Early payouts to startup execs a troubling trend

http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2011/10/08/BUIB1LESO0.DTL

by nradov • 15 years ago

77 51 15 years ago

gruseom4• 15 years ago

Troubling to whom? You have to read the article to find out:

this is a new phenomenon, at least at these multimillion-dollar levels. And it's a very troubling one in the eyes of some investors.

Not troubling in general, nor even to investors in general. Just troubling to some investors. What's bad about the balance of power shifting toward founders when it was so unbalanced the other way for so long? Let's remember where the pendulum is swinging in from: a few months ago there was a video of Silicon Valley in the 70s with stories of entrepreneurs giving up 98% of their companies in order to raise any money at all. The real story here is the long-term trend.

Is there evidence to support the claim that these deals diminish companies' long-term prospects? There isn't any in the article.

Goldhaber said it sends a signal that entrepreneurs don't believe in the long-term prospects, and makes VCs question whether they should.

Obviously not the VCs who just signed the deal. Seems like markets behaving like markets to me.

nimrody• 15 years ago

If it's only the execs (founders I assume) then this may create unhealthy tension within the company.

Think about the company's employees. Especially the ones who joined early on. They are usually working nights and weekends hoping for an IPO or a buyout. How do they feel about this?

gruseom4• 15 years ago

But this is an argument not that the trend is bad, but that it should go even further and benefit not just founders but early employees as well. I'm inclined to agree. No doubt investors who feel this way are advocating strongly for employees' interests while structuring deals.

Actually, the trend does seem headed this way. Just as the balance between founders and investors has been shifting, so it is shifting between founders and early employees. Scarcity in the hiring market for top talent is one indicator. It is bound to be exacerbated by the fact that creative people who want to work at a startup can easily just found one themselves. We may see the line between founders and early employees blur over time.

None of this seems very troubling. It looks to me like creative people being rewarded more, and earlier, for value they add. Perhaps it is more troubling if one has nothing to add but money. But even that seems short-sighted. Why not maximize the total value created?

chrisbennet• 15 years ago

I can see one upside of founders taking cash early; their treatment of the early employees foreshadows how they will treat them when the actual equity event happens.

Otherwise, an early employee would have to wait/work years longer for the actual equity event (if it ever comes) to find out how they will be treated.

j_baker2• 15 years ago

Don't be naive. Markets behaving like markets created a dot-com bubble, Enron, and a housing bubble. Just because the market is behaving like a market doesn't make that behavior good.

Besides that, I just don't have any sympathy for founders who don't want to wait a few more years to make their millions. The point of starting a company should be to do something useful for society. It shouldn't be a race to the exit.

gruseom4• 15 years ago

No market fundamentalist here. My point is that this is one case where the market seems functional. Investors who make these deals will lose, if they're so bad. So what do their competitors have to complain about?

Edit: Your tone seems a bit bitter, no? There are many ways to be useful to society. Helping people travel cheaply to cool places, for example. I don't really want to be told why I should start a company, though. Demand that I benefit society and I will probably just play punk rock instead. But damn it there might be social benefit lurking in that too!

geoffschmidt• 15 years ago

I don't see this as troubling at all - actually, the opposite.

In the 90's, people cashed out by taking their companies public. Now, for a variety of reasons including the new burden of complying with Sarbanes-Oxley, founders are waiting much longer to go public. So they are cashing out by selling some of their founder shares to private investors.

This is in the interests of the investors because it aligns their interests with those of the founders. Say you started a company, it's kicking ass, and you face a choice. Plan A is a $100MM acquisition offer. But there's also Plan B, an ambitious expansion. Plan B gives you a 50% chance of $1B in two years, and a 50% chance of failure. If you had no assets before you started the company, the only sane thing to do is to sell out. (Not that I am suggesting that sanity should always rule the day.) But your investors probably prefer plan B. If they let you cash out $5MM or $10MM of your stock, then they make your risk tolerance more like theirs, and you can both get excited about Plan B -- which, assuming your startup is actually producing something of value, is better for the world, too.

And it's probably also better for the investing public that tech startups don't make it to IPO until they are a bit more fully baked.

jroseattle4• 15 years ago

That, or the motivational carrot to drive to success has been reduced.

It's purely observational on my part, but a founder who is sitting comfortably vs. a founder who is not -- I've seen the difference, and it very often comes down to motivation, drive and determination.

Each situation is different, but given the hungry founder (like, actually hungry) vs. the comfortable founder -- I'll take the hungry founder almost every time.

gruseom4• 15 years ago

In that case investors will have to get good at identifying founders who are not driven solely by money. There are a lot of those too.

Shenglong• 15 years ago

The thing is, at that stage, do you really think anyone will abandon half a billion dollars just because they've already taken out 5 million? I wouldn't, at all.

If I cashed out a few million, what would I do with it? I'd pay my debts, buy a respectable place to live, eat healthy meals, buy a car, and buy generous gifts for all the people who've helped me along the way. Maybe most important, I'd show my friends and family I made the right decision.

But a few million is not nearly enough to buy everything I want, and there's no way I'm going to ditch such a high-potential project just for a quick payout. In fact, now that I've tasted wealth, it's more likely that I'll make sure I keep it.

The hungry founder fears staying hungry. The comfortable founder fears becoming a hungry founder and staying hungry - and I think the latter is a much more prominent fear.

nknight2• 15 years ago

By that logic, no one but an investor should ever be permitted to cash out, since you must retain that motivational carrot!

This worldview seems completely cynical and utterly immoral, and reality runs roughshod over it in any case. Two words: Steve Jobs.

rdl• 15 years ago

It definitely varies per person.

There's clearly a level of financial uncertainty where a founder is LESS productive. But, there are ways (which don't necessarily overlap) a founder could spend "excess" money which don't inhibit drive at all.

Probably the lowest hanging fruit would be to eliminate actual debt (founders may have student debt, credit card debt from earlier in the company, etc.); getting rid of debt probably won't change behavior. Maybe other health-related things. Actually, a lot of this could just be handled as "generous startup perks" vs. payouts; if I knew I could always fly in domestic E+ or upgrade-to-F on my preferred airline, and stay in a decent hotel, I'd be a lot more into taking back to back business trips all the time.

Taking care of someone else's expenses (e.g. kids, parents, or other dependents) probably won't reduce motivation, either. Fixing things which inhibit a founder's productivity (paying for a housekeeper, driver in some cases, closer apartment to the office, ...) seems like a good idea.

It's probably a bad idea to pay someone enough to become an investor, or to buy/build a house (oh god no for BUILDING), indulge in expensive AND time-consuming hobbies, etc.

The gray area is when founders would actually take an outright sale, but are given a choice of $5-10mm now and continue instead; that's enough to possibly reduce drive, but not as much as selling out.

One option might be to put some of the payout into a "lockbox", where it's safe for reasons of diversification, but not accessible. e.g. you sell, get $1-2mm into your 401k, or into an account which is inaccessible (but safely invested) for 5 years. That way, your downside risk is covered if the company tanks, but your lifestyle doesn't change.

Although, anything like this will make Bay Area luxury car dealers very sad. :(

jodrellblank• 15 years ago

Similar to "humans aren't meant to be happy, we're meant to want to be happy", founders aren't meant to get rich, they're meant to want to get rich.

jedberg2• 15 years ago

Just to clarify one thing, the founders in the AirBnB case were not selling anything to investors -- they were taking a dividend, which is even worse for the early employees, because the founders get rich without dilituing themselves, precluding the other employees from doing better in a subsequent round.

garry• 15 years ago

To be clear, the Airbnb team is offering liquidity to all of the employees to address this very concern, and have since resolved this issue.

zszabo2• 15 years ago

i sure hope no investor is ever so foolishly naive as to accept claims like "50:50 chance to grow the business by an order of magnitude...in the next 2 years" without the heaviest grain of salt.

More realistically, chances are that any contract between them and the founder(s) states clearly that a sale within the first n# of years can only occur if the offered on the table is m%, m being >= 100 (more likely, m >= 120, 150 or more).

If OTOH only a fraction of the offer has been invested, then it is nearly guaranteed that they will be highly motivated to sell.

If the company is growing fast, it is not in the founders' interest to sell themselves so short. In fact, i doubt there exists empirical evidence that would support the likelihood of such a situation. VCs are logically only far less motivated to keep a business operating (after all, likely their only tie to it is financial) than the owners themselves -- whose baby, after all, it is. So when the founders are ready to bail, a sane investor would immediately pick up on the ominous implications regarding the future viability of the business and try to moderate their personal exposure as much as possible.

kevinpet• 15 years ago

This article completely misrepresents the email. Chamath Palihapitiya seemed to take the most issue with the fact that the deal was structured with most of the money going out as a dividend. It's not about the founders taking money out, it's about the founders taking money out without dilution.

momoro• 15 years ago

Apart from suggesting that entrepreneurs are "trying to hit the lottery," the article does not attempt to explain why founders and early employees are taking cash early.

The simplest explanation is that someone is willing to offer it to them. Many of the companies the author mentions had very high acquisition offers at some point. Founders and early employees could have taken the opportunity then to cash out, but they didn't.

My guess is that a lot of this is VCs compensating founders for not accepting acquisition offers and instead going for something bigger.

This is perhaps not an optimal situation, but it may be better than acquisitions in terms of creating longer-term value.

zszabo2• 15 years ago

That scenario is likely precluded by the conditions that come along with the investment capital. Nobody has ever gotten rich from signing blank checks. And while there may have been the occasional, foolish investor to do just that, everybody else in that position has already internalized the rules of what not to do if they want to have a hope of hanging on to some of their investment. If in life there is no such thing as a free lunch, then by extension, nobody in the position to be directly involved views VC as a free handout.

3pt14159• 15 years ago

Provided that a company's financials arn't half baked like Groupons were, an early diversification of investments is in everyone's interest.

Where funny accounting happens there should be lawsuits, not a general call for founders to stop taking some off the table.

forensic2• 15 years ago

Oh those poor investment bankers!!!

Those innocent investors are being taken in by the cruel and shrewd entrepreneurs!!

Who gives a shit?

They're investment bankers.

I'm pretty sure they can handle their own money and don't need investigative journalists to stick up for them.

Find something real to report.

karamazov• 15 years ago

It looks like they can afford to hire some PR firms as well.

wonnage• 15 years ago

First off, venture capital != investment banking.

Secondly, if your goal in business is to extract what you can from foolish VCs and run, you're destroying many things. One is obviously investor value. But you're also destroying all the other startups that could've put the money to good use. In which case as a founder or director you're no better than these inside-trading Ponzi-scheming main-street-hating 1% banksters your lot loves to hate.

But hypocrisy is lost on the hypocrite...

chopsueyar3• 15 years ago

I watch all my games on Broadcast.com and pay my local taxes with govWorks website.

forensic2• 15 years ago

...

So let me get this straight.

You're arguing that, based on ethical considerations, entrepreneurs should go easy in negotiations with investors.

And they should do this for ethical reasons. To help "investor value" and "other startups"

And this ethical argument is important enough that it should be prominently displayed and argued by journalists.

This is some kind of cosmic joke right?

Charity is for poor people.

deepGem• 15 years ago

As others have pointed out, how is this a problem ? If the VCs are offering cash out to founders and early employees - it's just to sweeten the bitter side of a non-acquisition. It's not like the founders will take the cash out and retire to a private island as the author implies. Money is not a motivator for most of these founders and if it is - then the VCs are making a bad choice in not just offering the cash outs,but in the basic investing they are doing in that company. VCs are not that short sighted or stupid.

SurfScore• 15 years ago

This reminds me a lot of professional sports...you see a lot of athletes get criticized for "not being a team player" because they want the huge contracts, but people don't realize that ITS A BUSINESS. If you see an opportunity to make something in the tens of millions of dollars, why wouldn't you jump at that? Its hard not to get sentimental about it, but some people don't view their companies as more than a venue to make money, and its a FACT that if you couldn't make money doing it, 99.9% of businesses would not be started.

Personally, I don't agree with the "easy cash-out" strategy, and I think that what you find is that with the REALLY successful businesses, the game changers, money is never at the top of the list of priorities for the founders, its usually viewed as an added benefit. However, from a business standpoint, working long hours and taking advantage of an opportunity to earn some serious cash for your effort can't really be criticized.

martinkallstrom• 15 years ago

The article completely disregards that there is a business interest for the investors to align the interest of board and management in a startup.

If a startup is going to take the shortest path from a well-funded garage op to a mature company, you need everybody on the same side of the table.

Hitchhiker• 15 years ago

" Here we meet a very important feature. It would seem as if this were circular reasoning; profits fell because investment fell, and investment fell, and investment fell because profits fell. " - Jan Tinbergens

"You'll stop looking for who's to blame; instead you'll start asking, What's the system? The concept of feedback opens up the idea that a system can cause its own behavior." - Pg.34 ( http://lnkd.in/kK7hdJ )

Or to joke via P vs NP, always easier to verify a solution than to create one.

philwelch• 15 years ago

I'm trying to take the perspective of a founder here. Let's suppose I have a startup that's showing signs of success and growth. I'm some combination of funded and profitable that means I can keep running for awhile. My startup have the potential to grow into the billions. I'm earning a subsistence salary and have no significant assets aside from my equity in the startup itself.

If an acquirer offered enough for the company that I personally would make at least 10 million from it, I wouldn't hesitate to sell at that point. My VC isn't hungry or broke like I am, he's just an investor who rationally wants me to go for the billions. My employees aren't hungry or broke like I am, they're earning market salaries and their only hope of a decent equity payout is for me to go for the billions. But I'm just subsisting and I don't have the stomach to avoid cashing out early from an acquisition. We have a problem.

Now let's suppose I raise another VC round and partially cash out. Now I have my millions, just like the VC's. I'm still left with a good stake in the company. Now our interests are aligned; I want to go for the billions now too. I no longer have any reason to sell it short.

Truth be told, I'm not a founder and I've never faced this myself. Maybe even taking a startup to this point requires crazy, dedicated risk-takers who will turn down significant wealth for the promise of absurd wealth, and I'm just not that kind of person. Maybe if I ever invest the time and effort into a startup necessary to get to that point I'll grow the stomach to take crazy risks. But I just don't understand the argument that paying founders a few million in a late VC round makes them less motivated to swing for the fences and build billion dollar businesses. Hungry people don't turn down a decent meal for the promise of a huge feast later on.

sek• 15 years ago

Then why not go for an IPO?

These companies don't go public because they are not sustainable yet. This is what VCs are for, they take the risk to lose 100% of their investment.

When now the founder cashes out, he is not in the same boat as the VC any more. The investors have to trust you, because they have almost zero influence in the company. When you now cash out then they are asking, why? It is a sign that the founder himself doesn't believe in the valuation. When the founder would be sure that his company will be worth billions, he is loosing money by cashing out. It is simply unfair, because there is a big information asymmetry between the two parties.

There may be exceptions when there is a personal problem, but most of the time a decent salary is enough for everyone.

Anyway, i think this is better than in the new economy. Back then the little guy got screwed and now professional investors. I don't feel sorry for them, they could do something against it with an endorsement. For an outsider it should just be a warning sign not to be too confident in these startups.

0x122• 15 years ago

An IPO may be much further down the line and not everybody wants to (or has to) run a public company. 'Going Public' is not just a positive thing, it comes with a large pile of headaches as well and it isn't unusual at all to see a big chunk of money go towards all the duties that come with being a public company.

On top of that you have to weigh every word you say in public.

0x122• 15 years ago

You've nailed it perfectly. It's all about risk and trade-offs between security and risk.

rscale• 15 years ago

I agree with you completely. It's rational for a "hungry" founder to prefer a 50% chance of a $250MM exit to a 20% chance of a $2B exit which is exactly wrong for the VC.

I like that some investors are wising up to the reality that you can get better outcomes if you make sure the entrepreneur's utility curve is aligned with the investors'. That said, I do think there's a difference between providing the entrepreneur liquidity and buying him a megayacht.

jlarocco• 15 years ago

I'm also not a founder, so this might be a dumb idea..

But if you're doing well enough to have several employees and funding and stuff, wouldn't you pay yourself a reasonable salary?

It seems hard to believe a company could be doing that well, but the founder would be in dire straits financially.

shabble• 15 years ago

The simple answer is: because every single dollar/pound/yen you're not paying yourself, you could be using to grow your business.

Imagine you're semi-profitable, you've got enough to pay wages for a few months while you finish off your next iteration/product and bring in new cash. Then your project gets delayed, and all of a sudden you're running out of cash to pay the actual programmers. Do you try to make them take a cut and risk them jumping ship, or do you cut your own salary to close the cash gap?

These sorts of things happen with (from what little I know) quite alarming regularity. The founders are almost certainly taking out less cash than everyone else up until the equity starts being traded.

The same sorts of decisions can occur even if you're not desperately squeezed for cash. Do you bump your personal wage up, or do you use it to hire that kickass designer you just found who can really polish up your stuff and give you a better chance at success?

The whole founder-as-martyr approach explains why they feel justified in taking out early cash, and why there's a general feeling that '1st employee' shouldn't get any early cash - they've already gotten their fair share through their wages up til now. It gets a lot more complicated when your employee is taking a pay-cut to work for you on the hopes you'll succeed, but then it's up to you and them to negotiate some sort of fair compensation scheme when you do get cash in.

cletus2• 15 years ago

Founders cashing out isn't the problem. It's common--even encouraged--for late stage founders to partially cash out so as to align their interests with the startup, particularly if they're not otherwise sufficiently wealthy to aim for the fences.

Not all deals seek to diversify the founders and there are a number of warning signs:

1. The cash out is too soon. The company is still growing rapidly and in need of capital;

2. Too much of the funding round goes to the founders when the capital requirements of the company are still high. If the company is already profitable then a paying out the founders makes sense;

3. Such offers are only available to the founders rather than all employees.

Two recent deals fall into the highly suspect category: Groupon and Airbnb.

In Groupon's case, the early investors are paid out. Eric Lefkofsky has cashed out to the tune of almost $400 million [1], Groupon has has dubious accounting practices, it is only cash flow positive by screwing merchants and it basically looks like a giant scam.

In Airbnb's case the founders are using a large chunk of the funding round to pay themselves a dividend [2]. Dividends are normally a way to distribute profits to shareholders. Imagine if you take a $1 million loan from the bank, paid yourself a $500,000 dividend and then declared bankruptcy.

What's worse, most employees will see none of this because most of them have options not shares.

So this deal fails the smell test too.

Twitter is a more borderline case. $400 million seems reserved for cashing out employees [3]. If that's open to all employees I'm generally OK with it. If not, it's a problem. That being said, I believe Twitter's future is far from assured. It's unclear how many "real" users they have and what those users do. The large majority seems to just follow celebrities. I'm not convinced it can really go mainstream.

[1] http://venturebeat.com/2011/06/10/the-questions-about-groupo...

[2] http://articles.businessinsider.com/2011-10-01/tech/30232499...

[3] http://mashable.com/2011/07/20/twitter-8-billion/

chopsueyar3• 15 years ago

Excuse my ignornce, but what is Twitter's business model?

I can understand Groupon and Airbnb, but what about Twitter?

cletus2• 15 years ago

Exactly.

DanielRibeiro• 15 years ago

Also, as pg said on The Venture Capital Squeeze[1]:

In fact, letting the founders sell a little stock early would generally be better for the company, because it would cause the founders' attitudes toward risk to be aligned with the VCs'. As things currently work, their attitudes toward risk tend to be diametrically opposed: the founders, who have nothing, would prefer a 100% chance of $1 million to a 20% chance of $10 million, while the VCs can afford to be "rational" and prefer the latter.

[1] http://www.paulgraham.com/vcsqueeze.html

jpdoctor• 15 years ago

> Far too many silly, derivative and pointless companies are cranked out in the desperate hope that they can secure just enough press attention and VC love to make the founders a few million bucks.

So in summary: We're partying like it's 1999 again.

eding• 15 years ago

small payouts, yes, to pay down a mortgage or for home/family-development. but nothing multi-million, especially 8-digits-- definitely not.

but small payouts do give founders enough security to swing for the fence.

Early payouts to startup execs a troubling trend

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