In last week’s article, Christian mentioned that the biggest cap table issue is when a founding team has too little ownership. This makes logical sense — equity is deferred compensation, and the more equity a founder holds, the larger their ultimate payout. If rounds are overly dilutive to founders, taking an earlier (and smaller) exit can actually return more capital to a founder than building a larger company.
However, there are instances where decreasing founder ownership is a good thing. The average time from company founding to exit is 7.6 years in the US and 8.9 years in Canada.
Founders may want to run profitable so they can pay themselves more, as well as free themselves from the perpetual fundraising cycle. Hence, profits set you free.
Founders typically earn a below-market salary for the entirety of those years, indicative of the promise of future equity and their personal commitment to the company’s success. However, founders have bills to pay and mouths to feed and intrinsic motivation to maintain. This is the driver for allowing founders to exchange some of their equity for capital (providing them liquidity) via a secondary component to a VC round. A secondary sale is when an investor sells their shares to another investor. New capital, therefore, goes to that investor, rather than to the company’s balance sheet.
So does it make sense for this round to include a secondary component to provide founder liquidity? That depends on a few factors:
- What’s the company’s growth trajectory? This is probably the most important consideration. Secondaries are primarily driven by investors wanting to increase their ownership beyond the round’s constraints. The higher your company’s growth to date (and projected future growth), the more investors are likely to consider secondaries to grow their ownership.
- What round is it? The Series A is typically the earliest a secondary might be considered, and even that might be considered too early by your investors. If there’s no reasonable level of confidence that the company will exit at a value higher than the capital invested, then you’re highly unlikely to convince investors that founder liquidity is a reasonable request.
- How much capital is being returned? Providing enough liquidity incentives the founders to have a longer-term focus by alleviating short term personal capital concerns. Ten percent of the founder’s overall ownership is a good rule of thumb for the maximum secondary size — too much can cause misalignment as subsequent funding rounds may reduce founder ownership too much.
- Are there extenuating circumstances? If the founder has financial pressures (such as law school or other professional accreditation loans), has been paying themselves a dramatically below-market salary (to the point that it’s dramatically impacting their quality of life), or generally feels demotivated, it’s a sign that the salary/equity balance isn’t right and some early liquidity might resolve the situation.
Providing liquidity to founders is likely to open questions about providing liquidity to employees. If you don’t feel comfortable allowing your employees to exercise some of their options, it’s likely too early for a founder secondary.
Christian’s take:
I have a lot of anonymous quotes that I often use, one of them is “profits set you free.” For founders of early-stage venture-backed businesses, profits are frequently in the distant future. That’s as designed. Almost all VC-backed companies forgo near-term profitable for rapid growth — growth beyond even the reinvestment of organic cash flows by using outside capital. In turn, that venture capital money comes with venture capitalists who, while generally aligned with the founders, are counting on growth to fuel their own business model.
Generally, this all works out fine. However, when a company is within striking distance of profitability at the cost of some growth, and the founders are under-compensated from a cash perspective, a misalignment can be created. The founders may want to run profitable so they can pay themselves more, as well as free themselves from the perpetual fundraising cycle. Hence, profits set you free.
Secondaries play an essential role in these situations. They realign the interests of the founders and investors. The theory being, by providing cash to founders, secondaries reduce founders’ temptation to slow down growth to generate free cash flow. Furthermore, by meaningfully de-risking founders personal situation, founders can feel more comfortable doubling down on growth at the expense of profitability. Precisely what the VC prefer — and hence a realignment of interests.
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