Money Changes Everything
Yahoo’s recent acquisition of social-bookmarking site del.icio.us gives me the perfect excuse to write about a topic that’s been brewing in my brain for a few weeks. I started thinking about the evolving roles of venture capitalists, large technology firms and startups after reading a Paul Graham essay, “The Venture Capital Squeeze”. Paul’s thesis is that startups are increasingly acting as outsourced R&D shops for bigger companies, taking advantage of the agility and innovative nature that are characteristic of small teams. VCs are thus facing more competition from Google and its ilk, who are keen to snap up cool startups before they are sullied by outside investors.
His solution is for VC funds, who are still swimming in cash, to allow a certain proportion of their investment to go straight into the founders’ pockets. This makes them more competitive since it tempers the stark choice that often faces entrepreneurs: get moderately wealthy immediately by selling out or accept funding in the hope of becoming truly stinking rich, but at much higher risk.
I agree wholeheartedly with Paul that traditional corporate structures are changing rapidly, in the technology space and elsewhere, and the idea that startups can and should be created with the explicit goal of selling their intellectual property and team to a larger player is certainly borne out by the del.icio.us acquisition. Del.icio.us is the quintessential Web 2.0 success story: a cool innovative idea and a healthy and fiercely loyal user community, but no mainstream awareness or business model. At the rumored purchase price of $25-30 million, it is probably a good buy for Yahoo. After all, this sum is a drop in the bucket for Yahoo, so even a free service without built-in revenue streams can be valuable if it improves overall user experience and thus revenue generation on other Yahoo properties.
At the same time, I can’t get myself to accept the idea that entrepreneurs should reject VC money unless they are allowed to cash out partially. First of all, the experience of del.icio.us is an excellent illustration of why raising VC money can be good for company founders even if their goal is a short-term strategic sale. It’s probable that the del.icio.us folks made out better financially for having accepted VC and angel investment in April. Yes, this diluted their stake in the company, but having strong financial backing gives you huge leverage when negotiating with a potential acquirer. Had they raised only enough angel money to keep their servers ticking over, they probably would have experienced a much more stressful few months and still ended up with less money.
And I simply can’t bring myself to believe that cash payouts by VCs wouldn’t reduce the incentive to go for a big win. The lure of riches is a large part of what keeps us working 14 hour days, sacrificing our social lives, boring our friends and family and all the other things that entrepreneurs endure. I’m certainly in favor of founders earning a decent wage once VC funding is secured, but a large cash payout is a bad idea. And add to this the potential for fraud. In the last bubble, companies were set up purely for the purpose of enjoying access to large sums of money. These perverse incentives would get that much stronger if unscrupulous “entrepreneurs” could put investment cash directly in their pockets.
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VC’s should be able to weed out the unscrupulous entrepreneurs, or they aren’t doing their job and deserve their fate.
Consider being an entrepreneur faced with three options: (1) quick decent cash through an early sale for $10M split among the group, angels, etc.; or (2) giving up 25% for $2.5M ($1.5M into the company and $1M to founders (say $200K to each the founders to make them comfortable but not rich), then the company shoots for the moon; (3) $2.5M into the company for 25%. Which do you take?
#2 limits your downside, like a collar on your options. It can be a good thing. If you have a business model with real revenue (potential revenue) you might go for #2 or #3, but #2 is more comfortable. Still huge upside but at least you won’t lose your house if it flops. Real entrepreneurs manage risk. To take a few chips off the table and still have upside makes sense.
Comment by Mike — 12/15/2005 @ 12:36 am
Yes, I agree that it would take a very confident entrepreneur to choose #3 over #2. My point was more that VCs are unlikely to go for this. Of course, they can try to weed out unscrupulous characters, but I can’t see why they would want to create this problem in the first place.
Comment by Matt — 12/15/2005 @ 3:18 pm