Concern Grows Over Founders Cashing Out Too Much, Too Early

Six months ago, economist Paul Kedrosky found himself in a curious situation. After being introduced to a new service, along with several other potential investors, the founder of the service announced that as part of any seed-stage deal, he expected immediate liquidity for up to 25 percent of his shares.

Kedrosky, a seed investor in the investor information service StockTwits among other companies, quickly passed. “It wasn’t just an alignment issue; it just shows terrible judgment,” he says. Still, the deal was done, and Kedrosky says he’s right now looking at three angel deals and that all have involved discussions about founder liquidity. “It’s been astonishing.”

The trend appears to be growing. Citing a company he wanted to fund “as far back as 18 months ago,” venture capitalist Mark Suster says that he also abandoned the idea “because its founders were taking too much off the table, too early.” The entrepreneurs had founded the company just three years prior and the startup was producing less than $20 million in revenue, yet the team asked for $20 million during a follow-on financing round, and they got it — just not from Suster.

“They were doing really well, but how can you tell me that $20 million isn’t going to change the lives of some twentysomethings?” says Suster of the founders, who are now selling the startup.  “I definitely feel like so much money was a disincentive. It could have been a billion-dollar company.”

Providing liquidity to founding teams isn’t new, of course. Union Square Ventures is one of many firms that have long given their blessing to entrepreneurs once they’ve achieved “something meaningful,” says Union Square cofounder Fred Wilson. Ideally, “meaningful” means “more than [that they’ve just gotten] a product out into the market that lots of people are using but [also] built a business, a team, a revenue model – maybe even become profitable.”

Wilson says he isn’t receiving onerous demands by Union Square’s startups, or seeing them from the prospects with which he meets.

But others say that a frothy market is changing things across the board, and that the days of providing entrepreneurs with the kind of “modest but significant” liquidity that Wilson sanctions — enough to “change founders’ economic situation for the better – by letting them buy a house in the Bay Area, or an apartment here [in New York], or helping them raise a family,” he says – are fast receding.

The best-known liquidity cases, unsurprisingly, involve some of the hottest Web companies on the planet right now, including the daily deals services LivingSocial and Groupon. Half of LivingSocial’s newest $400 million round was used to purchase employee and early founder shares. Meanwhile, Groupon investors have twice returned money to founding investors and employees, including last April, when Digital Sky Technologies led a $135 million round and again in January, when Groupon raised a staggering $950 million from eight firms, including DST. Indeed, a filing showed that just $377 million went to the company and that the rest was used for shareholder liquidity.

Yet even startups far removed from the big leagues are making employee liquidity a competitive provision, according to one high-profile investor of a billion-plus-dollar fund, who asked not to be named.

“A few years ago, someone with a profitable company might say, ‘I want $500,000 or $750,000 so I don’t have to worry about my mortgage and can pay for my kids’ college education. Then it shifted to breakeven, where you’d get requests from entrepreneurs who’d kind of proved their business. Now they’re saying, ‘I want $5 million to $7 million in liquidity’ before a company is even proven and its model fully established,’” he says.

How big a problem is it? It’s hard to know. No numbers exist yet to suggest that early and more employee liquidity impacts a company’s performance negatively or positively. Years from now, it may still be impossible to identify liquidity as the driving factor in whether certain companies made it or flopped.

Still, investors do not think it’s an auspicious trend — even while they feel forced to play along.

“To some degree, entrepreneurs are in the cat bird seat right now and they’re able to drive up deals to terms that don’t make a lot of sense,” says the investor. “Liquidity is one of them.”

“It’s the equivalent to IPOs, where founders took out companies that weren’t producing anything meaningful to get liquid,” adds Suster.

“Mark Zuckerberg could take $500 million off the table and no one could care,” says Suster. “He’s proven he’s in it to build something big. But other founders should not be cashing out before they’ve created any value.”

And to those investors letting them do just that? “I have two words,” he says. “Caveat emptor.”