Wednesday, February 3, 2010

Deal Terms: Liquidation Preferences, Founder Options

Liquidation preferences have always seemed to be a case of having your cake and eating it too for investors. I'm guessing the original intent was strictly for downside protection. But it's become a way for investors to guarantee a certain upside--risk mitigation at the expense of common.

Put another way, it's terms like these that value capital over people. A common example I give when explaining it to incredulous entrepreneurs is this (let me know if I have it right): say you raise $1 million at a $4 million pre, giving a total of $5 million., so 20% to the VC.

Then you exit for $10 million--double, right? So what's the VC take?

28%.

First million out the door, leaving $9 million, then pro-rata distribution, so 20% of $9 million = $1.8 million, so $2.8 million total, or 28% of the exit. Return of capital is important--I think as an entrepreneur I am obligated to return capital, so I don't mind the downside preferences---a 1x cap makes sense to me.

Of course a $20 million exit makes the impact of the preference a lot less, but it still values that capital more than the people, which, ironically, are what VCs typically say they value most in a deal.

On options for founders: I have mixed feelings about this and have been on both sides of the argument. As a founder you create the idea, company, revenue, model, value, etc. And you have stock for that.

And then you play a ton of roles getting the company to greater value, for which everyone is compensated through salary and options, except you, where you end up donating your labor for the benefit of everyone else. As you add more people, you get more and more diluted.

And I say suck it up early on.

You get a lot of special treatment as a founder, so don't nitpick about a couple points of employee options. Not early, anyway. Later on, though, you get past the love stage.

If you're CEO, you now have tons of liability and new, real responsibilities and obligations that go far beyond the creation and founding of a company. And I think you should get market-average options, and market-average salary if there's enough revenue and investment, and if you take less than market salary your options should increase with a 20% kicker or so to address their illiquidity.

My biggest regret in the 4 companies I've started, funded, and run has nothing to do with ownership, though. It's that I put in 80 to 100 hour weeks, thinking that I had to do that to make it work, and nearly killed myself doing it. It's amazing how much time some of us spend obsessing about opportunity while neglecting ourselves.

Options? Screw the options. You'll get much more out of a life coach, and none of the resentment from employees and investors because you're dickering over a few points in options on top of your massive stake.

2 comments:

  1. 80-100 hour weeks, for something you love: Priceless!

    I figure that a guy who has "done" three companies must love what it entails.

    What would you have done as an alternative to the obsessive hours? In hindsight, do you believe that there wasn't incremental value to the additional attention?

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  2. Well, I love parts of it. I'm thinking about the alternatives...there's definitely a benefit to the attention--more knowledge. But there's effective time and less effective time. Something I struggle with.

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