August 20, 2005

Why "founder sales" are actually a good idea

Venture capitalists never like deals where their money is used to buy the shares owned by founders and other early investors. They like the money they bring in to go "into building the company" - ie, towards hiring people, building a product, etc. Unless, that is, they are desparate to get in on the deal.

Gary Rivlin of The New York Times reports that such "founder sales" deals are now becoming more common in the US. Companies like eHarmony, Webroot Software, Fastclick, etc., have witnessed the founders "using venture deals to cash out some of their equity without the bother of a public offering or an acquisition".

If the VCs are so hungry for the deal, why do the founders want to cash out early? Are they not as confident as the VCs about the success of their business and hence, a getting a much larger payoff at a later point?

The reason, Woodside Fund partner Thomas Shields explains, is since a founder is typically "stock rich but cash poor". Such a situation is actually not good for the company as a whole since such a founder "just might be overly conservative in his or her business decisions for fear of losing everything." "If you can give these guys a little bit of liquidity so they're comfortable taking more risk, but not so much that they're not hungry anymore, then it can be a very good thing."

What Shields says makes a lot of sense. So much so that I think it might be a good idea for VCs to actually insist on "limited founder sales" when they invest in a company. I think this will help reduce the all-too-famailiar clashes between founders and their VC backers post the initial honeymoon period. Letting the founders take "a little bit off the table" reduces their risk in doing what VCs what companies all their investee companies to do: grow faster.