Interest Misalignments in Silicon Valley Startups

Everyone’s aligned in a Silicon Valley startup, right?  Give everyone some options so everyone has skin in the game and then everyone wants what’s best for the share price:  one for all and all for one!

Not so fast.

In this post, inspired by a chat with longtime serial entrepreneur Ken Ross, I’ll delve into what I see as the common alignment issues in Silicon Valley startups.  While I am a big believer in broad employee share ownership, one shouldn’t make the mistake of believing that simply because everyone has shares that they are automatically and permanently aligned.

In my estimation, there are four drivers of potential misalignment.

• Portfolio theory
• Shareholdings and net worth
• The “exit” concept
• Irrational considerations

Portfolio Theory

The most common cause of misalignment is driven by portfolio theory.  VCs typically invest in 10-15 companies and work in partnerships of 5-10 partners.  Thus a VC might get “carry” (i.e., a slice of the investment profits) on 50-80 companies.  A friend once calculated that a VC gets the equivalent of a VP-level (or better) equity stake in each of the portfolio’s companies.

Entrepreneurs and executives, however, have but one life to give and must work at one company at a time.

Divergence can result when VCs want to take more risk than founders and executives because they have placed 80 bets while the executives have placed one.  This can manifest itself in pushing for overly aggressive operating plans or declining “base hit” acquisition offers in favor of “swinging for the fences” each time.   Time can compound this divergence as accumulated sweat equity tends to make the founders and executives more conservative over time.  (Think:  “I have 8 years of my life in this thing, we can’t take that risk.”)

In addition, VC is increasingly a “hits business” – i.e., a fund that delivered an IRR of 35% might deliver only 15% excluding its top two investments.  Thus, VCs are generally more afraid of selling too early than too late.  While founders often tell tales of VCs declining early acquisition offers that could have earned them a quick $20M, VCs might tell the tale of VMware, which sold for $625M in 2004 and is now worth $41B.

Portfolio theory has other effects that are more subtle.  You might think of a given venture-backed company as in one portfolio.  In reality, the company is in numerous “portfolios” at different levels:

• The fund level.  The expectations for a company become a function of the performance of the other companies in the fund.  If they are performing poorly, pressure may increase to deliver a big result.  Alternatively, if the fund is old, has lackluster performance, and the VC firm has subsequently launched several high-performing funds, a lack of interest may develop.

• The partnership level.  Different VC firms set have different investment objectives and reputations.  Some want to quietly deliver great returns.  Some favor operating guys as partners, other favor financial types.  Some like seeing their name in the press; some don’t.    As a general rule, the more early-stage and the more big-name the partnership, the more they will want portfolio companies to swing for the fences across the entire portfolio.

• The partner level.  Each partner in a fund has his own set of companies.  VC partners track each other’s performance closely and a partner’s fate over time is, in large part, determined by his investment performance.  In addition, since most VC firms are fairly stove-piped, expectations for a given company are probably more shaped by its partner’s portfolio than any other.  Factors that influence the partner’s motivations include the performance his portfolio, his existing status in the firm (e.g., venture partner looking for a big-hit to make general partner, or established leader in the firm, or in-trouble and need of a big-hit to stay in the game), and his future plans (e.g., retirement).

• The partnership-partnership level.  Suppose early-stage VC firm 1 does a lot of business with late-stage VC firm 3, as is often the case.  You can then think of your company in the “intersection” portfolio between these two partnerships.   Why does this matter?  To the extent that VC3 is dependent on VC1, they may make decisions that optimize the VC1/VC3 relationship over those that they might think best for a given portfolio company.  (Think:  “if Bob ever wants to work with us again, he’d better go along with us on this decision.”)

Shareholdings and Net Worth

The size of someone’s position, particularly relative to net worth, can cause a divergence of interests.  Consider a hypothetical company with 25M shares:

• The founder owns 5M shares.
• The total employee option pool is 5M shares.  (Of which Joe Engineer has 20K shares.)
• VC1 owns 10M shares, having paid an average of $1.60/share across two rounds.
• VC2 owns 5M shares, having paid $3.00/share in leading the second round.

Let’s consider a proposed $6.00/share offer for this company, for a total exit of $150M.

• The founder would make $30M and be set for life.  He votes yes.
• VC1 would receive $60M which does not move the needle relative to the size of his $600M fund.  On a return basis, he makes 3.75x, a poor result for an early-stage VC.  He votes no.
• VC2 would receive $30M which moves his needle even less.  He makes a 2.0x return, low for a late-stage investor.  He votes no.
• Neither VC partner will gain any bragging rights because the exit is small in an absolute sense.   This confirms their no votes.
• Joe Engineer would get $120K pretax or about $60K post-tax.  He can buy nice car, but he still can’t touch a Silicon Valley house.  Joe doesn’t get a vote, but if he did, he’d vote no, too.

The interesting thing here is that Joe Engineer is much more aligned with Winston the VC than he is with the company’s founders and executives.  Joe would vote no for two reasons:  first, $60K after tax doesn’t move the needle for him and odds are (since he chose to work at the startup), Joe is a true believer in the technology and thus thinks of this deal as sell-out.  Amazingly, Winston votes no for the same reason:  $60M doesn’t do much for his fund and he also sees the deal as a sell-out.

Now, the founder would have made $30M and, using typical ratios, the CEO would have made $7.5M, and the key VPs somewhere between $1.5M and $3.0M.   In most cases, they would all vote yes.  (But in reality only the founder and CEO are on the board and actually get a vote.)

The scenario changes dramatically if the founder is already rich.  Imagine the founder made $100M on his previous startup.  Now, a $30M exit is uninteresting because it results in neither a lifestyle upgrade nor a status change.  Now, the founder aligns with Winston and Joe in voting against the deal.  You can analyze the CEO’s vote in a similar fashion.

The “Exit” Concept

Managers want to build great companies; VCs want great exits.

Unfortunately, building a great company is neither a necessary nor sufficient condition to enable a great exit.  At only 3 years old, Bebo sold to AOL for $850M.  A spectacular exit, no doubt, but a little more than 2 years later AOL sold it for less than $10M.  A great company?  Certainly not.  YouTube, while infinitely more ubiquitous, barely makes money but was sold to Google at 18 months old for $1.65B.  A great exit?  Yes — goosebumps quality even.  Did they even have the time to build a great company?  Not really.

The best managers tend not to focus on great exits.  They focus on building great companies.  In fact, the “IPO as exit” is almost purely a VC notion.  In reality, an IPO is almost certainly not an exit for the CEO; he or she is de facto bound to the company for at least the next several years and his/her ability to sell shares is highly restricted.

I have always believed that IPOs are like high-school graduations – they are a beginning, not an end.  Godfrey Sullivan, CEO of the red-hot company Splunk, seems to feel similarly, saying “we consider an IPO the 3rd mile of a marathon. The IPO is an early milepost, not the destination.”

In the best-case scenarios, building a great company will indeed lead to an IPO which will be yet another milestone in a long journey of success.  But this is not always the case.  I’ve seen companies (e.g., Versant back in the day) twist into pretzels to make it through the IPO window and provide a reasonable exit for the investors only to end up living-dead zombies thereafter.

Now, I have not found the particular VCs with whom I have worked over the past 20 years particularly exit-focused.  Most are surprisingly patient and indeed want to focus on building great companies.  But, you cannot ignore the possibility of divergence when some of the passengers can exit the bus reasonably quickly post-IPO while others cannot.

The terminology “exit” reflects this pretty clearly.  For employees, customers, staff, and executives, the IPO is not an exit.  Nor, for that matter, are most acquisitions.  Founders, key executives, and key staff are often locked in (through various mechanisms) for 1-3 years after a deal closes.

Irrational Considerations

As humans, we must recognize that we do not always act rationally.  Behavioral economics reminds us that we are subject to a bevy of rules and heuristics that can cause us to make sub-optimal decisions.

Some decisions that appear irrational are rationally motivated  — but by either an unknown personal or non-shared goal.  Others actually are just plain irrational.  For example:

• Anchoring:  I need to make $50M.  (Because I decided that I need to make $50M.)
• Benchmarking:  I need to make $50M.  (Because my roommate at Stanford made $50M and I’m smarter than he is.)
• Fame-seeking:   I need to be famous and will take increasingly risky bets in order to achieve that.  (Arguably this is a rational decision derived from a non-shared goal, but if you are on the board of a company you have a duty to its shareholders so I’d argue it’s irrational from that perspective.)
• Dreaming:   This technology is going to change the world, despite much evidence to support that contention.  (Because I made it and it’s really cool.)
• One-more go:  I will take increasingly risky bets because I’m retiring soon and this is my last chance to get one more for my legacy.  Shoot the moon.

The trick here is most founders are, by definition, a little crazy.  The confidence and zeal it takes to quit one’s job, develop a product idea, start a company, and raise venture capital is well beyond that of the average “reasonable” person.  Thus, it can be hard for founders to know when to stop pressing bets.  The same traits that enabled them to be successful as founders present a risk they overplay their hands, and destroy shareholder value in the process, in the long term.

Conclusion

In this post, I’ve tried to highlight some of the common sources of potential misalignment between the various shareholders of a startup enterprise:  founders, venture capitalists, CEOs, executives and rank-and-file staff.  Hopefully, I’ve demonstrated that things aren’t as simple as they might appear and that just because everyone might own shares, doesn’t mean they have aligned goals and motivations.

If you think I’ve missed any good examples, please let me know.