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By Allan Leinwand Some of my colleagues and I were talking about how the investing climate of venture capital has changed given the capital efficiencies of Web 2.0 companies. Web 2.0 companies can leverage open source software and commodity hardware to build very interesting businesses with […]

By Allan Leinwand

Some of my colleagues and I were talking about how the investing climate of venture capital has changed given the capital efficiencies of Web 2.0 companies. Web 2.0 companies can leverage open source software and commodity hardware to build very interesting businesses with limited capital required – often less than $500,000 total. Once these companies do prove to be interesting, they are quickly acquired by the big players in the space for both the technology and the team (the acquire-to-hire phenomenon).

So, how does a venture capitalist who wants to put multi-millions of dollars into a company put money to work in this environment? One method that seems to be getting more popular is to have the venture capital go toward providing liquidity for the founders (buying secondary shares). This method can serve multiple purposes:

1) It gives the venture investor the desired ownership;

2) It providers some liquidity to the founders who may be living on sweat equity; and

3) It aligns the financial interests of the company and investors.

An example might be an interesting startup company that we’d like to invest in that only requires $1 million of investment to become profitable. The founders of the company may value themselves at $7 million given their user adoption rate or revenue traction.

If we invested only $1 million we would own a small percentage (say 12.5 percent) of an $8 million post-money valuation. If we invested $3 million in the company we would own 30 percent of the company. We still inject $1 million into the company to get it to profitability, but the other $2 million of investment goes to the founders to buy 17.5% of ownership.

So, we get the ownership we desire, the founders get liquidity (while still retaining an interesting ownership percentage) and we achieve alignment between the venture investors and company to build a successful business.

This investment strategy assumes that the founders of the company understand the balance between greed and fear. If they are absolutely convinced that they have a home run, then greed takes over and there is no price that can allow venture capital to buy ownership. While some venture capitalists think this investment strategy has its perils, we are seeing it as a potential way to invest in capital-efficient companies with compelling business models.

What do you think – would you sell off a portion of your company for some liquidity or does greed overpower fear these days?

Allan Leinwand is a venture partner with Panorama Capital and founder of Vyatta. He was also the CTO of Digital Island.

  1. Startups.in/India Saturday, December 16, 2006

    $1mil investment @ $8mil post-money valuation = 12.5% ownership — makes sense
    $3mil investment @ $10mil post-money valuation = 30% ownership — makes sense

    But could you please clarify on what exactly did you mean by — “We still inject $1 million into the company to get it to profitability, but the other $2 million of investment goes to the founders to buy 17.5% of ownership. So, we get the ownership we desire, the founders get liquidity….

    Thank you.

  2. He means that traditionally, company founders give up a percentage of their companies in return for capital that can be injected into the company. They do not immediately profit themselves.

    In this scenario, the founders give up a bigger slice of the pie in return for capital for the company AND some cash for themselves. The investor benefits from owning a bigger share of the company.

    Personally, as a company founder, I would seriously consider doing this. More than likely you are giving up some future profits, but it could be worth it.

  3. Artashes Toumanov Saturday, December 16, 2006

    Allan, you are saying:

    “This investment strategy assumes that the founders of the company understand the balance between greed and fear. If they are absolutely convinced that they have a home run, then greed takes over and there is no price that can allow venture capital to buy ownership.”

    You make it sound like its the founding teams of startups that usually get greedy. What about the investors that ALLOW (and promote) this behavior in the first place by throwing millions at often questionable companies. Just this past week I read a couple of stories of out-of-mind VCs that together “donated” (can’t really call it an investment) $14 Million to two user-generated sites that are not even unique in their offering, do not generate any revenue, and have about 45 other competitors (each) sharing the turf. Throwing all these millions into repetitive services and non-unique technology will allow them to run unprofitable for years. I am very curious to have this discussion and hear what you have to say about this.

    “Would you sell off a portion of your company for some liquidity or does greed overpower fear these days?”

    It would seem that greed has always overpowered anything. I can’t see how these days are different.

    Best,
    Artashes

  4. Allan,
    In your posting, you asked:
    “What do you think – would you sell off a portion of your company for some liquidity or does greed overpower fear these days?”

    For me, the answer to the above question depends on the stage of development of the business as well as an entrepreneur’s desire for control of his/her business. To a venture capitalist, an entrepreneur’s strong need for control may come over as greed. However, control rather than greed may be at the root of an entrepreneur’s intransigence. In many cases, I feel that an entrepreneur’s intransigence relates to the inverse relationship between liquidity and control: more liquidity resulting in lesser control on the one hand and less liquidity meaning more control on the other hand. As an owner of a unique meta-search engine with a disruptive advertising model, I’m facing this classic dilemma of liquidity vs. control. My ideal solution would be to have more liquidity through seed capital or angel investment while maintaining greater control of my business and its vision. If additional capital investment facilitates achievement of my business vision while giving me creative freedom, I’ll certainly welcome the investment. My goal is to have more liquidity as well as solid partnership in building a sustainable business. Certainly, greed is not part of my equation.

    Best regards,
    Rod.

  5. Hi Artashes,

    Agreed on greed overpowering other motivations – point well-taken. Concerning VCs “donating” money to investments that do not have a unique value proposition, lack revenue and have tons of competition… I’m not sure I subscribe to that investment philosophy.

    Take care,

    Allan

  6. The issue is whether you can live on thin air while the company is being built, or whether you have obligations (such as a family) to attend. There must be a balance somewhere, I think it would be wrong to give $1 million each to two founders in the above example, why not just strike it somewhere in between – a nice salary that makes the founders feel comfortable?

    I doubt a salary proposal would trigger the greed point, and would allow them to concentrate on their business, rather than on how many food stamps they have left for the week. It is likely that before receiving funding, the founders have already been suffering for a few months (or years), so why keep the suffering going?

    No venture is equal, so it’s hard to make a rule that fits all, but in general, I believe in keeping the founders comfortable, which gives them no excuse to give less than 110% to the venture, and stay fully focused.

  7. I agree with the funding strategy, though I also think there’s way too much money going to way too vague projects right now, something I just humbly blogged about (I’m just a marketer, no VC or startup). With respect to the greed factor, I guess it’s up to the VC to recognize if the greed is based on something real, ie are they sitting on the next MySpace. In case they are, you know what to do. You can squeeze them, but why would you. If you feel they’re ‘also ran’ material, you’d push for the bigger stake or let them go somewhere else. But perhaps VCs should let them go somewhere else rather than anything, if they think they’re dealing with a potential ‘also ran’.

  8. If this does take hold, it will be an ENORMOUS development to the startup world. Much more companies will get launched. Many would-be entreps now waiting on the sidelines, taking salaried jobs by necessity due to family issues or simply wanting to live to a reasonable standard, will now find the startup route an actual career path. Depending on how far this goes, the resulting yearly salary could surpass an equivalent “real job”.

    Up to now, the creedo when it comes to launching a company has been “there’s no points just for playing”. Now, there would be.

  9. Allan,

    I agree that we’re seeing more of this trend here at Lightspeed, especially with consumer internet companies since they take so little money to start. This has not been the case as much in other sectors. We’ve recently closed on financing where founder liquidity was a portion of the investment (company had been in business 4 years) and are in the process of closing a second (company has beenin buinsess 1 year). In both cases, our incentives were to increase our ownership levels and to better align our incentives with the founders who could now be more focused on building a big company. The founders wanted to diversify their risk since their net worths were largely tied up in the fortunes of their company which was private (and illiquid) and still risky. Everyone felt like it was a good result

  10. Nitin Borwankar Monday, December 18, 2006

    Hasn’t this always been happening behind the scenes anyway. At some point between Series A and the next round if a founder has “cash flow problems” hasn’t it been the case that VC’s would offer to buy some of the founder’s stock and allow them liquidity?

    The difference here is that it is coming out of the dark corners and becoming a regular part of the funding transaction.

    As far as the comment about just give the founders a better salary, I would comment that one of the biggest debts the founder is usually carrying is a home mortgage. This is a certain amount of risk taken already, given the current home market.

    If liquidity allows payoff of all or most part of the mortgage, a founder can breathe a lot easier. A larger salary will have to be really (unrealistically) large to make any dent in a home mortgage, especially here in the Bay Area.

    So yeah, liquidity for founders (potentially) at each funding round makes sense.

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