‘Little rewards’ keep founders happy, motivated

For venture capitalists, waiting years for a promising portfolio company to mature is at worst an inconvenience. But for entrepreneurs—who commonly have all their assets tied up in a startup—that wait can be an exercise in extreme anxiety.

Partners at San Francisco-based The Founders Fund believe they’ve come up with a way to alleviate that stress. The firm, launched two years ago by founders of the PayPal online payment service, is attempting to popularize a class of stock that entrepreneurs can cash out in increments as their companies grow.

Called Series FF (as in Founder’s Fund), the shares go to a startup’s founders in an early stage round, much like common stock. The difference, however, is that FF shares can be converted into any future class of stock during later rounds of funding. In practice, this means founders can cash out sums, typically ranging from a few hundred thousand dollars to a bit over a million, as their companies meet milestones to attract new investment.

“We think it’s a positive change in the motivation of entrepreneurs to have little rewards along the way rather than six years of delayed gratification,” says Luke Nosek, a venture partner at The Founders Fund, which focuses on early stage investments in Internet companies. In the near-term, he also sees the Series FF program helping the firm—which markets itself as an entrepreneur-friendly VC fund—get in on sought-after deals.

Evangelists

The Founders Fund partners say they’re hoping the FF share concept will become broadly accepted in the venture capital industry. While there are other means to reward entrepreneurs, such as bonuses and loans made against equity, partners say their system provides an easier way to align founders’ interests with those of venture capitalists.

So far, the FF share concept has gained modest traction among VCs. Foundation Capital General Partner Charles Moldow first encountered the equity class during a joint funding round with the Founders Fund last year in search engine startup Powerset. Today, he says, Foundation is considering instituting a share program for early stage deals modeled on Series FF, though it will probably call it something else.

We think it’s a positive change in the motivation of entrepreneurs to have little rewards along the way rather than six years of delayed gratification.”

Luke Nosek, Venture Partner, The Founders Fund

Moldow says he likes the idea of letting founders cash out small sums because it makes it easier for them to resist lowball acquisition offers.

“As investors, what we don’t want to see are people going for early liquidity vs. optimal liquidity,” he says, adding that a Series FF-type offering promises to be easier to arrange than a loan against a founder’s equity. It’s also more straightforward than having a founder sell some common stock to a private buyer. That can be messy for VCs and startups because it creates a new market value for shares and can require re-pricing of all outstanding options, Moldow says.

Using Series FF shares also has some tax advantages over paying bonuses to startup founders. Principally, that’s because proceeds count as capital gains and not as compensation, which is typically taxed at a higher rate, says Steve Malvey a tax law partner at Orrick, Herrington & Sutcliffe who worked with The Founders Fund to develop the Series FF stock structure.

VC concerns about complying with Section 409A, the notoriously complex three-year-old tax law provision that sets restrictions on deferred compensation plans, may also boost popularity of Series FF-type share programs that don’t fall under the jurisdiction of that code, attorneys say.

The FF structure also sets some restrictions on the amount of stock a founder can sell during future funding rounds, says Powerset CEO Barney Pell. Anything beyond that amount would require investors’ approval. Typically one-fourth or more of a founder’s stock will be in FF shares.

Pell sees the FF program as especially useful for investors in startups that could be acquired by an incumbent very early in their development. The ability to cash out shares in a later funding round, Pell says, means founders don’t have to “choose between no money unless we become the next Google or some money right now.”

It solves one of the common problems that you often have of transitioning founders either out of their executive roles or out of the company altogether.

Diane Burton, Associate Professor of Entrepreneurship, MIT Sloan School of Management

“It’s particularly relevant when you have the kinds of opportunities that could truly be massive,” he says.

For a firm new to the venture space, the FF program could provide a leg up in a competitive funding environment, says Peter Rip, a general partner at Crosslink Capital.

But while Series FF may be effective as a marketing strategy for The Founders Fund, most investors don’t need to go to the trouble of creating a separate share class for entrepreneurs.

“You wouldn’t see Sequoia doing this, because Sequoia doesn’t have to,” Rip says. Crosslink, he adds, has also found mechanisms to put money in founders’ pockets without the need for a new class of stock. Currently, it’s working with one portfolio company to secure some returns for founders as the company, currently cash flow positive with annual revenues over $20 million, ramps up growth.

Sound familiar?

Of course, the concept of cashing out founders’ shares before an exit is nothing new in venture circles. Kleiner Perkins Caufield & Byers, Rip recalled, bought shares of Intuit from founder Scott Cook prior to the company’s 1993 IPO. Softbank also profited and provided liquidity to Yahoo founders Jerry Yang and David Filo by purchasing some their stock prior to the Internet portal’s 1996 market debut.

You wouldn’t see Sequoia doing this, because Sequoia doesn’t have to.”

Peter Rip, General Partner, Crosslink Capital

The Founders Fund partners, too, are no strangers to pre-IPO liquidity. The 2000 merger of startups Confinity and X.com, which later became PayPal, generated cash for founding team members well in advance of company’s 2002 IPO. At the time, Nosek recalls, they were “too busy working” to have much fun spending the money. But for most entrepreneurs, particularly in the pricey San Francisco metropolitan where The Founder’s Fund’s portfolio companies are based, living expenses are a burden. One aim of the Series FF program, says fund managing partner Sean Parker, is to keep these founders from jumping ship for a post with better pay.

Parker says he’s not concerned that early cashouts will affect founders’ motivation. The desire to see their companies succeed—combined with the prospect of much greater rewards through an eventual exit—ensures that few will give up the 16-hour workdays merely because they made some money through a Series FF stock sale.

Pell agrees. Certainly the possibility of generating a phenomenal return-on-investment is a motivating factor, he says. But jumping to the conclusion that founders would simply retire after receiving big chunk of cash misunderstands what it means to be an entrepreneur.

But not all founders stay on to see their startups mature. From a reverse perspective, the Series FF program also makes sense for venture capitalists looking to bring new management to a portfolio company, says Diane Burton, an associate professor of entrepreneurship at MIT Sloan School of Management.

“It solves one of the common problems that you often have of transitioning founders either out of their executive roles or out of the company altogether,” she says. With FF shares, entrepreneurs would know they’d still get compensated even if they don’t keep their executive position after a new funding round.