Are VC Payoffs Bad?
June 13, 2007
Ron Conway is upset that "third-rate VCs are paying off entrepreneurs." He suggests,
What’s happening is third-tier VCs are trying to get deals away from Sequoia and KP and offering entrepreneurs some cash as part of the deal. I firmly believe that all the cash going into a company belongs in the company. I don’t want entrepreneurs to be bought off.
Ron is a well known angel investor and he is frustrated that we are in a buyer’s market. But what is really happening? Perhaps these cash payments are a way to align the interests of entrepreneurs and venture capitalists. How? Simple, lets say you raise $1MM from a VC in exchange for half of the company. Now lets say that someone offers to buy the company for $5MM. After some complex math the entrpreneur realizes that he can make $2MM if he sells. The VC wouldn’t consider selling the business for less than $10MM and only after a certain number of years trying to turn their investment into a $50MM company. The $2MM payday for the entrpreneur is likely lifechanging, but it is unacceptable for the VC.
It is well known that Facebook’s Mark Zuckerberg was paid out during the financing round by ‘third-rate VCs’ like Accel and Greylock. With a little cash in their pockets, Mark and his team have been able focus on the long term success of the platform, pushing aside billion dollar offers. Wow, everyone is happy. Ironically, Ron is an early advisor to Facebook…
Ron calls these payment ‘payoffs’, but they aren’t payoffs at all. In most early stage deals the entreprenuer owns 100% of the outstanding shares of the company. He can either sell his shares or agree to dilute his shares by issuing new ones or a combination of both. Interestingly Ron works hard to get the most for his money, typically by getting an entreprenuer to accept the lowest valuation possible. Entrepreneurs try to get the highest valuation possible. Why? Buying a small percentage of an entrpreneurs shares for cash is a great way to reduce the entrepreneurs downside, while preserving the venture capitalists upside.
Ron’s primary arguement is that "The entrepreneur taking a million bucks out of the company that should have stayed in the company says the company doesn’t have as much a potential for success." This may be true if cash is scarce, but as Ron pointed out it is a buyer’s market. There is too much cash chasing too few deals. If a VC can afford to pay an additional $1MM over what the company needs to succeed what is wrong with that? It is not like the VC is going to underfund his investment, surely he is too smart for that. The truth is that deals are getting more expensive and that is bad for angels like Ron…
