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FF Class Stock - Partial Founder Buyout is Alive

Posted on December 20, 2006

Founders Fund LogoMy friend Noam Wasserman (check out his blog for more great founder research) sent me a note last night with a link to a piece about a new class of stock called FF stock that the guys at the Founder’s Fund have started to work into their term sheets. Noam sent the article my way because we have talked a lot about the idea of partial founder buyouts as a way to better align the interests of VCs and entrepreneurs and FF class stock is an attempt at making partial founder buyout a reality.

Soon after I saw Noam’s note I caught my friend Fraser Kelton’s piece on FF stock and knew I had to put some of my own thoughts together so here we go!

First off, it is great to see innovation in early stage investing starting to become more commonplace. It is no surprise to me that the Founders Fund is leading the charge on this. The Founders Fund, for those who don’t know, is a VC fund in which all the investment professionals were entrepreneurs and in some cases still are. The Founders Fund team is responsible for founding companies like LinkedIn, Facebook and Paypal.

The latest innovation the Founders Fund has implemented is the idea of FF class stock. The basic idea is this: FF stock is convertible to any future class of stock during a new issuance of stock. Let’s say there is a new issuance of stock in a company due to a funding round. At that point the founders can convert their FF stock, if they choose, and sell it to investors. I am sure there is more legalese involved (a lot more no doubt) but that’s the basic idea (check out VentureBeat for more).

FF stock allows entrepreneurs to partially cash out early on to make their lives a little more comfortable. I would argue that partial liquidity early on affords entrepreneurs the ability to focus more on the company and go for the big win which is exactly what VCs want to do. Interests are aligned. Case closed, right?

Well, as I have talked about in the past there are some investors who don’t like the idea of partial founder buyout/FF class stock. Their main argument, from what I have seen, is that entrepreneurs will be less hungry if they are able to partially cash out early. That may be true for some but I think most entrepreneurs are in the game to see their baby succeed and are able to keep their eye on the prize regardless of what else is going on.

What other issues could investors have? It seems that investors may not like that fact that entrepreneurs would be able to cash out before them. It also looks like investors don’t see upside for themselves in the PFB equation. These thoughts were expressed in comment on this post. The comment, shown below in full, was written by an angel investor.

The reasons why founders are jazzed about FF class stock are obvious, but so are the reasons why investors are opposed to them. As an angel investor, I think it is ridiculous to allow even a small liquidity event for founders before investors with cash in the deal receive anything.

Founders, by the way, take salaries and benefits along the way. If investors have to wait on an exit for some “comfort”, why should founders or management be relieved early? Ah…yes, greed.

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.

VCs were looking to put money to work in Flickr previous to the Yahoo! acquisition and we all know that some money was left on the table by the founders. Can you blame them though? These were their options (simplified of course):

  1. Let a VC or VCs take a bunch of the company away from us, sit on our board and decide where our baby should go and, since they’ll push us to a huge exit, we may possibly never make it and walk away with $0 (while the VC still has a number of portfolio companies and is diversified).
  2. We can pocket $20+ million and get nice jobs at Yahoo! as well.

However, if a fund came in and allowed them to have some of their stock set aside and available to convert in a later round/issuance of stock for a small amount of liquidity they may have went for the big win and taken the VC money. In that case the founders would have probably made more and the VCs would have had a winning investment.

With more companies able to start up with no outside investment VCs will need to start innovating and providing incentives to entrepreneurs to get the best deals. However, entrepreneurs should be careful as there are implications for them as well.

Fraser points out the million-dollar-Saturn incident and I’ll quote the VentureBeat anecdote as Fraser did to illustrate the point.

The founder of Viaweb, a Paul Graham company, cashed out in order to buy his wife a Saturn car. It became known later as the “million-dollar-Saturn,” because of the worth that stock would have been had he kept it.

There are always pros and cons to any innovation and they come from both sides of the fence but, all in all, I love to see innovation happening in early stage investing. I can’t wait to see how FF stock plays out over time and whether or not it finds its’ way into more term sheets.

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3 Comments so far
  1. Fraser December 20, 2006 2:06 pm

    I bet the recent M&A market of big companies buying companies: out of HR budgets (i.e. buying for talent), buying for feature sets, etc. etc. and causing an option at the $5 - $20 M level will lead to even more innovations / experimentations with early-stage investing. Which is great news for everyone.

    Here’s a question: do you think the successful innovations will be included by investors in sectors other than light web-services?

  2. Eric Olson December 20, 2006 3:26 pm

    Good question Fraser. Off hand I think adoption of successful innovations in early stage investing by VCs outside of the light web-services category will be slow at best. The low cost of start-up in the light web-services space and the early buyouts coming from large companies are pushing VCs to be innovative.

    Since these characteristics aren’t present or as prevalent in other spaces the VCs will not be forced to think about innovation or about adopting innovative practices from their light web-services bretheren. Basically, I think they’ll take the “if it ain’t broke, don’t fix it” approach.

    What do you think?

  3. jeff barson December 20, 2006 5:41 pm

    Eric,
    Here’s the response I left to that comment.

    Hey there 5280Angel,
    Thanks for the comment. I’ll blog on this later after I think about it for a bit but here’s a PDF from Noam Wassermans Founder Frustrations blog detailing some issues with founder compensation.
    http://www.people.hbs.edu/nwasserman/entrepcomp_proceedings.pdf

    “At the same time, there are also reasons why founders may receive less compensation than non-founders. First, entrepreneurs’ decisions are affected by their alternative employment opportunities (Gimeno, Folta et al. 1997). Executives with high levels of firm-specific human capital should be less likely to exit their companies than executives with lower levels of firmspecific human capital (Becker 1964; Gimeno, Folta et al. 1997; Castanias and Helfat 2001).

    Most pertinent to this study, founders may possess and develop skills that are more firm-specific than non-founders (Wasserman 2003), making them relatively less valuable to other companies
    and less likely to receive attractive outside offers.

    Considering founders’ stronger attachment to the companies they start (Dobrev and Barnett 2003), boards may perceive them as less likely to leave for an outside offer, further enabling boards to give them lower compensation than a similar non-founder would receive. Founders might also voluntarily accept lower compensation at the companies they founded. Recent researchers have emphasized the “psychic income” entrepreneurs earn from the companies they founded (Gimeno, Folta et al. 1997) and the fact that, in contrast to the identity of people who join an existing company, the identity of organizational founders is “tightly linked” to that of the company they founded (Handler 1990; Dobrev and Barnett 2003). Accepting less compensation may also be more acceptable to founders who became accustomed to acting very frugally while their newly founded companies were cash poor and needed every possible dollar to be spent on building the company. It may also be more acceptable to founders who believe that their compensation anchors the compensation of the rest of the TMT (Allen 1981).

    Founders and boards may also have to pay more compensation to attract non-founders.

    Although company founders have deep knowledge of their companies, executives recruited from the outside know far less, and companies therefore may need to pay them more to attract them to an unfamiliar environment. The information asymmetry between founders and non-founders would therefore lead to compensation differences even if they were equally risk averse.

    It should be noted that the strength of many of these factors is likely to weaken over time. For instance, on the founder side we might expect the degree of founder attachment to decrease as the company matures, more people get involved with shaping the company, and it becomes more formalized and less founder-dependent.

    On the non-founder side, as a company matures, it becomes easier for outsiders to assess the company’s quality and performance (Wasserman 2002), and it should be less necessary to pay a large risk premium to attract them. Thus, we might expect any “founder gap” to be smaller in older companies than in younger ones.

    H1b: Founders will have lower cash compensation than non-founders. This gap will be wider in younger companies than in older companies.

    An alternative explanation for a difference in founder versus non-founder compensation is that, rather than having different levels of influence over compensation, founders and nonfounders have different levels of risk aversion. Therefore, we might expect founders to prefer a different mix of equity versus cash compensation. To control for differences in preferences and for equity effects on compensation, the models control for equity held by each executive.”"

    Might be greed. Might not.