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Fixing the Venture Capital Model

Posted on January 15, 2006

There has been a lot of talk for a while now about fixing the venture capital model. As it stands now, there are things about the model that do not align the wants and needs of VCs with entrepreneurs. For example, VCs need exits at certain time intervals because their funds only last 10 years (for the most part) and entrepreneurs are sometimes forced to grow too quickly or be acquired too soon because of this. While the structure of VC funds probably isn’t going to change any time soon (after all, the people that invest in VC funds need their money back to pay pensions and do charitable work) the question is: What can be changed? The answer: deal structure.

The way VC deals are structured is something that, with a little creativity, can make the system much better for both parties. There is a fundamental problem between VCs and entrepreneurs. VCs want entrepreneurs to shoot for the stars and to be the next Google. Sure, entrepreneurs want that too. If they didn’t, they wouldn’t be in the game and taking the risks that they are. However, if someone comes along and offers an entrepreneur $25mm for a company he built in his spare time and for little of his own money he is going to take the cash or at least be very tempted to especially if it is his first company. However, that $25mm offer looks paltry to a VC who, lets say, put $7mm into the deal at a $22mm post money valuation (and sees the company eventually being worth $500mm). The return on investment for the VC does not line up with the return on investment for the entrepreneur.

Partial founder buyout can change this dynamic by giving the entrepreneur a little liquidity early on. Let’s say that, in the above scenario, the VC actually put $10mm into the deal but $3mm was actually paid in cash to the entrepreneur and $7mm went into the company. Now, the entrepreneur has $3mm in the bank. This is not enough to make him too comfortable but it is enough to reduce, if not eliminate, his urge to sell out quickly for $25mm. Now, the entrepreneur is more likely to take the plunge with the VC and try to become the next Google knowing that his house and his childrens’ college educations are taken care of.

If this type of situation was in practice today I think we would have already seen its effects. Let’s take Flickr for example. The founders of Flickr built the company on a shoe sting in their spare time. Network effects began taking hold and before they knew it they had an incredible company on their hands. At that point the founders needed to make a decision: do they take capital from a VC and scale the business like crazy possibly gaining nothing or do they take the “sure thing” offer on the table from Yahoo! and cash out early possibly leaving money on the table but also taking in enough money to live comfortably forever? In this case the founders took the Yahoo! deal and probably regret it today but can you blame them? They were looking at a lot of guaranteed cash or getting their ownership diluted possibly for $0 return. The same situation could be applied to a number of other companies including del.icio.us.

With partial founder buyout a lot of entrepreneurs would be still out there building their companies and VCs would be left with more quality investments. Everybody wins (except maybe Yahoo! and Google since they wouldn’t be seeing any more inexpensive acquisitions). To make things clear, this is not an original idea. I have seen others write about it and have been surprised that there hasn’t been much take up. I thought I would write about it to get it back into the discussion so please tell your friends (especially if they are VCs and entrepreneurs) about this blog entry so they can add to the discussion in the comments and on their own blogs. This is something that needs to be looked at because it could change the start-up game forever and in a positive way for all involved parties.

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12 Comments so far
  1. Jeff Clavier January 16, 2006 1:03 am

    This type of structure makes sense in more mature deals, especially if the company is raising money for the first time. For early stage plays, the ones typically not raising a lot of cash at low valuations, the maths don’t really work.

    Interesting topic/debate for a VentureWeek ?

  2. Eric January 16, 2006 9:04 am

    Good point Jeff. If companies are only raising say $1mm then the math is tough and the founder buyout wouldn’t amount to anything significant. This could be a great topic for VentureWeek… I’ll have get working on that!

  3. Adam January 17, 2006 9:03 pm

    Excellent post. I agree that this is a great topic for VentureWeek.

    I see two important points that VCs will probably consider:

    1. Control. Many VCs may believe they’ll lose some control/power once they provide the founders with a $3mm safety net.

    2. Company growth. $3mm may be better off growing the company instead of sitting in the bank.

    As an entrepreneur in the Web 2.0 space, I can definitely see how partial founder buyout aligns the interests of both parties. However, it doesn’t seem to be an idea that VCs are quite ready to adopt.

    I can’t really blame Flickr for what they did.

  4. Eric January 18, 2006 10:03 am

    Great points Adam. I think you are absolutely right that VCs will consider the points you outline. I don’t think that VCs would lose any control because the extra $3mm (in this case) would buy them more of the company. However, the argument that $3mm could be put to better use growing the company is a strong one.

    I would argue that giving entrepreneurs a safety net would take away much of their desire to sell early and would keep them focused on the long term ultimately giving VCs better returns.

    I also can’t/won’t blame Flickr for what they did. I probably would have done the same. Hopefully VCs will start to look at ways to change the model for the better even though they really don’t have to. If they do something, companies like Flickr will go for it and most likely yield large returns for them.

  5. Adam January 18, 2006 7:12 pm

    Good thoughts on all counts. In terms of VC control…

    I agree that a VC who pays $3mm to a founder gains more control in terms of % ownership of the company. However, that VC may also be losing “control” (power) over the founder who now has $3mm in the bank and is no longer as desperate. The control that should matter is the additional company ownership, not the “control” over the founder. I’m just not sure many VCs see it that way. That’s why I think part of their issue with partial owner buyout is “control”.

    If/when more companies start exiting early because it’s the safer way out, VCs may have to begin using ideas like this to entice more startups to stick around for the long run.

  6. Eric January 18, 2006 10:36 pm

    Agreed. The control that should matter is more ownership of the company. Control over the entrepreneur should not be the goal of any investment/transaction. However, I don’t doubt that there are some VCs out there who try to obtain that type of control and would resist partial founder buyout because of it.

  7. […] Partial Founder Buyout. By letting the founders cash out early, VC’s can align attitudes towards risk between the founders and themselves. Paul Graham has an excellent essay on this. Eric Olson takes a central idea of Graham’s essay, allowing the founders to cash out, and provides a simplified explanation of the argument. The argument boils down to this: a founder would rather have a smaller return that’s guaranteed over a larger return that’s risky. […]

  8. […] But, I wouldn’t start cheering if I were a software entrepreneur, though that’s been the tone of some of the posts I’ve read. A breakdown in the VC model suggests less demand for equity in the componentized software and services category. Meanwhile, lower entry costs suggest more supply than heretofore, which seems to be supported by the plethora of ‘Web 2.0′ tagged innovations floating around. This makes suggestions such as this one, that VCs will partially cash out entrepreneurs early just plain silly. That might happen if the supply/demand balance were strongly shifting the other way - it’s not. […]

  9. Pat July 14, 2006 3:24 pm

    By providing a pfb it alleviates the stress of looking for your next paycheck and allows the founder to more fully develop the company for greater valuation long term.

  10. […] The latest podcast in Pascal Levensohn’s VC-IO entrepreneur series came out today and the subject matter was CEO compensation and the founder discount. Compensation in start-ups is something I am very interested in and, as long time readers know, I have talked about ways compensation could be structured differently to better align VCs with entrepreneurs (the previous link is to the first in a string of “fixing the VC model” posts). Little did I know that there was a man by the name of Noam Wasserman, Harvard Business School professor and blogger (I am now subscribed to his feed), who has done a lot of research in this area. […]

  11. […] I do think that there are clear benefits to investors especially in the new age of web start-ups where companies don’t need a lot, or any, outside capital to get things moving. The example I go to time and time again is Flickr. […]

  12. […] course a lot of folks, including myself, have talked about this type of situation but this may be one of the bigger instances it actually […]