Making the case for cash out deals

Don Dodge has a write up from a Microsoft conference last week where he chaired a panel of VCs.  His main message is that VCs are still investing (true, but at a much slower pace…).  The piece I want to bring out though is the discussion of how to motivate founders.

Don reports that John Giannuzzi of Sherbrooke argued that stock options don’t motivate founders, and that they don’t align the interests of founders and VCs, largely because there is no downside risk.  Instead he prefers to ask founders to invest in the business, so they are directly aligned.  I can see the logic of this argument, but my suspicion is that in practice for founders who are not independently wealthy (which is most of them) this approach will tend to push you towards smaller outcomes.

At DFJ Esprit we have done a number of deals where we have let founders partically cash out, including Buy.at, and this echoes the approach of Founders Fund (early investors in Facebook, Slide and a number of other hot web startups), as described by Don:

Founders Fund approachFounders Fund
has a completely different approach, allowing founders to cash in some of their stock in the first funding round. Founders Fund, as the name implies, is a VC firm started by founders of startup companies. Peter Thiel and two other PayPal principals, along with Sean Parker (Napster, Plaxo, Facebook) are the partners at Founders Fund, and each has been through all the phases of starting a company. They feel that investor’s interests are more aligned if the founders have some money on the side so they aren’t compelled to accept the first exit opportunity that comes along. They feel the startup founders will be more willing to hang in there for a longer period of time and hold out for a bigger exit.

Too true.  For many founders a little bit of early liquidity takes away the short term requirement for relatively small amounts of cash (school fees, slightly bigger house etc.) and allows them to focus on aiming high.

You do, of course, have to be sure that everyone will still be motivated to turn up to work.  At the end of the day that is mostly a judgement call, although making sure that the founders still have much more wealth tied up inside the business than they have outside it is also to be recommended.

  • Chris H

    Absolutely correct – couldn’t agree more. I’ve been through various stages of a start-up and one of the big issues for us was that the first offer we had on the table enabled us to have a level of security.

    Don’t get me wrong, we weren’t looking to drive Porsches or pay off mortgages, but it was tempting to not have to worry about bouncing school fees that month.

    We didn’t take the offer and a few years later, when trading was tougher, we all had to bail sooner than we would have liked, as personal agendas changed.

    I think that there is no “one size fits all” solution but the idea that the founders, especially those who may be older and have commitments, can afford to live on baked beans for three to four years is short-sighted.

  • Chris H

    Absolutely correct – couldn’t agree more. I’ve been through various stages of a start-up and one of the big issues for us was that the first offer we had on the table enabled us to have a level of security.

    Don’t get me wrong, we weren’t looking to drive Porsches or pay off mortgages, but it was tempting to not have to worry about bouncing school fees that month.

    We didn’t take the offer and a few years later, when trading was tougher, we all had to bail sooner than we would have liked, as personal agendas changed.

    I think that there is no “one size fits all” solution but the idea that the founders, especially those who may be older and have commitments, can afford to live on baked beans for three to four years is short-sighted.

  • I agree with the approach of the Founders Fund and as an entrepreneur myself I would welcome a cash out into my own pocket, however, the venture capital asset class in Europe is probably performing at about negative 5% overall. When a founder raises €10M and uses €2M of that to buy a house and a new car, the eventual sale of that house and car do not go back to the fund and will not help to move the needle of the Internal Rate of Return (IRR) of the fund in the right direction.

    So cash-outs do not directly put money to work in the companies entrepreneurs and VCs are building.

    I propose a new model of cash outs that does not drag down the needle on the investors’ funds and still solves the problem of aligning the interest of the founders and the investors to hold out for the really big exit.

    I founded The Founders’ Club which enables founders of VC backed companies to basically pool 5 to 10% of their future exit into a Limited Partnership. We are cherry picking the best deals backed by the top performing VCs and building portfolios of 30 VC backed companies per portfolio. The result is that if a founder raises VC funding from a tier I VC he agrees to pay 5 to 10% of his / her exit into the Club and that cash is distributed among all the members of the club. So each time any of the other 29 companies crystallize an exit, each founder gets paid cash. http://www.The-Founders-Club.com.

  • I agree with the approach of the Founders Fund and as an entrepreneur myself I would welcome a cash out into my own pocket, however, the venture capital asset class in Europe is probably performing at about negative 5% overall. When a founder raises €10M and uses €2M of that to buy a house and a new car, the eventual sale of that house and car do not go back to the fund and will not help to move the needle of the Internal Rate of Return (IRR) of the fund in the right direction.

    So cash-outs do not directly put money to work in the companies entrepreneurs and VCs are building.

    I propose a new model of cash outs that does not drag down the needle on the investors’ funds and still solves the problem of aligning the interest of the founders and the investors to hold out for the really big exit.

    I founded The Founders’ Club which enables founders of VC backed companies to basically pool 5 to 10% of their future exit into a Limited Partnership. We are cherry picking the best deals backed by the top performing VCs and building portfolios of 30 VC backed companies per portfolio. The result is that if a founder raises VC funding from a tier I VC he agrees to pay 5 to 10% of his / her exit into the Club and that cash is distributed among all the members of the club. So each time any of the other 29 companies crystallize an exit, each founder gets paid cash. http://www.The-Founders-Club.com.

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