If there is one piece of advice I would give to the founders of BST, it is to consider selling a part of their personal stock in the company at that stage. I’m not talking about F-U money here, but only enough money to not have to think about whether you can afford to go out to dinner, or finally trade-in that jalopy you’ve been holding together with duct-tape. My recommendation is that founders should consider selling between 5%-10% of their stake (so if the founder held 20% at this stage, he/she could be selling shares equivalent to a 1%-2% stake in the company) once a company gets to a high-priced Series B or a Series C.
The objective is really to be able to get some risk off the table for the founders and not leave all their eggs in one basket. If you can use that money to set aside a financial cushion for yourself, or maybe in a really good scenario, make a down-payment on a house, that’s a great outcome. If things go well, and your company succeeds beyond your wildest dreams, it will end up being the most expensive house ever (because you could have held your stock and made a lot more on it). But, if things go south, then you’ll be thanking your stars that you at least got that little something for all the effort and years you put in.
I have been amazed that most VCs who are on the boards of these companies don’t counsel founders to do this. To the contrary, I suspect that lots of VCs don’t like this idea. They want to keep the founders “all-in” in the startup, because they feel that otherwise the founders won’t be motivated enough. When I run into that kind of thinking, all I can do is call bullshit on it — it just makes me fuming mad.
If you’re a founder who has worked your tail off for many many years (where “many many” is usually >>4 years) and you have succeeded in building a fair amount of value in the company, then why shouldn’t you be able to take some of that value off the table? VCs invest in a portfolio of companies. So they’ve already reduced their risk by spreading their $$s across a number of companies. Not only that, in most cases VCs aren’t even investing their own money, they’re investing OPM – Other People’s Money. Founders, by contrast, have everything tied in to the success or failure of their startup. They’ve usually scraped by for many of the early years, paying themselves (if at all) less than they could earn if they took a job rather than working on their dream. Yes, they do it because they are passionate about it and couldn’t imagine doing anything else, but, if the founders build a company that is being valued at many tens, and sometimes hundreds of millions of dollars by VCs, then IMHO they deserve to see some of that value in cold hard cash.
Founders who end up taking some money off the table and build a financial cushion for themselves, are more likely to want to “go long” in the company. It aligns the incentives of the VCs and the founders better so that the founders are then comfortable enough that they are willing to take that moon-shot.
By the time a company gets to its Series B or Series C, it is quite common for the founders to have lost control of the board or the company in general. By this point in time, the VCs usually outnumber the founders on the Board and can set the direction of the company (For instance, blocking when the company can be sold. There are far too many cases where the VCs want the company to shoot for an even bigger exit and in the process miss the window for an exit leaving the founders with nothing). If the founders cannot control the direction of the company, why should they leave 100% of their risk on the table? If they’re giving up control, that should come in exchange for having some recognition of the value they have created so far.
Of course it is important to note that all my comments above apply only when the company is doing well and is seeing significant up rounds. And that too usually when there is sufficient investor demand for the next round, i.e. the leverage needs to be in the company’s hand (rather than investors) for any type of founder liquidity to even be an option.
There are several arguments against providing founder liquidity:
1) The money doesn’t go to the company, but into founders’ pockets: Yes, the money from founder liquidity does go to founders’ pockets, but that’s entirely the point. If this argument is being brought up, then the only test is to see whether the capital needs of the company have already been met or not. If they have, then there is no reason the founders shouldn’t get some liquidity of their own.
2) Fairness to other early employees in the company: This is a very critical and important point, that is often overlooked by founders. I firmly believe that if there are early employees who have been with the company long enough and have meaningful enough stakes in the company, they too should have the opportunity to sell some of their vested stock, or vested and exercised options. This does lead to a discussion around what’s the right threshold to set for whom this opportunity is offered to and to whom it isn’t. I believe this is something that needs to be determined on a company-by-company basis. In most situations that I have come across, the founders usually have a significantly longer tenure working at the company than even the earliest employees and so a founders-only cut-off is acceptable. However, if that’s not the case, then more thought should be put into determining that threshold.
3) Setting a precedent for the price of the Common Stock: This is the biggest issue with founder liquidity. Founders typically hold Common Stock in the company, but they (obviously) want to sell the Common Stock at the same price as the Preferred price or close to it. By selling Common Stock there is a risk of setting a precedence for the price of the Common Stock, which can then impact the price at which future options can be granted. It is important to note that this transaction is one data point for the price of the Common. So when a valuation firm looks at the complete picture, the movement in the price of the Common Stock may either be small, or the price may not move at all because the transaction can be considered to be a one-off transaction (i.e. if someone else were to go and sell Common Stock in the company, it wouldn’t be valued the same way, especially as there isn’t really a liquid market for it).
There are creative solutions to the problem of setting the price of the Common Stock which have been devised and used by many startups. This is by no means a comprehensive list, but here are just some of the approaches that I’ve heard of:
1) The founders stock is purchased by a neutral third party, rather than a VC who is an investor in the company. If the VC is already an investor (and especially if he/she is on the Board) then that person already has a lot of knowledge about the company, and it will be difficult for any purchase by the VC to then be considered a one-off transaction.
2) The company can repurchase the founders’ Common Stock at the fair market value (FMV) price of the Common Stock, sell an equivalent amount of Preferred Stock, and then give the founder a bonus for the price differential between the Preferred price and the Common price. The downside is that while the purchase of the Common Stock results in capital gains, the payment of the bonus, results in taxable income for the founder. Additionally, the company now just added on additional liquidation preferences — but this may be acceptable since the founders are likely to be the largest holders of the Common.
One advantage of this approach is that the purchaser of the stock could even be a current or new investor and doesn’t have to be a third party. This may even turn out to be a good approach for the new investors to get to their desired ownership in the company or for current investors to reduce their dilution.
3) In some cases, if the founders, or their lawyers had enough foresight, some portion of the founders stock may have been issued as Preferred Stock. The concept of the Series FF stock is a good example of this. In this situation, since the founders own some portion of their equity in Preferred Stock, the issue of the Common Stock pricing doesn’t occur. However, setting up a company with such a structure is uncommon and more importantly doing so can send a negative signal to the early investors in the company and potentially create an additional risk for the early financing for the company. (I have more extensive views on this, but this post is getting long enough!)
In summary, I think it is important for founders to consider getting some amount of liquidity when a company gets to a high-priced Series B or a Series C round. It’s a rational thing for the founders to do and I would also encourage the VCs who are investors in these rounds, to consider counseling founders on this option. Whether the founders exercise that option or not is a different issue, but at least it should be an informed decision. To that extent, I hope this post sparks some discussion on this topic, which typically doesn’t get much air time and stays something that only gets discussed behind closed doors.
In my humble opinion, when used correctly, founder liquidity can be a tool that rewards founders for their years of effort in building a valuable company, and aligns the incentives of the founders with the VCs to build an even more hugely valuable company.