Some Thoughts On Founder Liquidity

I saw a post last week that suggested that VCs competing to win deals is leading to excess amounts of founder liquidity. We haven’t seen that sort of thing to be honest. It may happen but it is certainly not rampant.

I also saw this tweet from Sam Altman yesterday:

If you click on that tweet, you will see a long and somewhat interesting discussion of the issue on Twitter. I don’t completely agree with Sam’s tweet, as I will outline below, but as my son and his friends like to say, “he’s not wrong.”

I’ve written a bunch about this issue over the years but the search function on this blog is pretty weak and it is not easy to go find all of those posts. So I will try to summarize my thoughts in tweetstorm format:

1/ when I got into the VC business in the mid 80s, there was little to no founder liquidity. VCs largely believed that founders should get liquid when they got liquid.

2/ that started to change in the late 90s when the VC market went bonkers and to some extent it was a good thing. to some extent it was not.

3/ i have evolved my point of view on this issue a lot over the years and i now believe that providing some founder liquidity, at the appropriate time, will incent the founders to have a longer term focus and that will result in exits at much larger valuations because, contrary to popular belief, founders drive the timing of exit way more than VCs do

4/ figuring out the “appropriate time” is tricky and there is no hard and fast rule. the twitter discussion on Sam Altman’s tweet focuses on how many years the company has been in business and i think that is a very flawed metric

5/ instead i would focus on whether the company has achieved sustainable and lasting enterprise value, meaning that there is no question it will exit at a significant number that is well in excess of the capital invested at some point in the future

6/ passing that test means that the common stock is “good money” and that the choice of the founder to sell it is not mitigation of risk issue as much as it is an asset allocation issue

7/ i am not a fan of founder liquidity sales that result in more than 10% of the founder’s position being liquidated at any one time

8/ an important exception to that rule is when a founder is leaving the company, particularly at the wishes of the board. in that situation i believe, if the test I outlined in #5 is passed, it is prudent for all involved to provide some liquidity to the departing founder and the 10% rule is not really valid in this situation

9/ i generally prefer that founder liquidity be provided by funds that are set up to do that sort of thing and not by the VCs who have been providing primary capital to the business. i believe that our capital should be used to continue to support the business and reserved for that until the company has become sustainably profitable

10/ once a company has become sustainably profitable, which in and of itself is a bit tricky to measure (GAAP Net Income positive?, EBITDA positive?, Adjusted EBITDA positive? cash flow positive?), I am more comfortable with the VCs buying in founder liquidity sales

11/ EOTS

I have seen too much founder liquidity too early in a company’s life mess things up. You do have to be very careful about this sort of thing.

And founder liquidity inevitably leads to questions about employee liquidity and angel liquidity. Like all things in life that involve money (and many that don’t), actions have consequences that are much broader than you might imagine. So once you start providing liquidity to founders, you need to at least start thinking about a liquidity plan for others as well.

What we have done in a number of our most successful portfolio companies is to wait until the company is sustainably profitable (this is such an important moment in a company’s evolution) and then think about tender offers to founders, employees, and early investors/angels. Interestingly, in these sales the employees and founders tend not to be particularly aggressive in their selling. The early investors and angels tend to be more aggressive than the insiders. Which makes a lot of sense if you think about it.

I will end this post with a quote The Gotham Gal shared with me yesterday from J. Robert Beyster, the founder of SAIC:

I have found that employees are more patient investors than the public. They are willing to wait longer for returns because they want a good place to work. They allow the company to invest in long-term growth and not just short-term gains.

So whatever you do, don’t let your company become owned too much by investors and not enough by founders and employees. It’s the folks who work at the company that make it tick and if they are not deeply invested in the business, you have a recipe for failure.

PS: There is a difference between a company “having created lasting sustainable value” and “being sustainably profitable”. The latter almost always means the former is true. But the former does not require the latter to be true. I could get into why this is so in more detail but this post is long enough already.