Purchasing Founder Shares Before an Exit Event

Fred Wilson wrote today about his dislike for stock buybacks. He argued that it sends the wrong signal to the market and used as a case TheStreet.com, where he was an investor:

With our stock buyback we were signaling to the market that we had no good ideas about how to spend that cash. We were signaling that we didn't see much of a future in our business. And smart investors bet against those kinds of companies, managements, and boards.

I couldn't agree more. Yet, I also think that the recent trend of new financing rounds cashing out founders also sends the wrong signal. A lot of the super-angels and early stage guys are arguing that it makes sense to put some cash in founders pockets as it usually takes longer than expected to reach an exit. Actually, I'd be interested to hear what Fred's take is on this. 

In general, this makes sense. Often founders are taking zero salary and may be forced to wait 5 to 7 years until an exit event can take place. Yet, I personally believe that once past the seed stage, it makes more sense to give the founder(s) a realistic salary as opposed to cashing them out, even partially. After getting initial funding, a Series A or later financing is going to bring a couple million into the company at a minimum. If the company is really rocking, it may be 20, 30 million or even more. This allows for realistic salaries and if the founders are still around, they should be compensated fairly and won't need to cash out early. Sure, there may be no room in the round so an investor offers to buy founder stock. Again, all makes sense. Yet what message does this send to the market?

Just as a stock buyback may signal to the market that the company has no idea how to spend it's cash, founders selling shares may indicate that they don't believe in a home-run exit. As VC's, we are looking for the home-runs. Yes, the singles, doubles and triples support the portfolio strategy. Yet, ultimately what we are all looking for is the home-runs.  If a founder is unwilling to hold on to his full stake until the exit, he may not believe that he can ever achieve a truly spectacular exit. Smart investors, in my opinion, would also bet against this. 

Comments

[Shafqat]

Interesting post, but as an entrepreneur, I have to disagree. We take large risks, go without any salary, and then take minimal salaries for many years on the premise that we are gearing up for the home run.

Often that puts huge strains on family, or affects homes/mortgages/kids/education etc. At some point, cashing out some shares will help alleviate that stress and allow me to focus wholeheartedly on the homerun. A competitive salary would be nice, but will not come close to relieving the situation at home. So as I see it, cashing out some founder stock doesn't mean entrepeneurs don't believe in the home run. It means they can now focus 100% on that homerun.

[Paul Jozefak]

Shafqat, generally I agree that after years, the founder is probably in a situation where he needs cash to even things out at home. Yet, I still argue that selling shares is not the way to do this. If the founder truly believes that the company will be a home-run, there would be no justification for selling shares early as he or she sell too low. If he is compensated fairly, meaning somewhere around 100k plus a year, I don't see where he needs more at home. If he thinks he will eventually be a millionaire and wants to live the life early, his or her problem. I, as a shareholder, don't get my exit value until the company is sold or goes public. Why should the founder, whom I took the big risk on up front, cash out before I do? We both decided to work together and take risk together. I have no problem compensating him fairly and trust me, you can live pretty well off 100k a year after taking no salary. If your lifestyle calls for 200 or 300k plus a year or far more, then the start-up world is not for you. If your company is really rocking and you've raised a couple rounds, are worth it as a manager and show results, more than a 100k a year is also easily do-able. Again, as I said before, the shareholders in my opinion should all be in the same boat. Keeps everyone honest. If a founder takes a couple million out before any exit event has happened, I am worried about their motivation thereafter. Vice verse, if I see another shareholder (VC) wanting to bail out early, I become just as concerned so this sword cuts both ways.

[Howard Edelman]

I'm not sure where you live Paul, but I live in the SF Bay area and a salary of $100K a year post burning through personal resources, leveraging credit cards, kids, supportive wife, house, etc and taking no or a greatly diminished salary for several years through the ramp up just doesn't cut it. Look, I think most enterpreneurs, myself included, understand the risks of starting ventures and the failure rate statistics. The average period until liquidation is 8-10 years which can be a long period of finanial stress for a founder. You put your skin in the game and persist. I think investors and board members often don't compensate management properly and hide behind the "pay day" argument. Acquiring companies often want the founder as much as the company. They recognize that the person who got the company from the beginning to the end is rare and valuable. I think many founders don't realize the leverage they can have in negotiating with the board given where the value is placed by the acquirer. Boards should be much more generous and mindful of properly compensating management. What is the difference between $150K or $200K and $100K in the scheme of the company. Management needs to be taken care of and relieved of this stress so they can focus on the homerun. Cheap boards get what they pay for, management who will look elsewhere for what they need financially while they still have their stock options.

[Paul Jozefak]

Howard, it all depends on the lifestyle and how much one feels they are "entitled" to. If you're a founder and you're going to make millions at exit, I really have no tears for you in regards to the "rough" years where you have to get by on $100k a year. Agreed, $150k or a bit more may be in line regarding salary for top management. I could even easily see $200k or more if the company is already doing $5-10mm in revenues. This is all justifiable, especially for first-time founders who haven't had any exits to-date.

At the same time, I really don't care much about founders being able to live the lifestyle of their neighbors in SF or the Valley. The freshly arrived Indians and Chinese are living four to an apartment pumping out competition. I need cash for developers and teams (just as much as founders do if they care about their company) to remain in the company. If one is selling shares early on top of a fair salary so they can send their kids to private school or buy the Mrs's a new car, priorities are wrong.

Surprisingly, every successful entrepreneur I've ever worked with has never had this conversation with me. Those who hit it out of the park always left cash in the company and never sold shares early. They wanted as much equity as possible at exit. Sure, they scrimped at home and maybe weren't fair to their families. They never questioned though whether they were motivated to hit it out of the park. Especially not because they had to live frugally at home.