Risk It is the core of our business. Differences in risk preferences and risk assessment are the root causes of nearly all VC-Entrepreneur conflict. But we don’t talk about them much. And we certainly don’t talk much about how to close the gap between us. Entrepreneurs and VCs talk about valuation, “ability to execute”, “barriers to entry” and term sheets. These are all derivative of risk preferences and risk assessment.
Alignment. Brad Feld and Fred Wilson have an ongoing series of VC clichés. I don’t remember if “we are aligned with [management] [the investors]” is one of them. Nevertheless, it should be. Bill Burnham had a nice piece some time ago about how to maximize alignment among investors by structuring the various rights and terms. However, true alignment among all interests, each shareholder, Common or Preferred, is nearly impossible. Everyone has different risk preferences and assesses risk differently. (There are even differences in risk preferences between VCs. The utility of a $50M gain on a $5M investment is markedly different for a $100M fund and a $1B fund. In that sense, smaller funds are more aligned with founders on risk preferences.)
Risk Preferences. It is much easier to solve for risk preferences than for risk assessment. Starting a company is analogous to the first night in a casino for some entrepreneurs. If you are fortunate enough to create a small, but meaningful trove of winnings early in the night, you face the decision of taking a modest win home or staying longer and winning bigger or losing it all. If the early win is meaningful enough and if you were forced to stay and keep placing bets, most players would move to a ‘don’t lose’ strategy rather than a ‘win big’ strategy.
So it is with small companies. When a small company has achieved some success and the unrealized value of that success is a meaningful cache of personal wealth to the founders, risk preferences shift from ‘risk neutral’ to ‘risk averse.’ This can be profoundly sub-optimal for institutional investors who are risk-seeking by design. (Venture investments have payoff characteristics that resemble options more than equities.) Most investors think they need management to be “at risk” to act like owners, not employees. In reality, we don’t want them to act like owners. We want them to act like investors, taking the same risks we would take. The challenge is getting management to take more risk in good companies and less risk in bad companies. The companies that underperform need more money, diluting management, turning them into employees taking too much risk with other people’s money. The good companies need less cash, generating more wealth for founders, driving them to wealth conservation. Unless this is managed, we will underinvest in winners and overinvest in losers.
When this risk preferences issue is addressed, it is usually addressed by taking some chips off the table, figuratively and literally. The best mechanism is the partial buyback of founder stock. Most VCs hate this because they want all the cash they invest to fund the tangible expenditures that create more shareholder value. But investing even more cash in a business managed by risk adverse executive is truly a worse decision.
I was told many years ago that the founders of Intuit sold some of their personal holdings to Kleiner Perkins when they were investing. Intuit was facing a choice of being a small, profitable business, or doubling down to own the category. Part of the investment strategy was to align a great team with the potential upside. More recently, I heard that the Skype founders were partially cashed out when the VCs invested. That outcome is now part of the Bubble 2.0 legend. (I do not have confirmation of either story, but I hope they are both true.)
The most dangerous and divisive time to do it is when there is no independent assessment of value. If I value the company at $60M, I compound the impact of any valuation error by buying both Preferred and founders’ stock at that price. If the Company has an acquisition offer at $75M, but founders and investors want to keep going, after taking some chips off the table, a valuation of $60M with a partial buyout keeps the upside open for everyone, reducing both founders risk of economic ruin and my risk of misassessment of value.
I am not arguing that buying founders stock should be a universal part of an investment strategy. There is tremendous signal value in a founder’s willingness to sell early. Huge. One of the best indicators of a top in a public stock is insider selling. Yet, people sell for many reasons, not all of which are because of a loss of faith in the future. Part of our due diligence is to understand motivations.
As final point, I should point out risk preference and risk assessments are linked in the decision to sell founders’ shares. The price at which you are willing to sell may not be the price at which I am willing to buy. That spread is risk assessment.
Postscript
Someone just pointed out this post by Paul Graham just a few days ago. It contains the following:
My second suggestion will seem shocking to VCs: let founders cash out partially in the Series A round. At the moment, when VCs invest in a startup, all the stock they get is newly issued and all the money goes to the company. They could buy some stock directly from the founders as well.The question of when and if this is appropriate is entirely situational. But as Paul points out, there are times when buying founders' shares might be part of a wealth maximizing strategy for everyone. It's not about the Series (A, B, or G). It's about creating insurance to align interests.
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