravagant needs. Basic needs vary by location and personal circumstances (e.g. married with kids vs. single and 25 years old). For a typical 28-35 year old founder I think the right number is probably between $500k – $1.5 million. I’m assuming this in Silicon Valley, LA or similar locations. But money off of the table is comensurate with the stage of business.
- Founders have to also be the KEY employees going forward. Only people who are delivering value going forward can take money off the table. It’s not charity – it’s an incentive alignment.
- Obviously for super successful companies (Facebook, Zynga, etc.) these rules don’t apply. No one could fault Mark Zuckerberg if he wanted $20 million. He’s earned it.
- If the founder has earned a few million in the past the rules don’t apply. The rationale is to align incentives. If you took out $3 million in your last deal I’m assuming our incentives are already aligned. Another $1 million isn’t going to fundamentally change your life. You’re probably wanting $10 million plus on the next deal.
- You get a carve-out for rule 7 if you’re recently divorced and your spouse is devouring your money. Joking aside – I’ve seen this twice already.
I don’t know – I think these are directionally correct. I’d love people to weigh in on the comments with where you think I got it wrong or what points I should add.
Post script: The VC’s rationale in our debate was:
- “all money in a start-up should remain in the company.” Only if it’s truly early stage would I agree.
- “it’s not fair to the rest of the employees who don’t get to take money out.” Two answers from me. In most start-up companies a handful of people really determine the majority of the outcome of the company. I’m not saying others aren’t important but a few really drive the economic value. So I think it’s OK for the “key players” to monetize. But if that’s not egalitarian enough for you then you can always have everybody take a proportional amount off of the table.