Do your equity numbers for the founders assume a four year vesting cycle? Obviously going from angel to later stage VC will take a number of years. In your 'quick flip' scenario, founders will avoid dilution in later rounds but won't they also prevent themselves from fully vesting the equity they owned pre-investment?
fredwilson
· 10 months ago
Founder vesting provisions are all over the map on the early exit but I think the most common provision is accelerated vesting of founder equity on exit
Founder vesting is generally to protect the investors and other founders from one of the founders deciding they aren't into it any more and taking off with a big slug of equity
Chris Hill
· 10 months ago
I understand the investors and other founders wanting to be protected against one founder walking away with a big slug of equity but this is irrelevant to my point. The case that you described in your original post was the 'quick flip' scenario and how to maintain founder equity.
The most common form of acceleration is one year, whether single or double trigger, correct? Under your 'quick flip' scenario, if an investor were to exit a two-year old investment then the founder would only earn 75% of his fully-diluted equity (two years of vesting plus one year acceleration).
Is this correct? If so, is the un-vested founder's equity split pro-ratably among all equity holders? That would seem to unduly enrich the investor. How did you handle this with FeedBurner?
tmarman
· 10 months ago
Chris, I think what Fred was saying is that the purpose of these provisions is to protect "dead equity" from a founder who walked vs. punishing a founder for a quick exit.
Our stock purchase agreement says that basically with any "Change of Control" (merger or dissolution) the Repurchase Right goes away (i.e., we are fully vested). I think it's fairly customary to accelerate all vesting .
fredwilson
· 10 months ago
Tim that is pretty normal, but again, there is no "standard" on this one. It's negotiated a lot.
rafer
· 10 months ago
Chris, for founders, anything other then a full vestup on early sale is unusual (and unreasonable).
fredwilson
· 10 months ago
I'm not sure where I said this (another comment?) but most founder vesting provisions have acceleration upon exit and it's not normally just one year.
Speaking of FeedBurner, Dick Costolo wrote what I think is the best post on vesting upon exit that I've ever seen
you bring in a CEO on 50% basis of founder(s), and spread additional 50+% to 5 senior managers?
or does that include options for all employees?
presumably only applies when founders don't remain top managers through exit/IPO, which I guess is the default assumption?
if you had 2 co-founders, bringing CEO in on same basis seems like a good deal for the CEO who is taking far less risk with a VC-backed company.
fredwilson
· 10 months ago
There's no "typical" in all of this
But a hired CEO will generally get 5-7% of the company if they join early and less if they join when the business is already ramping and making money
If the entire team is 20%, think 25% to CEO, 75% to rest of mgmt team. That's everyone include admins
curmudgeonly troll
· 10 months ago
makes much more sense - thanks for clarifying!
Blaine Cook
· 10 months ago
Your split doesn't include non-management employees. That's disappointing. To what extent do you think employee grants are normal or fair?
fredwilson
· 10 months ago
Sure it does
The 20-25% includes all employees, including the ones who are no longer with the company
Your last question Blaine is really hard to answer
My guess is that many of them are fair, particularly when the founders are experienced and so are the employees
Inequity results largely from inexperience on the founders part and to a lesser extent on the employee's part
Kevin
· 10 months ago
So what's a normal grant for, say, the first employee? Assuming a non-manager engineer type.
fredwilson
· 10 months ago
There's no normal
Is the engineer a co-founder?
Are there engineers on the founding team?
Has there been an angel financing already?
Kevin
· 10 months ago
I am curious about the answer for all those situations. I don't really know how to learn this stuff besides bugging VCs on their blogs. ;-)
Let's say the 2 co-founders (1 engineer 1 business-type) have just gotten $100k angel and are hiring an engineer. What sort of equity range for that engineer would you expect.
fredwilson
· 10 months ago
1-2%
Facebook User
· 10 months ago
1-2% after seed funding dilution or on exit? If later then the key engineer (typical first hire) need to start with 4-8% post seed, no?
Facebook User
· 10 months ago
er, make that 3-6%. I don't want to encourage unreasonable expectations. ;-p
fredwilson
· 10 months ago
1-2% post seed funding is what I think is typical.
That would be ~0.5% at exit.
Facebook User
· 10 months ago
thx Fred. I've been involved mostly with self-funded startups at prototyping stage so my numbers are not typical. I did turn down a first hire position awhile back that exited for $100mil but I have no regrets since 0.5% of that after 4 years is... Maybe I am being unreasonable.
Anyway, I now spend most of the time on the other side of the table so 1-2% post seed sounds very reasonable. ;-) Thanks again for a rare insight into a rather elusive subject.
fredwilson
· 10 months ago
I've seen higher and lower but that seems about where the avg is
Blaine Cook
· 10 months ago
Ahh, ok, that clarifies things, thanks. "20-25% for the management team" was the bit that confused me, since it seemed to imply just the management, and I wasn't sure where to fit non-management employees.
Agreed that the actual split is dependent on experience, and hard to answer. ;-) I was just worried that you were saying that only founders and management were entitled to a non-trivial amount of stock.
fredwilson
· 10 months ago
Sorry that wasn't clear Blaine. Former employees often make up a meaningful part of the cap table. At Facebook, I think it's a significant number.
AndyFinkle
· 10 months ago
I would think that data from a few years back will be different as a result of the economic environment we are in currently. With the IPO market locked up, I think we will see more exits like delicious. I think this will be especially true in the lower tiers (sub $75 valuations).
I hope that Sim's survey asks for dates as well, it will be interesting to see HOW things have changed (if my assumption that they have is even correct)
I would be hard pressed to guess any market, but I certainly wouldn't guess on more early exits. To see many more early exits like Delicious, you're implying a willing buyer. At least what I've seen so far is much more stratification -- folks boning up on massive rounds to make it through the rough times, and folks that are going to get poached on their deathbed (sometimes by that first batch). The idea that there are folks out there paying up to buy early I haven't seen, but maybe I'm not looking closely.
And don't forget the third category of course, those that won't exit in the near term because they can get profitable and wait, or have a long enough time horizon from founding and enough momentum to make it through.
AndyFinkle
· 10 months ago
I don't disagree ...I was more thinking some of the larger Public netco's buying at good valuations & LOTS of small mergers of equals. Re your 3rd category...Lots of companies in the deadpool (IMO) never needed to get there. Even my very 1st startup (1996) is STILL alive (albeight not making meaningful money)...and is TOTALLY self sustaining http://bit.ly/tqvUi
fredwilson
· 10 months ago
The third category is what we are hoping for in all of our investments
Ales Spetic
· 10 months ago
My rule of thumb is: one round, one third dillution. That assumes that the round is a "proper" one, such that it takes the company to the next big milestone. It implicitly sets the valuation and expectations. Reality can be different, however it's a good model to start with.
Philip Baddeley
· 10 months ago
In the UK, companies have to file accounts and details of shareholdings at Companies House. Equity Fingerprint http://www.equityfingerprint.com/ takes this data to produce Equity Fingerprints (essentially cap tables in pictures) and we have over three hundred on the site. It would be great to take this post and all the comments and make a paper for the EF site with full acknowledgement. Is that OK? Noam Wasserman of Harvard Business School has a database http://founderresearch.blogspot.com/. Many of his contacts appear to be more interested in being "kings" as he puts it. I distinguish, for students and beginners, between Active Equity Companies which use equity to build a business and Passive Equity Companies which account for >99% of companies formed. Does anyone know any courses which deal with this equity issue from the point of view of the entrepreneurs/founding team as opposed to the view of VCs on which there is plenty of information. Very few people who teach entrepreneurship seem to understand the creative tension of building businesses and the emotion of using equity. Marc Andreesson in his interview with Charlie Rose, see you earlier post, touches on the subject and mentions the big difference in valuation between preferred and ordinary shares in Facebook; $15bn to $3bn. I could go on but this is a comment not a post. I do comment on my blog www.cambridgecluster.com on how companies use or not use equity to build businesses. I am sure you will make it simple for us!
fredwilson
· 10 months ago
Phillip please feel free to use this post and comments as you see fit. Everything that is said on this blog is free to distribute via CC license.
I am not aware of any courses on this topic, but HBS does have a pretty deep case history of startups.
David Semeria
· 10 months ago
Fred, your breakdowns make no distinction between common and preference shares.
You just need to look at recent events at FB to see the difference between the two. Microsoft bought preference shares at a $15bn valuation, whilst FB itself values its own common stock at around $3.6bn.
Even if the 4-5x difference is excessive, the general point holds.
Since investors generally get preference stock, whilst founders and employees get common, the true dilution is even higher than your numbers suggest, and further reinforces the notion that VC money is, in my view, very expensive.
rafer
· 10 months ago
The jargon is mildly confusing, because not all Preferred shares have preferences, but in general you are correct. The VCs take their money off the top (based on clauses called liquidity preferences and/or participation) from 1 - 3X before the remaining proceeds are split according to share amounts -- including the VCs shares once again.
David Semeria
· 10 months ago
My fault: in the UK we call preferred stock preference shares.
fredwilson
· 10 months ago
Scott I'm not sure I'm agreeing with your 1-3x math. Most of the preferred stock we own is straight 1x no participation. In that case, above the valuation we paid going in, we share equally with the founder.
rafer
· 10 months ago
That's a fair exception to take. I was stereotyping and should have made clear that USV, FRC, and maybe a couple of others were consistent exceptions. What I described is median behavior for funds, particularly large ones, except at the top of the cycle.
fredwilson
· 10 months ago
Are you sure about that scott? I've seen a lot of term sheets over the years and participation and liq multiples have been in the minority of them
fredwilson
· 10 months ago
A couple points on that david:
1. many companies in our portfolio have built values well above the amount of preference in their cap structure so in those situations, common and pfd are essentially identical. The Facebook situation with the MSFT stock is a bit unusual and I wouldn't focus too much on it. 2. the times when pfd vs common matters is normally a sale/exit where the investors don't get a very good return.
Certainly entrepreneurs should understand the math around preference. We build liquidation models for every one of our companies and share them with the founders and management freely so they understand when and where preference matters and when it does not.
David Semeria
· 10 months ago
Thanks Fred.
It's ironic that entrepreneurs (like me) voice our gripes here when you yourself display a level of openness and honesty far above the industry average.
Chapeau!
fredwilson
· 10 months ago
Maybe there's a reason for that. The best companies listen to their customers. And entrepreneurs are the VC's customers
David Semeria
· 10 months ago
People like you, Guy Kawasaki, Robert Scoble etc, demonstrate that you don't have to behave like JR Ewing to make your mark.
That said (and before the violin playing starts) I would still argue strongly in favour of all stockholders owning only common. A lot depends on what the founders initially bring to the table, and how much value the VC adds.
In the same way that some people believe a handshake is worth more than a contract, I believe that any multi-owner business should be founded on equality, trust, and a general feeling that if you push the other guy too far he'll moydah ya.
fredwilson
· 10 months ago
i hear that all the time, but let's say you invest $1mm in my company and you negotiate for 10% fof the business (a $10mm valuation)
you have one board seat but i control the business
i decide to sell the business for $5mm, i take $4.5mm and you get $500k.
is that fair?
no, it is not
that's why preferred stock exists, plain and simple
David Semeria
· 10 months ago
That's what shareholder agreements are for.
What about: founder confers 1m lines of code, patents, trademarks etc and the investor confers some money. Things don't work out and the company gets acquired for less than the investor put in. The investor exerts his 1x preference and keeps all the money.
That's even less fair, especially if the acquirer is purchasing the company for the original code and IP.
fredwilson
· 10 months ago
Shareholder agreements are about blocking deals. That's not a good answer. I hate vetos and blocks and much prefer creating an understanding upfront about how the pie will get divided and let the entrepreneur call the shots in terms of exit
There might be some investors who will buy common in an early stage venture they control but I am not one of them
There's a reason that pfd stock exists and its the market standard
Some investors got hosed a long time ago and learned from it
David Semeria
· 10 months ago
Clearly, each situation should be judged on its own merit.
And whilst I disagree with you on the issue of preferred stock, and as I've made clear above, I really respect your willingness to engage the entrepreneurial community - especially on thorny issues such as this.
fredwilson
· 10 months ago
We are allowed to disagree and it's really important for people who disagree to understand the other's perspective. So this dialog has been valuable to us and to everyone who reads it
Seth Lieberman
· 10 months ago
It will be interesting to see how equity grants and dilution changes over the next few years. Many current companies are going to (have been) crammed down due to the economy and exits are pushed off. Founders will have to raise more capital and suffer more dilution. At the same time employees with existing option grants may be under water- key folks will want to be made whole. On the other side new employees/mgmt may care less about the equity and more about the cash as happened in 2001-2003. I suspect the overall effect will be that founders will end up with less equity than they anticipated.
fredwilson
· 10 months ago
That will be unfortunate.
I know this is a touchy subject and I hesitate to bring it up. But the whole Sequoia "RIP Good Times" thing was as much about making sure founders cut back and conserved cash to preserve equity ownerships as it was anything else. VCs get a bad rap for cramming down and diluting entrepreneurs. And it will always be the case because it is our capital that causes the dilution. But most VCs I know, and certainly the best VCs, don't want to see entrepreneurs get diluted. It's not a zero sum game by any measure and the ideal is we make money together.
Seth Lieberman
· 10 months ago
Fred- Sorry, to be clear I was not implying that VCs and others were unfairly or egregiously diluting founders. My logic was really quite simple:
1. Capital is very scarce right now 2. Economic times are uncertain 3. Therefore those with capital (you et all) will require more for your risk profile. 4. That means more equity, more security, more [insert value here] 5. QED existing equity holders will have less.
I think this is perfectly reasonable and in fact correct. And of course, existing shareholders may have less today, but more in the long run. I do believe most VCs (perhaps you are even above and beyond in your enlightenment) realize that capital contributions are not, in and of themselves, value creation. They are simply a means to value creation and that is what entrepreneurs do, so if entrepreneurs have no vested interest, they won't play. So making sure mgmt and founders etc are a piece of the pie is the only way to build value. But my comment stands that I think where as 2 years ago a founder might have kept X, he/she will now end up with .75X. A entrepreneur might be happy at productive at 8% but would prefer 12%, but can not longer keep that much.
fredwilson
· 10 months ago
I didn't think you were implying that
I saw it as an oppty to get on my soapbox about VC/founder dilution issues
You may be correct but I am working hard to see that it doesn't have to happen that way in our companies
Phil
· 10 months ago
If a project / "start up" is virtually 100% automated, runs smoothly with only a few hours of work a day by a project manager, a few hours a week programmer time, is seeing steady natural growth and is Turing a small profit, would it be best to attempt an exit at this stage?
Or is it better to ramp up and build a full management / marketing / engineering team along with it's own incorporation etc and sell a developed independent company, even though the newly formed company may take some time to realize a profit?
fredwilson
· 10 months ago
There's no way to answer that question without seeing what the market would pay for it.
If you can get a bid, then you can evaluate that against the cost and dilution of the go it alone approach.
Greg_Gerber
· 10 months ago
I've been looking for solid information like this for months. TY.
Daniel Cohen
· 10 months ago
I've heard Sequoia talking about 25% for mgmt AND founders, and then 75% for investors. Also, I would think that we will see less % for founders in deals done in 2009/2010.
fredwilson
· 10 months ago
Let's see what Sim's survey says. I bet it's less than 75% for investors.
Prof. Noam Wasserman
· 10 months ago
Fred:
As Philip Baddeley mentioned above, I have built a very rich dataset (thousands of private IT ventures over the last decade) for my research on founders. I've already done some analyses in this realm, but would love to discuss with you what additional analyses might shed light on your questions (and would be fine with your posting the results here if you wanted). Drop me a line if you want to discuss it.
Professor Noam Wasserman Harvard Business School
fredwilson
· 10 months ago
Noam, I will email you
Dan Cornish
· 10 months ago
The founding team gets 5% equity by the time an average time an exit comes along and there is a 50% chance the founding team or at least the CEO will be replaced and only a 20% chance of success (meaning an exit with liquidity) in normal times. Now in uncertain times the chance of a an exit is less and the dilution and terms of the founding team will be more harsh, the argument for bootstrapping or only Angel investment becomes stronger for the software sector. I am sure people can correct my math/statistics but I am wondering if anyone has ever done an analysis on the overall returns to founders as a group? Are the returns the same profile as LPs in Venture funds?
fredwilson
· 10 months ago
Dan
I think this is an overly pessimistic assessment
Noam Wasserman, a professor at HBS, has done a lot of research on this
Fred, Thanks for the link. I have learned quite a few things. Some highlights include: First time Founders provide better returns to VC investors, RIch vs. King is the basic question a founder should ask themselves before raising VC and finding the right VC is the most important thing to do while raising money. It dawned on me that a lot of the tension in the VC - Founder relationship comes from a mismatch. A VC who knows a founder is interested in being a king is dishonest if they invest money with the idea that the founder(or founder team) can be kicked out but make them rich. The VC should just pass on this kind of investment. A Founder(Founding team) is dishonest if they think that a VC will not try to remove them if they are not focused on large monetary returns regardless of what happens to the business. The rare relationship is when the goal of building a great business and a great monetary are shared both by investor and Founder.
Thanks again for providing such a great community.
fredwilson
· 10 months ago
If shakespeare was alive, he'd be writing tragedies about VCs and founders
Prof. Noam Wasserman
· 10 months ago
Or HBS case studies about them. :->
fredwilson
· 10 months ago
are you sure he could even get into HBS?
mike
· 10 months ago
yo
DorianBenkoil
· 10 months ago
this kind of info is very useful and exactly the kind of transparency that needs to come to the investment world. Thanks for it, Fred.
Ido Dubrawsky
· 10 months ago
I disagree to a certain extent. I think that Tom Friedman's position is more of taking the $20 billion dollars that the government would pour into trying to save GM and Chrysler and using it for the basic research to take help take ideas from the drawing board to the point that VCs would be more interested in it. Yes there will be some duds but as with any emerging field there will be some entrepreneurial efforts that need just a bit more incubation before it's "ready for prime time." As long as the taxpayers and Congress were aware of and on-board with the idea that some of these will fail and that this could be an overall losing proposition and that there won't be any Congressional witch-hunt should things not work out for the best. It's still a better gamble than pumping this money into GM's and Chrysler's carcasses...there the odds are much higher against success without costing the taxpayer more
Dave Broadwin
· 10 months ago
It is always good to be reminded of the effects of dilution and to hear the related concerns. One point that sometimes is lost on my clients is the difference between ownership dilution and financial dilutions. 25% of $100 milliion is better than 75% of $10 million.
leigh
· 10 months ago
I know of some cases where "incubators" can take up to 25% in exchange for 'services' and/or investing consulting. I think some (especially these days ) younger founders may end up being taken advantage of. It would be great for you to do a post at some point giving some practical advice and boundaries (i.e. when they are being presented with 'it's this or nothing' fear plays a role - but when do you think it's not worth it no matter what....)
fredwilson
· 10 months ago
I would not dilute for anything other than talent or money, period
basilpeters
· 10 months ago
Great post and outstanding discussion as usual, Fred. I believe the optimum vesting formula is to vest half of founders' stock linearly over three years and the other half only on an exit. This creates the best alignment between the founders and early stage investors (in my case, angels). This is my post on why I believe this is most fair to everyone http://www.angelblog.net/Share_Vesting.html
fredwilson
· 10 months ago
So if a founder works for ten years but there is no exit and then leaves, he/she is only half vested?
basilpeters
· 10 months ago
Yes, I think that is most fair for two reasons:
1. When an investor invests, I believe the implicit agreement is that the entrepreneurs will work to increase the share price AND to execute an exit. In a significant number of exits as much as half of the ultimate value is created during the final transaction (in public companies they call that a control premium, but it's even more significant in private company exits.) If someone who is part of the team leaves before that value is created, I don't think it's fair that they take that value with them.
2. If someone leaves, the board has to find a replacement. If the person leaving doesn't leave some of their equity behind to incentivize their replacement, then all of the other shareholders have to suffer the full dilution effect of their departure (whether it's equity or cash).
I've used this formula in virtually all of my early stage investments for over 15 years. Many of the benefits are psychological and extremely difficult to prove, but I am convinced this formula creates a fundamentally better alignment between founders and early stage investors (especially in this exit environment.)
fredwilson
· 10 months ago
I've been doing VC for about the same time you've been doing it Basil and I don't feel comfortable tying that much equity to an exit
But I understand your point
basilpeters
· 10 months ago
Fred, I respect your position. What I love about this business is that nobody has come close to figuring it all out. I believe the best way we can all move entrepreneurship and early-stage investing forward is through an open, constructive dialog. You are doing an exemplary job of stimulating the discussion and providing the platform.
fredwilson
· 10 months ago
And I am sure if we did a deal together, we'd figure out how to structure the vesting in a way that makes both of us and the entrepreneurs comfortable
All Comments
think the most common provision is accelerated vesting of founder equity on
exit
Founder vesting is generally to protect the investors and other founders
from one of the founders deciding they aren't into it any more and taking
off with a big slug of equity
The most common form of acceleration is one year, whether single or double trigger, correct? Under your 'quick flip' scenario, if an investor were to exit a two-year old investment then the founder would only earn 75% of his fully-diluted equity (two years of vesting plus one year acceleration).
Is this correct? If so, is the un-vested founder's equity split pro-ratably among all equity holders? That would seem to unduly enrich the investor. How did you handle this with FeedBurner?
Our stock purchase agreement says that basically with any "Change of Control" (merger or dissolution) the Repurchase Right goes away (i.e., we are fully vested). I think it's fairly customary to accelerate all vesting .
It's negotiated a lot.
provisions have acceleration upon exit and it's not normally just one year.
Speaking of FeedBurner, Dick Costolo wrote what I think is the best post on
vesting upon exit that I've ever seen
http://www.burningdoor.com/askthewizard/2007/06...
you bring in a CEO on 50% basis of founder(s), and spread additional 50+% to 5 senior managers?
or does that include options for all employees?
presumably only applies when founders don't remain top managers through exit/IPO, which I guess is the default assumption?
if you had 2 co-founders, bringing CEO in on same basis seems like a good deal for the CEO who is taking far less risk with a VC-backed company.
But a hired CEO will generally get 5-7% of the company if they join early
and less if they join when the business is already ramping and making money
If the entire team is 20%, think 25% to CEO, 75% to rest of mgmt team.
That's everyone include admins
The 20-25% includes all employees, including the ones who are no longer with
the company
Your last question Blaine is really hard to answer
My guess is that many of them are fair, particularly when the founders are
experienced and so are the employees
Inequity results largely from inexperience on the founders part and to a
lesser extent on the employee's part
Is the engineer a co-founder?
Are there engineers on the founding team?
Has there been an angel financing already?
Let's say the 2 co-founders (1 engineer 1 business-type) have just gotten $100k angel and are hiring an engineer. What sort of equity range for that engineer would you expect.
That would be ~0.5% at exit.
Anyway, I now spend most of the time on the other side of the table so 1-2% post seed sounds very reasonable. ;-) Thanks again for a rare insight into a rather elusive subject.
Agreed that the actual split is dependent on experience, and hard to answer. ;-) I was just worried that you were saying that only founders and management were entitled to a non-trivial amount of stock.
part of the cap table. At Facebook, I think it's a significant number.
I hope that Sim's survey asks for dates as well, it will be interesting to see HOW things have changed (if my assumption that they have is even correct)
http://twitter.com/A_F
And don't forget the third category of course, those that won't exit in the near term because they can get profitable and wait, or have a long enough time horizon from founding and enough momentum to make it through.
That assumes that the round is a "proper" one, such that it takes the company to the next big milestone. It implicitly sets the valuation and expectations. Reality can be different, however it's a good model to start with.
Noam Wasserman of Harvard Business School has a database http://founderresearch.blogspot.com/. Many of his contacts appear to be more interested in being "kings" as he puts it.
I distinguish, for students and beginners, between Active Equity Companies which use equity to build a business and Passive Equity Companies which account for >99% of companies formed.
Does anyone know any courses which deal with this equity issue from the point of view of the entrepreneurs/founding team as opposed to the view of VCs on which there is plenty of information.
Very few people who teach entrepreneurship seem to understand the creative tension of building businesses and the emotion of using equity. Marc Andreesson in his interview with Charlie Rose, see you earlier post, touches on the subject and mentions the big difference in valuation between preferred and ordinary shares in Facebook; $15bn to $3bn.
I could go on but this is a comment not a post. I do comment on my blog www.cambridgecluster.com on how companies use or not use equity to build businesses.
I am sure you will make it simple for us!
Everything that is said on this blog is free to distribute via CC license.
I am not aware of any courses on this topic, but HBS does have a pretty deep
case history of startups.
You just need to look at recent events at FB to see the difference between the two. Microsoft bought preference shares at a $15bn valuation, whilst FB itself values its own common stock at around $3.6bn.
Even if the 4-5x difference is excessive, the general point holds.
Since investors generally get preference stock, whilst founders and employees get common, the true dilution is even higher than your numbers suggest, and further reinforces the notion that VC money is, in my view, very expensive.
stock we own is straight 1x no participation. In that case, above the
valuation we paid going in, we share equally with the founder.
1. many companies in our portfolio have built values well above the amount
of preference in their cap structure so in those situations, common and pfd
are essentially identical. The Facebook situation with the MSFT stock is a
bit unusual and I wouldn't focus too much on it.
2. the times when pfd vs common matters is normally a sale/exit where the
investors don't get a very good return.
Certainly entrepreneurs should understand the math around preference. We
build liquidation models for every one of our companies and share them with
the founders and management freely so they understand when and where
preference matters and when it does not.
It's ironic that entrepreneurs (like me) voice our gripes here when you yourself display a level of openness and honesty far above the industry average.
Chapeau!
That said (and before the violin playing starts) I would still argue strongly in favour of all stockholders owning only common. A lot depends on what the founders initially bring to the table, and how much value the VC adds.
In the same way that some people believe a handshake is worth more than a contract, I believe that any multi-owner business should be founded on equality, trust, and a general feeling that if you push the other guy too far he'll moydah ya.
you have one board seat but i control the business
i decide to sell the business for $5mm, i take $4.5mm and you get $500k.
is that fair?
no, it is not
that's why preferred stock exists, plain and simple
What about: founder confers 1m lines of code, patents, trademarks etc and the investor confers some money. Things don't work out and the company gets acquired for less than the investor put in. The investor exerts his 1x preference and keeps all the money.
That's even less fair, especially if the acquirer is purchasing the company for the original code and IP.
There might be some investors who will buy common in an early stage venture they control but I am not one of them
There's a reason that pfd stock exists and its the market standard
Some investors got hosed a long time ago and learned from it
And whilst I disagree with you on the issue of preferred stock, and as I've made clear above, I really respect your willingness to engage the entrepreneurial community - especially on thorny issues such as this.
to understand the other's perspective. So this dialog has been valuable to
us and to everyone who reads it
I know this is a touchy subject and I hesitate to bring it up. But the whole
Sequoia "RIP Good Times" thing was as much about making sure founders cut
back and conserved cash to preserve equity ownerships as it was anything
else. VCs get a bad rap for cramming down and diluting entrepreneurs. And it
will always be the case because it is our capital that causes the dilution.
But most VCs I know, and certainly the best VCs, don't want to see
entrepreneurs get diluted. It's not a zero sum game by any measure and the
ideal is we make money together.
1. Capital is very scarce right now
2. Economic times are uncertain
3. Therefore those with capital (you et all) will require more for your risk profile.
4. That means more equity, more security, more [insert value here]
5. QED existing equity holders will have less.
I think this is perfectly reasonable and in fact correct. And of course, existing shareholders may have less today, but more in the long run. I do believe most VCs (perhaps you are even above and beyond in your enlightenment) realize that capital contributions are not, in and of themselves, value creation. They are simply a means to value creation and that is what entrepreneurs do, so if entrepreneurs have no vested interest, they won't play. So making sure mgmt and founders etc are a piece of the pie is the only way to build value. But my comment stands that I think where as 2 years ago a founder might have kept X, he/she will now end up with .75X. A entrepreneur might be happy at productive at 8% but would prefer 12%, but can not longer keep that much.
I saw it as an oppty to get on my soapbox about VC/founder dilution issues
You may be correct but I am working hard to see that it doesn't have to
happen that way in our companies
Or is it better to ramp up and build a full management / marketing / engineering team along with it's own incorporation etc and sell a developed independent company, even though the newly formed company may take some time to realize a profit?
pay for it.
If you can get a bid, then you can evaluate that against the cost and
dilution of the go it alone approach.
As Philip Baddeley mentioned above, I have built a very rich dataset (thousands of private IT ventures over the last decade) for my research on founders. I've already done some analyses in this realm, but would love to discuss with you what additional analyses might shed light on your questions (and would be fine with your posting the results here if you wanted). Drop me a line if you want to discuss it.
Professor Noam Wasserman
Harvard Business School
I think this is an overly pessimistic assessment
Noam Wasserman, a professor at HBS, has done a lot of research on this
His blog is at http://founderresearch.blogspot.com/
You may find some good info there
Thanks for the link. I have learned quite a few things. Some highlights include: First time Founders provide better returns to VC investors, RIch vs. King is the basic question a founder should ask themselves before raising VC and finding the right VC is the most important thing to do while raising money. It dawned on me that a lot of the tension in the VC - Founder relationship comes from a mismatch. A VC who knows a founder is interested in being a king is dishonest if they invest money with the idea that the founder(or founder team) can be kicked out but make them rich. The VC should just pass on this kind of investment. A Founder(Founding team) is dishonest if they think that a VC will not try to remove them if they are not focused on large monetary returns regardless of what happens to the business. The rare relationship is when the goal of building a great business and a great monetary are shared both by investor and Founder.
Thanks again for providing such a great community.
1. When an investor invests, I believe the implicit agreement is that the entrepreneurs will work to increase the share price AND to execute an exit. In a significant number of exits as much as half of the ultimate value is created during the final transaction (in public companies they call that a control premium, but it's even more significant in private company exits.) If someone who is part of the team leaves before that value is created, I don't think it's fair that they take that value with them.
2. If someone leaves, the board has to find a replacement. If the person leaving doesn't leave some of their equity behind to incentivize their replacement, then all of the other shareholders have to suffer the full dilution effect of their departure (whether it's equity or cash).
I've used this formula in virtually all of my early stage investments for over 15 years. Many of the benefits are psychological and extremely difficult to prove, but I am convinced this formula creates a fundamentally better alignment between founders and early stage investors (especially in this exit environment.)
don't feel comfortable tying that much equity to an exit
But I understand your point