Last week, I attended the OnHollywood Conference in Los Angeles. During one of the panels, DFJ’s Tim Draper made a shocking statement: “Selling Skype was the saddest day of my year”. Huh? A multi-billion dollar exit constitutes the saddest day of a VC’s year?
Tim went on to explain that he felt Skype had a chance to be an absolutely huge standalone company, perhaps worth another 5-10x what eBay paid. He said he is always pushing his entrepreneurs to hold out and not sell too soon. And in doing so, he put his finger on an issue that runs at the heart of VC-entrepreneur misalignment.
VCs typically have a very diverse portfolio, allowing them to have many “swings at bat” to see a start-up become successful and pay out. They make good money off the fees in both good times and bad, but they only make great money if they have very large exits. Mediocre exits don’t typically move the needle for them personally or for their funds.
On the other hand, entrepreneurs typically have all their financial eggs in one basket: their start-up. When they have a chance to make good money with 100% certainty, their instinct is to jump at it. If they hold out, “double down” and pursue a bigger outcome, they are simply adding financial risk to their personal portfolio.
Let’s do the math on an example to see how this plays out. Let’s say an entrepreneur owns 10% of their VC-backed start-up and someone comes and offers them $100 million. Thus, they stand to make $10 million if they proceed with the sale. Let’s say a VC fund owns 20% and thus will take away $20 million, but assume they’ve invested $5 million already in the company, yielding a net capital gain of $15 million. Further, let’s say the VC’s “carried interest” is 20%. Therefore, the general partners of the fund take home $3 million. Let’s say there are 6 partners that split the carry evenly – that’s $500k for each general partner.
So the entrepreneur is thinking “I can take home $10 million now and change my life” and the VC board member is thinking “I can take home $500k and have an ‘ok’ outcome for me and my fund. But if I push the entrepreneur to ‘double-down’, perhaps we can sell this thing for $200 million in two more years and perhaps we should do a few acquisitions to bulk up to aim for $400 million in four years.” See the problem?
This debate tends to be one of the hardest around the board room, particularly today as the IPO market remains dead but the M&A market has become fairly robust. One discussion I’d like to see more of: VCs allowing entrepreneurs to take money off the table to align interests and address this conundrum. Perhaps I’m too “soft” on entrepreneurs, but I have no problem with an entrepreneur taking a few million off the table so that their mortgage and college tuition is covered, freeing them up to embrace more risk and swing for the fences in a way that is aligned with the VCs. We recently did this in one of our portfolio companies and I’ve seen a few early exits recently in other start-ups because the VCs didn’t do this.
Either way, I’d personally welcome a few of Tim Draper’s "saddest days" in the coming years.
SEEING BOTH SIDES 
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Having been on the founder site of this equation the founder should take the $10M. Growing the company from $100M to $200M is going to involve a lot of risk and pain. It will also result in dilution of the founder’s stake so that they probably still only get $10M in the end.
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could not agree more!
risk asymetric of funders and founders is causing lots of misunderstanding.
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Great piece. It reminds me vividly of the tensions in eToys where the VCs pushed one of the top e-commerce companies at the time to spend every last cent, have no contigency plan, and swing for the fences because an $8b valuation wasn’t quite enough for them. Today, most people think eToys is gone. In fact, the remnants do well over $100m in business a year . . . and one of the best pieces (BabyCenter, an IDG investment) barely survived it all and now thrives as the #1 leader in its space as part of Johnson & Johnson . . . economics are economics, but if Tim Draper cared in the least about the employees of Skype, perhaps he would have at least held his tongue.
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Tim’s just great, great player: saying exactly what he should be saying, precisely because of the chatter his public relations game generates. Masterfully exceptional.
He has no downside. Either way, if he is condemned or glorified, he gets more business – without putting him self at risk by proposing partial cash outs for entrepreneurs.
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Is this just anothe sign that VC’s have lost touch with reality? Is Tim Draper the Paris Hilton of the Valley? Anything “saddest” or “happiest” should be reserved for loved ones . . . For VC’s to assign such emotional phrases to a “deal” just means that regular joes (entrepreneurs) could never relate effectively with VC’s (or just Tim Draper) . . . the gap is widening, I dont think many VC’s understanding the concept of “working entrepreneur” trying to make ends meet and support a family. Passion and love have nothing to do with “5x or 10x” . . . people’s priority are all screwed up when they have so much money that the basic emotions are tied to their own egos rather than tangibles accomplishments & families. . . end of my rant 🙂
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Great post. I can tell you as a VC-backed entrepreneur, the biggest issue is that the entrepreneur works 110 hours per week at an obscene stress level for his 10M. The VC attends a board meeting every 6 weeks for 2 hours. Yet the VC makes $3M. Nice trade off. Also the VC makes great salary off the mgmt fee. Entreprenuer probably makes enough salary to rent a crappy appartment.
I know your going to say that good VCs add value and work hard etc… But it is quite common knowledge that the really good VCs are the one that know how to get out of the way.
I see the dynamics changing in the valley and for the entrepreneur – this is an essential thing for the startup game, but perhaps not great for VCs. I sense nobody is going to cry about that.
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It appears my link from above isn’t working so here it is again. Enjoy!
http://www.ventureweek.com/blog/category/fixing-the-vc-model
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Great post Jeff. I wrote a lot about this a few months ago (http://www.ventureweek.com/blog/category/fixing-the-vc-model/) and I’m glad to see a VC share my thought of letting entrepreneurs take some money off the table early in order to align interests. There are some VCs who think this will lessen the entrepreneurs drive and that great entrepreneurs will never do it. I personally think that, what I call “partial founder buyout,” is not for every company but I still would like to see the choice become available. Flickr is an obvious case where PFB may have kept them in the game longer and yielded a larger payoff for all involved.
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I think the problem is knowing what amount of reward would keep the entrepreneur motivated. For instance allowing the entrepreneur to cash out $1M in the scenario you mentioned combined with an assumed salary of $150K would make many comfortable enough that it might reduce their drive.
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