Opinion

Felix Salmon

The most expensive lottery ticket in the world

Felix Salmon
Apr 21, 2014 15:25 UTC

No Exit, the new book from Gideon Lewis-Kraus, should be required reading for anybody who thinks it might be a good idea to found a startup in Silicon Valley. It shows just how miserable the startup founder’s life is, and raises the question of why anybody would voluntarily subject themselves to such a thing.

A large part of the answer is that Silicon Valley is gripped by a mass delusion, compounded by a deep “fake it til you make it” attitude toward success. Why do so many people in Silicon Valley want to be founders? Because every founder they meet is always killing it, crushing it, having massive success, just about to close a huge round, etc etc. At some level, they must know this is impossible: if 90% of startups fail, it simply can’t be the case that all of the startups they know are succeeding. After all, failure is not something which just suddenly happens overnight, when you thought you were doing great all along. But people tend to believe the evidence of their own eyes, and what they see is a combination of two things: the founders they know all seemingly doing great, and also a steady stream of headlines showing other founders cashing out for millions or even billions of dollars.

On top of that, startup founders have Silicon Valley cachet: they’re the stuff of legend. Everybody wants to be Mark Zuckerberg or Steve Jobs or Jack Dorsey. There might be a generous paycheck in getting stuck on the Google bus for the next decade, but there sure ain’t any glory in it. And so a huge number of incredibly well qualified engineers, who in previous decades would have put their skills to work being a part of something much bigger than themselves, instead decide to go it alone.

There is no reason whatsoever to believe that computer engineers make particularly good entrepreneurs. Quite the opposite, in fact: engineers tend to do quite well in structured environments, where there are clear problems to solve, and relatively badly in the chaos of a startup, where the most important skills are non-engineering ones, like being able to attract talent and investors. No Exit makes it very clear that the life of a startup founder is a miserable one, and that engineers are invariably happier when they’re working for a big company.

Financially, starting up a company in Silicon Valley makes very little sense. You have a very high chance (indeed, a certainty) of having to scrape by on a very low income in a very expensive city. At a time of your life when you should be out enjoying life and meeting friends and generally having lots of fun, you will instead be unhappily tethered to your laptop at all times. In return for sacrificing a six-figure salary elsewhere and general enjoyment of life, you’re given a lottery ticket: you get a minuscule chance of making untold millions of dollars. Being that rich is, undoubtedly, nice. But is it so much nicer than the life of a well-paid computer engineer that you’re willing to give up your life, and hundreds of thousands of dollars in foregone income, in order to have a tiny chance of grasping that brass ring? I know a lot of happy people; there are a couple of successful technology entrepreneurs among them. But I would never say that the successful entrepreneurs are the happiest people I know. So where does it come from, this intense Silicon Valley desire to buy the most expensive lottery ticket in the world?

To find the answer, you have to look to the people running the lottery. In this case, those people are the angel investors and venture capitalists — the people who are throwing ever-greater sums of money at ever-greater numbers of startups, in the knowledge that the overwhelming majority of the companies they fund will end up failing.

What we’re looking at here is basically the Magnetar Trade, in human form. Magnetar had a long/short relative-value strategy in the subprime market: it was short a lot of subprime securities, while also being long a smaller slice of equity. While Magnetar was putting on its trades, the equity slice would make money; when everything blew up, the shorts made even more.

The Silicon Valley trade is also pretty close to being zero-sum. Even on a purely financial basis, if you add up all the profits from successful investments, they barely cover the losses on all the unsuccessful ones. A few big-name angels and VCs can do OK for themselves, but in aggregate the industry of investing in startups does not make money.

But the reality is much worse than that. Essentially the way that the startup ecosystem works is by taking the valuable labor of thousands of hopeful founders, and converting it into large amounts of capital for a tiny number of successes. The fulcrum of No Exit is the point at which it’s unclear whether the startup being followed by Lewis-Kraus will get its next round of funding: either it will raise a sum in the low seven figures, and survive, or else it will simply fail. And the message of the book is clear: the best possible outcome, in terms of the wealth, health, and happiness of the founders, would be the latter. Their startup fails, they get their lives back. They can work for a living and enjoy themselves and not stay stuck on the evil startup grind. If they do manage to raise their next round, that will only serve to prolong their misery.

Founding a Silicon Valley startup, then, is a deeply irrational thing to do: it’s a decision to throw away a large chunk of your precious youth at a venture which is almost certain to fail. Meanwhile, the Silicon Valley ecosystem as a whole will happily eat you up, consuming your desperate and massively underpaid labor, and converting it into a few obscenely large paychecks for a handful of extraordinarily lucky individuals. On its face, the winners, here, are the people with the big successful exits. But after reading No Exit, a different conclusion presents itself. The real winners are the happy and well-paid engineers, enjoying their lives and their youth while working for great companies like Google. In the world of startups, the only winning move is not to play.

COMMENT

I hope RadiumOne fails. Yesterday.

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Art, venture capital, and down-round phobia

Felix Salmon
Jul 16, 2013 14:32 UTC

Ben Horowitz has a great guide to the dreaded “down round” today — that unloved point in the evolution of a venture-backed technology company when it’s forced to raise money at a lower valuation than it received in previous rounds. Certainly, such things shouldn’t be unexpected. As he explains:

The average company on the S&P 500 IT index with $10 million in annual earnings would be worth $210 million in March of 1995, $820 million in March of 2002, $310 million in March of 2004, and $155 million in March of last year. And those are big companies with real earnings, so you can imagine how a private company’s valuation might fluctuate.

Still, Horowitz likens the experience to being “the captain of the Titanic”, and he notes that it only starts looking attractive when you realize that the alternative is “suicide”: “Down rounds are bad and hit founders disproportionately hard,” he writes, “but they are not as bad as bankruptcy.” And he notes, in a clear-eyed fashion, that it would take a “miracle” for a founder to survive the process. (Startup founders are short-lived at the best of times; it’s rare they can survive a down round.)

The problem here is clear: a simple lack of honesty and transparency when it comes to funding. Valuations go up and down, but no one likes to admit it; investors, in particular, love to delude themselves that the value of the company only went up after they bought in, and that they got a spectacular deal.

Indeed, this is one of the reasons why so many startups fail: taking VC money is a deal whereby, in practice, if you don’t grow super-fast, in both size and valuation, then you will be left for dead. David Segal, on Sunday, had an intriguing piece about what you might call distressed startup opportunities, but that’s a very, very new market, and one which VCs aren’t yet interested in. For the most part, VCs all operate according to the same convention, which treats downward valuation fluctuations not as some natural occurrence but rather as a mortal threat.

When I was reading Horowitz’s piece, I couldn’t help but be reminded of Allison Schrager’s article about how “high-end art is one of the most manipulated markets in the world”. Again, the problem is that the art market isn’t allowed, by its practitioners, to be a real market, and instead operates on a series of conventions which make it deeply broken on many levels.

There are two startling data points Schrager’s piece. The first shows that it doesn’t have to be this way: in China, she says, 50% of primary sales — sales of fresh works, which have never been sold before — take place at auction. That certainly helps explain why Chinese artists are so dominant in the contemporary-art auction-volume league tables.

The second is a story which shows what happens when artworks are not sold at auction: they can sell instead for a discount of 99%.

A few years ago a young art collector from New York I know bought a painting from a New York gallery. A few weeks later she went to the Miami Basel art fair where a celebrity heard about the painting. He offered to buy it for more than 50 times what she paid for it. She refused and he raised his offer to a sum that would mean she’d never have to work again. She explained that she would not bargain with him—any resale of the painting must go through the gallery, so they’ll get a commission and select the price—not her. The young collector knew there would be consequences to making the sale. She may have owned the painting, but reselling it at a profit without the gallery’s permission would blackball her from the art industry. To her, that was not worth the millions she was offered.

There are a lot of lessons to be drawn from this story, including of course the fact that we’ve been deep in bubble territory for at least “a few years” now. But mostly, it’s one of those unfalsifiable anecdotal beauties which the small and gossipy art world requires even more than it does money. Put aside the question of whether it’s literally true — that really doesn’t matter. What matters is the art-world conventions which are revealed here.

First is the way in which social currency — whom you know — trumps actual currency. The young collector in this story made a simple calculation: the value of a good relationship with the gallery in question was higher than the millions of dollars dangled in front of her by the celebrity. And of course the value of social currency is the reason why the celebrity was in Miami in the first place, too. The monster success of global art fairs like Art Basel Miami Beach, which have pretty much eaten the entire art world at this point, is ostensibly about commerce — but in reality has just as much, if not more, to do with the fact that they’re a way of getting a far-flung crowd together in the same place at the same time. For all the financial deals which are struck at art fairs, there’s just as much value, if not more, created in the social ties found at the endless round of parties and dinners at such occasions. In many ways, the spectacle of Jay-Z performing at Pace Gallery for six hours last week was his way of buying social currency in the art world — essentially, buying himself the option to lay out huge sums of cash for work by hot young artists.

Art, then, is very similar to venture capital, insofar as who you know matters — and also insofar as both markets go to great lengths to hide natural valuation fluctuations. “Down rounds” are if anything even more harmful to an artist than they are to a startup: galleries will, as a rule, drop an artist before selling her art for less than she was charging at her previous show. The reason is entirely to protect the gallery’s own credibility: the gallery wants collectors to see it as a place where they can buy art which is going to rise in value, and as a result it will do everything in its power to make it look as though the work of all of its artists is only ever going up in price rather than down.

Horowitz concludes his piece by saying this:

The only surefire antidote to capital market climate change is positive cash flow. If you generate cash, investors mean nothing. If you do not, then your success will depend upon the kindness of strangers.

Apply that lesson to the art world, and the conclusion is clear. No art has positive cash flow; ergo, all artists are dependent upon the kindness of strangers. Schrager takes this idea to its logical conclusion, considering — and then rejecting — the idea that an old-fashioned patronage model might be better for artists than the current grinfuck model.

She’s probably right about that, although there are certainly artists who quietly do quite well for themselves on the patronage model, selling their work directly to a small number of collectors and bypassing the craziness of the gallery system. Those collectors are well aware that the artists in question aren’t going to become auction-house stars, but that’s OK: they’re buying art for the right reason, because they love it, rather than for mercenary reasons surrounding dreams of future wealth.

The question is whether a more transparently market-based system, one where people understood that prices can fluctuate, would be better for artists than the current system, where artists’ careers, a bit like startup valuations, have to always be improving lest they fall into the art-world equivalent of bankruptcy. Schrager thinks it might be:

If pricing were transparent, it would probably be lower and art more available to a wider range of collectors. This would be an unwelcome move for dealers and elite artists but it could also demystify the market and lower tier artists could earn more because the market would be less segmented. To some extent technology is naturally making it happen. Websites are cropping up that sell primary art and make it more available to the masses. Even Amazon has set its sights on the art market. It plans to partner with certain galleries to sell some of their inventory online but it’s not clear whether it will become a “market for lemons,” where the best pieces from the most promising artists are still reserved for certain collectors and prices of promising emerging artists still unknown.

I’m not holding my breath: the art market, more than ever, is controlled by a handful of large international galleries, and those galleries have no incentive whatsoever to give up their pricing power. Doing so might be good for artists, just as transparency around fluctuating valuations would probably be good for startups. But it’s not going to happen.

COMMENT

Nice sharing.

China Ventures is a leading section at Tisunion which focused on developing business with China viewed from global strategy consultancy. China has the world’s largest and fastest growing trade markets. We strongly believe that most potential investment project will be dominated by china Market.

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Snapchat’s early cash-out

Felix Salmon
Jun 26, 2013 22:42 UTC

Dan Primack is awesome when he’s angry, and boy is he angry today, reacting to the news that Snapchat’s two co-founders have cashed out to the tune of $10 million apiece as part of its latest funding round. “This is desperate lunacy,” he writes, adding that these kind of deals “should scare the hell out of venture capitalists”:

The LP-VC-founder alignment has now been skewed, because only the last part of that triangle is now in the money…

Don’t I want entrepreneurs building for the long-term, rather than ones just waiting for the first decent exit opportunity? Entrepreneurs who care as much about their vision for its own sake, as they do for the dollars that vision can represent?…

VCs in general have gotten a bit too comfortable handing out millions of LP dollars to individuals who don’t really need it. Maybe that’s because certain VCs no longer view $10 million as the fortune it really is.

I agree that little good can come from these deals, from the VC point of view — but I’m less angry about it than Primack is.

For one thing, the LP-VC-founder alignment has always been skewed, with VCs getting by far the best deal. Most VC-backed companies fail; historically, that has meant the founders walking away with nothing. And LPs have not done very well either. Only the VCs seem to get paid no matter what. By allowing founders to sell equity outright in early rounds, VCs are allowing them to monetize crazy early valuations — just as they themselves monetize those crazy early valuations by using them to market their next multi-billion-dollar fund. Is it bad that the pendulum is swinging back a little bit from capital (VCs) to labor (founders)? No, it not.

Secondly, it is absolutely understood in the founder community that the deal you make, when you accept your first dollar of VC funding, is that you will be building for growth and exit, rather than trying to create something which you will bequeath to your children. If you want “entrepreneurs building for the long-term”, you want entrepreneurs who aren’t taking VC money in the first place.

Thirdly, especially in Silicon Valley, it’s downright silly to expect entrepreneurs to “care about their vision for its own sake”. This is the home of the pivot, of the serial entrepreneur, of the fail-fast culture, of A/B testing, of trying many different things until you find one which works. This isn’t about vision, it’s about the ruthlessness of the market. Indeed, founders who care too much about their vision, rather than about maximizing VC returns, are liable to get unceremoniously ejected.

Fourthly, if VCs have reached the point at which they no longer think of $10 million as being a particularly large amount of money, then it’s about time that a few founders could join those ranks as well.

Finally, we’re living in a world where VC-backed companies almost never IPO any more, and where private exchanges like SecondMarket and SharesPost are becoming an increasingly important source of liquidity. I had lunch with the CEO of Green Dot yesterday; it was funded by Sequoia Capital in 2003, and Sequoia is still the single largest shareholder in the company, ten years later, with no final exit in sight — despite the fact that Green Dot went public back in 2010. In that sense, IPOs have become just another funding round. If companies are privately raising sums of money which five or ten years ago could be found only in IPOs, then you have to expect founders to start getting liquid around those rounds, just as they used to do during IPOs.

From a personal-finance perspective, of course, it makes all the sense in the world that Snapchat’s founders should diversify their net worth away from being 100% invested in the highly volatile and illiquid equity of their company. VCs and LPs are all perfectly sophisticated when it comes to managing their personal wealth; founders should be allowed to be just as sophisticated. Otherwise, accepting VC money starts too look far too much like indentured servitude.

So good on Evan Spiegel and Bobby Murphy for cashing out: they created a great product, and now they’re rich. That’s how Silicon Valley is supposed to work. And if the current valuation doesn’t work for the latest tranche of investors, that’s more the LPs’ problem than it is the problem of Snapchat’s co-founders.

COMMENT

I’m surprised that Primack is so concerned about money for the founders because he also covers buyouts. It’s routine in buyout deals that executives are taking some dollars off the table while also maintaining a go-forward equity position. It’s not just top execs for large go-private deals who are pocketing meaningful amounts. That’s also very common in relatively small middle-market deals, because so many of those companies are family-owned businesses who are maintaining a minority ownership stake going forward. Overall, I’d say it’s common – perhaps even the norm – that the CEO of a private equity backed company has more wealth in outside investments than in company stock.

As an LP, what would scare me is to see a VC putting my money into (pre-revenue) Snapchat at an $800 million valuation. (In fairness to Primack, he also makes this point.) Maybe I’m too old to appreciate Snapchat, but it sounds more like one feature of a social network or mobile OS than a standalone platform, so I view the valuation upside as limited. Tough to see how Snapchat generates major advertising revenue because the whole point of it is to look at photos that quickly disappear. I’d also think some advertisers wouldn’t want their ads showing up next to sexts.

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Why VC-backed firms can’t stay private

Felix Salmon
Dec 17, 2012 19:21 UTC

Talking of VCs who don’t like it when founders decide to sell, here’s Marc Andreessen on the subject of the $1.26 billion sale of one of his portfolio companies, Nicira:

That company, standalone, would have done about $2 million of revenue this year; we just sold it to a public company, VMware, for $1.26 billion. We think that [the founders] sold too soon and too cheap. We wish that they hadn’t done that. We’re happy for their outcome, and they’re at VMware, and I think they’re going to be a huge success at VMware. We wish they had stayed an independent company. Because if they had succeeded in their vision as an independent company, it would for sure have ended up being worth many multiples of the $1.26 billion.

But there’s a problem with this kind of attitude, which Andreessen is well aware of: he doesn’t invest forever, and at some point his limited partners are going to want to see a return on their investment. If companies don’t sell, and they don’t go public (Andreessen isn’t a fan of going public, either), then how can VCs get their exit? Andreessen has an interesting answer to that one:

We want to fund the companies which are so successful, and so in control of their own destiny, that they don’t sell, and they also, ideally, don’t go public. And then in 10 years, 15 years, they’re all sitting in our portfolio; they’re all big, and successful, and private. And then we get  just enormous pressure and backlash from our limited partners, our investors, saying, basically, where’s my money. Why haven’t you taken these companies public, why haven’t you distributed the stock.

It’s a smart way of putting it: most VCs would love to have the problem of (a) owning the next Google, or Amazon while (b) not having returned the relevant stake to their investors. But there are two big problems with this model, beyond the hypothetical-future-fights-with-LPs problem. The first is that VCs concentrate very much on something called compound annual growth rate: they tend to want to maximize their annualized return on any given investment, rather than their total return. And the bigger and more mature that a company gets, the harder it becomes to generate annual returns in the 25% range. If the LPs aren’t complaining about not getting their money back, they might well be complaining about being invested in large, mature companies — which is not the point of VC investments at all.

The second problem is bigger: you can’t build a large, mature company in Silicon Valley (where Andreessen Horowitz makes substantially all of its investments) without paying smart engineers in equity. Silicon Valley employees don’t dream of working for the same private company all their lives: they dream of the riches that flow from options and restricted stock. If the employees of one of Andreessen’s companies genuinely believed that the aim was to be a closely-held mature private company in 15 years’ time, it would be much more difficult to attract top-tier talent.

No one has yet cracked this nut. There might be ways of selling non-voting minority stakes to investors with genuinely permanent time horizons — university foundations, for instance, or sovereign wealth funds — but that still leaves the question of price discovery: how is anybody to say how much the company (and therefore the equity) is worth? So long as the founders and investors have an interest in keeping that valuation as low as possible for as long as possible, any employee selling equity into such a scheme is likely to wonder whether they’re getting ripped off.

So while I applaud Andreessen for aspiring to staying private as long as possible, I doubt he’ll ever have the problem he’s talking about here. Which is also why his LPs won’t be concerned by these statements in the slightest.

COMMENT

Felix, I am assuming that you see this as what it is. A talking point, nothing more, nothing less.

It’s great narrative. “We want to build large, game-changing companies and businesses – not pursue liquidity events.” As an entrepreneur, that sounds really good, even if we both know that the path is liquidity within five years – either M&A, IPO or RIP.

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Instagram and the risk of selling low

Felix Salmon
Dec 17, 2012 17:24 UTC

Nick Bilton’s column about the Instagram fairness hearing is annoying on a number of levels. When I mentioned one of them this morning, Dave Winer asked for “a brief post” explaining a bit more. OK then!

It’s worth saying up front that Bilton has got himself a genuine story here: it looks as though Instagram’s CEO, Kevin Systrom, was economical with the truth when he testified in front of the California Corporations Department in August. He said that Instagram “never received any offers” from any potential acquirers other than Facebook, and generally dissembled madly:

At the end of the hearing, regulators asked Mr. Systrom a third time about other offers: if there had been “any other inquiries from third parties about a possible acquisition of Instagram” after the Facebook deal was announced. Although Twitter executives had since tried to contact Mr. Systrom, he replied, “I and the board have not received any.”

The first annoying thing about Bilton’s column is that although he quotes Systrom at some length, he never provides a transcript of what was said at the hearing: we just have to trust him that he’s characterizing everything correctly. Bilton is happy to tell us what “the transcripts show”, so there’s no excuse for not showing us those transcripts as well. Once again, we’ve got a situation where the NYT doesn’t care about posting primary documents, and in this case there’s no copyright reason not to post them.

The second annoying thing about Bilton’s column is that he’s approaching decisions made in March with the benefit of great hindsight. “Given that the privately traded Twitter is expected to make $1 billion in revenue next year, which would increase its valuation considerably,” he writes, “Instagram investors might have made millions of more dollars.” But of course at the time that Systrom made his decision, he had no idea what Twitter’s 2013 revenue was going to be. And even Bilton, frankly, has no idea what’s going to happen to Twitter’s valuation next year: it’s just as likely to go down as it is to go up.

The third annoying thing about Bilton’s column is that he’s he’s desperate to find a deeper scandal here, beyond the issue of what Systrom said when under oath. The fairness hearing, he says, “sought to determine if Facebook’s acquisition of the photo sharing service was in the best interest of Instagram investors”, and it’s possible that if Instagram had put itself up for a more public auction, then the final sale price could have been higher. “It is possible investors would have been better off selling in an open auction, to Twitter or even to Google or Microsoft,” writes Bilton, as though it’s somehow self-evidently scandalous that anybody might ever sell their company for less than the maximum possible amount of money.

But the fact is that the fairness hearing was not at heart an attempt to see whether Instagram sold for the maximum possible amount of money. It was rather, as the name implies, an attempt to see whether the price paid was a fair one. It was necessary because Facebook issued new stock to pay for Instagram, and as a result of issuing stock the company had to go through an arduous registration process with the SEC. In California, a fairness hearing is just a cheaper and easier way of being able to issue stock without having to go through the SEC — so that’s what Facebook did.

Bilton’s most annoying sentence comes when he writes this:

Although it might seem unimportant whether wealthy investors made a few million dollars less than they could have, those investors often represent funds that include workers’ pensions and mutual funds.

Firstly, wealthy investors, just like much poorer investors, always make less money than they could have; no one ever succeeds in maximizing their returns. This is especially true of investors who take minority positions in closely-held private companies. As Bilton notes, Instagram was controlled by its two co-founders: they could and did, within reason, sell to anybody they wanted, at whatever price they wanted. What’s more, Systrom was no naïf in such matters: he had a previous stint in Google’s M&A department on his résumé. The venture capitalists who invested in Instagram, like all venture capitalists, knew full well that they were taking a risk that the founders might sell for less money than the VCs wanted.

It’s one of the most well-known and biggest risks in the VC business: when founders are faced with the opportunity to make an eight- or nine-figure sum for themselves, they are very tempted to accept that offer, even if they would be better off holding tight. What’s more, personal relationships often make founders more receptive to approaches from certain individuals (like Mark Zuckerberg) than from other potential acquirers.

A VC investing in Instagram, then, or any other company controlled by its founders, is well aware that if the founder decides to sell to a certain company at a certain price, then that’s what’s going to happen. Even when the founder doesn’t control the company, the same thing can happen: once Arianna Huffington decided she wanted to sell the Huffington Post to AOL, for instance, her investors basically had to go along. The people running the venture capital funds take those risks on behalf of their own investors, the limited partners in those funds. And if you’re not comfortable with such risks, you certainly should never be an LP in any venture capital fund.

And while it’s true that pension funds do sometimes invest a small percentage of their holdings in venture capital, that really doesn’t change anything. I see this kind of argument all the time: talk to any demonized vulture funds, for instance, and they’ll very quickly bring up the fact that some of their investors represent pensions and teachers and motherhood and apple pie. (For a classic example of the genre, take a look at the press release headlined “US teachers march on the Capitol for a solution on unpaid Argentine bonds”.)

Bilton’s wrong about mutual funds: they don’t invest in venture capital. But never mind that. Systrom controlled Instagram, and he sold it for a billion dollars before it had a single penny of revenues, making his VC backers lots of money in the process. He had every right to do that, even if there was a better formal offer on the table from Twitter or someone else, which there wasn’t. His minority investors were never an obstacle in his way, and they never had any right to hold out for a better deal.

In fact, the only obstacle between Systrom and the Facebook acquisition was antitrust concerns. If the antitrust authorities thought that Facebook and Instagram were getting together in a sweetheart deal to sew up a large part of the social-networking market, then they could block the whole thing. Systrom didn’t dissemble in front of the fairness hearing because he was worried about being accused of short-changing his minority investors. Instead, he dissembled in front of the fairness hearing because he was worried that the FTC might block the deal on antitrust grounds.

In any event, it’s the dissembling which is the story here, not the fact that Systrom might have been able to get more money from someone else. It’s not a crime to sell too low.

COMMENT

Yeah I get that they have to take the cash and mix/type of stock into account, but that’s more a matter of risk-adjustment than accepting a ‘low’ offer. I don’t think Systrom could have gotten a better offer, but if that’s the case why the shadiness?

If I had to guess, he set himself up for a higher acquisition cost by minimizing the antitrust concerns very early on. I don’t see any other motivation for refusing to physically take term sheets from other bidders, but IANAL.

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Why going public sucks: it’s not governance issues

Felix Salmon
Jul 17, 2012 18:14 UTC

Marc Andreessen agrees with me that it sucks to be a public company. But he disagrees on the reasons why:

Basically, it was very easy to be a public company in the ’90s. Then the dot-com crash hits, then Enron and WorldCom hit. Then there’s this huge amount of retaliation against public companies in the form of Sarbanes-Oxley and RegFD and ISS and all these sort of bizarre governance things that have all added up to make it just be incredibly difficult to be public today.

Andreessen, of course, as the lead independent director at Hewlett-Packard, knows all about “bizarre governance things”. But Sarbanes-Oxley and RegFD and ISS don’t even make it into the top ten. And as for the idea that they’re “retaliation against public companies”, that’s just bonkers; in fact, it’s really rather worrying that we have directors of big public companies talking that way.

The three things mentioned by Andreessen come from three different places: Sarbanes-Oxley came from Congress; RegFD came from the SEC; and ISS is a wholly private-sector company which allows shareholders to outsource the job of ensuring that governance at the companies they own is up to par. If there wasn’t significant buy-side demand for such services, ISS wouldn’t exist.

It’s directors’ job to care deeply about governance, rather than to dismiss serious concerns from legislators, regulators, and shareholders as “bizarre governance things”. And for all that companies love to bellyache about the costs of Sarbox compliance, the fact is that if you’re looking to governance issues as a reason why it sucks to be public, you’re looking in entirely the wrong place.

The real reasons it sucks to be public are right there in the name. Being public means being open to permanent scrutiny: you need to be very open about exactly how you’re doing at all times, and the market is giving you a second-by-second verdict on what it thinks of your performance. What’s more, while the glare of shareholder attention on the company can be discomfiting, it tends to pale in comparison to the glare of public attention on the company’s share price. I was on a panel last week talking about IPOs in general and Facebook in particular, and I was struck by the degree to which Mark Zuckerberg’s enormous achievements in building Facebook have already been eclipsed by a laser focus on his company’s share price.

Zuckerberg — or any other CEO — has very little control over his company’s share price, but once a company is public, that’s all the public really cares about. If Facebook’s share price falls, all that means is that external investors today feel less bullish about the company than they did yesterday; if it falls from a high level, that probably just says that there was a lot of hype surrounding the Facebook IPO, and that the hype allowed Facebook to go public at a very high price. Facebook could change the world — Facebook has already changed the world, and did so as a private company — but at this point people don’t care about that any more. All they care about is the first derivative of the share price. And maybe the second.

When companies go public, people stop thinking about them as companies, and start thinking about them as stocks: it’s the equivalent of judging people only by looking at their reflection in one specific mirror, while at the same time having no idea how distorting that mirror actually is. Many traders, especially in the high-frequency and algorithmic spaces, don’t even stop to think about what the company might actually do: they just buy and sell ticker symbols, and help to drive correlations up to unhelpful levels. As a result, CEOs get judged in large part by what the stock market in general is doing, rather than what they are doing.

And meanwhile, CEOs of public companies have to spend an enormous amount of time on outward-facing issues, dealing with investors and analysts and journalists and generally being accountable to their shareholders. That’s as it should be — but it isn’t pleasant. When Andreessen says that it was very easy to be a public company in the 90s, he’s right — but he’s wrong if he thinks the 90s were some kind of halcyon era to which we should return. They were good for Andreessen, of course, who took Netscape public in a blaze of publicity and more or less invented the dot-com stock in the process. But they were bad for shareholders, who saw their brokerage statements implode when the bubble burst. And, as Andreessen rightly says, they were bad for the broader institution of the public stock market, which has never really recovered from the dot-com bust.

As a venture capitalist, Andreessen has a fiduciary responsibility to his LPs, and he needs to give them returns on their investment, in cash, after five or ten years. It’s a lot easier to do that when you can exit via an IPO. But the way to make IPOs easier and more common is not to gut the governance that’s in place right now. Instead it’s to embrace it, and make public companies more like private companies: places where management and shareholders work constructively together and help each other out as and when they can. Mark Andreessen is a very active and helpful shareholder of the companies that Andreessen Horowitz invests in — and he has a level of access to management and corporate information that most public shareholders can only dream of. If he likes that system, maybe he should start thinking about how to port it over to public companies, as well.

Update: See also this great post from Alex Paidas, who’s found a quote from Andreessen saying that all of his companies should have a dual-class share structure. Despite the fact that I can’t ever imagine Andreessen himself being happy with non-voting shares.

COMMENT

I heard Andreessen speak at the Stanford Directors’ College a few weeks ago. In addition to the type of rhetoric you describe he also said that if there was a way to get his money out of startups without going public he’l do it and if he has to go public he’ll only do it going forward the “controlled company” exemption the very specific exemption to exchange rules on corporate governance rules that gave Mark Zuckerberg all the power one his company and his board. Basically the board at Facebook serves at his pleasure.

Reed Hastings, a Facebook board member, said at the same event that he was still trying to decide of that made sense for him, given his philosophy that a board’s most important job was to hire and fire the CEO. If a board member can not take a position adverse to the CEO without the risk of being removed, what’s the point?

I’ve decided Andreessen is good for Andreessen but not so much for the rest of the capital markets.

Posted by retheauditors | Report as abusive

How venture capital is broken

Felix Salmon
May 7, 2012 15:17 UTC

I read quite a lot of papers about finance and investing, but I can’t remember the last time I came across a 52-page paper which I simply devoured, avidly, reading every word, and even following the footnotes. But such is the latest publication from the Kauffman Foundation, a truly wonderful report on the foundation’s own experiences in the world of venture-capital investing. This is required reading for all institutional investors with any kind of exposure to VC, and I sincerely hope that it succeeds, at least at the margin, in forcing those institutional investors to behave a bit more like investors, and a bit less like chumps being bullied into throwing millions of dollars into a series of opaque black boxes delivering decidedly subpar returns.

The Kauffman Foundation was created to encourage entrepreneurship; its endowment currently stands at some $1.83 billion. Of that, $249 million is invested in VC and growth equity funds; the foundation has been investing in VCs for 20 years now. As a rich, long-term institutional investor devoted to the cause of early-stage companies, the Kauffman Foundation is — or should be — pretty much the perfect LP as far as VC funds are concerned. And indeed, over the years, it has invested in 100 such funds, and therefore now has a spectacular real-world backward-looking dataset of VC returns from an LP perspective.

This is the kind of dataset that money, literally, can’t buy: VC funds’ investment agreements have such tight confidentiality clauses that Kauffman and other institutional investors would never be allowed to share this information with anybody else. But by anonymizing their data, and by self-critically coming clean on their own returns from venture capital, Kauffman’s investors have managed to put together a detailed and compelling report with a very simple conclusion: venture capital is not much of an asset class, and insofar as it is an asset class, it’s very, very broken.

Over the past 20 years, net of fees, Kauffman has been paid out 1.31 times, on average, the amount that it invested in any given fund — well below the standard “venture rate of return” of twice committed capital. The payout is meant to come after no more than 10 years, but the 10-year figure is honored mainly in the breach: Kauffman alone has 23 funds more than 10 years old, and eight funds more than 15 years old. One fund, at age 19, still retains more than 20% of the capital that Kauffman committed way back in 1992.

Here’s the bigger picture: the total amount returned by all of Kauffman’s funds. The red line is at that 1.31x average multiple:

returns.tiff

This is very much a short-head, long-tail dataset, with the short head having high returns and the long tail being decidedly disappointing. What’s more, the really high returns in this chart — the ones which achieve that “venture rate of return” of 2x committed capital — come exclusively from funds with less than $500 million committed: something which is very rare among top-tier VCs these days. What’s more, most of them also come from funds raised before 1995. If VC funds were good investments once upon a time, they’re not any more:

vintages.tiff

In reality, VC returns have been dismal for the past 15 years:

During the twelve-year period from 1997 to 2009, there have been only five vintage years in which median VC funds generated IRRs that returned investor capital, let alone doubled it. It’s notable that these poor returns have persisted through several market cycles: the Internet boom and bust, the recovery, and the financial crisis… In eight of the past twelve vintage years, the typical VC fund generated a negative IRR, and for the other four years, barely eked out a positive return.

I’m all in favor of investment strategies which display low-volatility returns, but only when those returns are actually positive; in reality, according to this report, the average VC fund returns less money to investors than they invested in the first place.

The Kauffman report makes a very strong case that the best way to look at VC returns is to benchmark them against a liquid public stock index: they like the Russell 2000 small-cap index. If you do that, you get a chart which looks a bit like this. The x-axis is PME, or public market equivalent: if a fund is lower than 1, as most of these are, then you would have been better off just investing in the Russell 2000. And while there are certainly funds which massively outperformed that index, in order to get that kind of performance you really need to invest your money before 1995, to take full advantage of the dot-com bubble.

pme.tiff

Given the high fees and the illiquidity and the inherent risks of venture-capital investing (the Russell 2000 can’t go to zero, a venture fund can), it’s reasonable to expect a venture fund to return at least 3% per year over and above the Russell 2000. Using that metric, 78% of the funds that Kauffman invested in have failed. And remember that Kauffman has more access to the top-tier firms than most VC investors.

But the really interesting thing about the Kauffman paper is that it doesn’t blame the VCs for this underperformance. Instead, it pins the blame squarely on the LPs — the investors who irrationally invest money with VCs.

The first thing they do is have a “VC bucket”, which then turns them into “bucket fillers”. VCs love bucket fillers, because an LP with a bucket is an LP with no ability to invest in something better instead, like the Russell 2000.

GPs we interviewed are very aware of “bucket filling” behavior, and said LPs with VC mandates act like the money is “burning a hole in their pockets.” They just need to spend it. Institutional investors governed by mandates presumably attempt to get into the ten to twenty top-tier VC funds; but if they can’t, they’re left to choose from second- and third-tier funds—a strategy that nearly guarantees returns unlikely to exceed a low-cost, liquid, small cap public index.

If you look at the performance of VC funds during the golden years of 1986-1999, it turns out that once you strip out the top-performing 29 funds, the rest — more than 500 — collectively invested $160 billion, and managed to return $85 billion to investors. If you can’t get into one of the best funds — and everybody knows which funds those are — then there’s really no point investing in venture capital at all. But what happens is that some investment board looks at VC returns inclusive of the best funds’ returns, and then mandate a certain investment in VC which assumes they’ll have some kind of access to those top-tier funds. And that’s an extremely dangerous assumption to make, because most of the time it won’t be true.

The second thing that LPs do is that they pay VCs to raise lots of money, rather than pay them for returns. Most of the income in the VC industry comes from the 2 bit of 2-and-20, rather than the 20 bit. Which means, as the report puts it, that “while a select group of VCs remain focused on delivering great investment performance to their investors, too many are compensated like highly-paid asset managers.”

As such, these GPs have every incentive to exaggerate early-year returns in their funds, despite the fact that the whole point of the way the funds are structured is to allow long-term investments which don’t pay off until many years down the line. Here’s the most astonishing chart from the report:

curve.tiff

What you’re looking at here is the self-reported returns from all 100 of the Kauffman foundation’s funds, plotted on a time zero axis. In theory, if you believe the VC industry’s hype, the returns should look a bit like the green line: negative in early years, as you make investments which won’t pay off for a long time, and then positive by year 10.

In reality, reported returns peak very early on, in month 16 — which just happens to coincide with the point at which the GPs tend to start going out on sales calls, trying to raise their next fund. (The blue line shows total fund returns, while the red line shows returns net of fees — the money which actually goes to LPs.) Of course, at month 16, none of the returns are realized: they’re driven instead by increases in portfolio-company valuations, and those valuations are set by the GPs themselves.

If GPs were incentivized mainly by their 20% performance fee, then you’d expect something like the green line, or at the very least you’d expect the performance to rise over time, as the fund’s illiquidity premium manifested itself. If GPs were incentivized mainly by their 2% management fee, however, then you’d expect something much more like the real-world red and blue lines, where performance figures are used more to raise new funds than to make money.

Here’s how the report explains GP math:

Data from the Foundation’s portfolio indicate that the median time to the first capital call of a subsequent fund is 26.6 months. As a thought experiment, assume a VC partnership raises a $250 million fund. Early in year three, exhibiting early positive IRRs, the firm raises a subsequent $350 million fund. Demand for Fund III remains strong, and the GPs raise another $500 million fund later in year five. Each new fund adds a fresh income stream to the residual fees older funds continue to generate over the ten-year life. Without visibility into the firm financials, LPs don’t see the total cumulative management fees the firm receives, and, more importantly, don’t know where those fees go. In this theoretical example, a moderately successful VC firm raises three smaller-sized funds within the investment period of the first fund; and the operating income climbs to more than $19 million by year five. Our experience would indicate that VCs may somewhat increase fixed costs like additional staff with subsequent funds, but in most cases expand very conservatively.

The Kauffman foundation has lots of bright ideas about how this misalignment of incentives could be fixed: for instance, investors in VC funds could ask for much more transparency on the costs of running those funds, pay a budget-based management fee instead, and then pay a performance fee which rises sharply when the fund genuinely outperforms the public markets. For instance, it could be 20% when the public markets are outperformed by 3%, 25% if the outperformance is 5%, and 30% if the outperformance is 7%.

Ian Charles ran an intriguing experiment in 2008, when he asked LPs how much of a performance fee they would be willing to pay to get into a top-performing, $250 million fund. He got bids as high as 72.5%, and a market-clearing level of 42.5%. Clearly it’s possible, in theory, for top VCs to charge much higher performance fees than they’re charging right now, and some of them are OK with budget-based management fees, too.

But here’s the weird thing: it’s the LPs, much more than the VCs, who are averse to any change on the compensation front. Investors, it turns out, are extremely conservative, and don’t want change even if it’s in their best interest.

One startling fact from the report explains why that might be the case:

Our own casual review of institutional private equity investors reveals median job tenure of around three years. There is much turnover at the LP investor level, which creates little incentive for any one investor to fight hard on behalf of their institution for better economic terms, especially if they are not getting paid for that outcome and views such behavior as harmful to industry ‘relationships,’ which the investor likely will find beneficial in landing their next job.

What this says to me is that the VC industry, as a whole, is being incredibly successful at extracting rents from dumb institutional investors. These investors wouldn’t dream of investing in a public company where there was no transparency as to basic questions like how much money the principals were being paid, but they happily invest in venture capital funds where the founders cream off so much of the income that younger top performers end up leaving the firm. And in general, VCs are incredibly good at playing fear off against greed: would-be investors really want massive VC returns, and they really don’t want to be left out in the cold. Even Kauffman does that: “We have chosen to stand down on terms,” they write, “when faced with an investment decision in a top-tier fund.”

The big picture, here, is that an enormous number of institutional investors are still chasing VC returns which haven’t really existed in the industry since the mid-90s. So long as all that money is chasing a relatively small number of opportunities, and especially now that valuations for early-stage tech companies are going through the roof, the chances that the average LP will make any money at all in VC are slim indeed. Venture capital is sexy, and it makes a lot of money for GPs. But investors need to take a very hard look at the asset class, and ask whether it’s worth it from an LP perspective. After reading this report, they should probably conclude that it isn’t.

COMMENT

The trend was on its boom in 1996, but then it decreases. The basic reason could be that people believe on equity investment. They just use to float stocks in the market to get some funds. http;//investmentfinancialmanagement.blo gspot.com

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Why dividend cash-outs are evil

Felix Salmon
Oct 2, 2011 15:56 UTC

Investor Chamath Palihapitiya wrote a strongly-worded letter to Airbnb CEO Brian Chesky yesterday, which promptly got leaked to Kara Swisher.

Palihapitiya was given the opportunity to invest in Airbnb’s latest round, but declined, partly because of the way it’s structured. Airbnb’s executives are taking $31 million in cash as part of the deal, and Palihapitiya was actually OK with that. But his problem was that $22.5 million of that is coming in the form of a dividend — which makes it look pretty evil, in an early-stage company where many employees only have options.

“If you want liquidity, that’s fine, but you should make it available to everyone,” wrote Palihapitiya, adding that “dividends are an approach used by cash rich operations to distribute excess earnings”.

In case Palihapitiya’s point isn’t clear, let me explain with a much simpler company, with just two founders and one new shareholder.

Adam and Bill set up a company — let’s call it Bubbl. The way the structure is set up, Adam has 1 million shares in Bubbl, while Bill has 1 million options to buy Bubbl stock at $1 per share. Bubbl is successful enough that potential investors start circling, and eventually a deal is done whereby Charles will pay $1 million to buy 200,000 shares at $5 per share.

Historically, such a deal would be pretty simple. Bubbl issues 200,000 new shares, which are sold to Charles for $5 each. And so after the investment, Adam still has his 1 million shares, Bill has his 1 million options, and Bubbl has $1 million of cash in the bank. Working on the assumption that at some point Bill will exercise all of his options, Adam’s stake in the company has gone down from 50% to 45.45%, since the total number of fully-diluted shares outstanding has risen from 2 million to 2.2 million.

Adam’s now worth $5 million on paper: he owns 1 million shares which are worth $5 apiece. And he owns 45% of a company with $1 million in the bank, so in a sense he has $450,000 in cash. But he can’t spend that cash — it belongs to Bubbl, not to Adam. The problem is, Adam wants to buy a nice house. And Bill, too, likes the idea of making some fast cash. So instead of doing this kind of old-fashioned deal, Adam and Bill decide that they’re going to do a cash-out deal instead.

Charles still buys 200,000 shares at $5 each, but Bubbl doesn’t issue any new shares this time. Instead, Adam simply sells Charles 100,000 of his 1 million shares. And Bill exercises 100,000 of his 1 million options, buying 100,000 shares at $1 each and immediately selling them to Charles for $5 each.

At the end of all this, there are still only 2 million fully-diluted shares outstanding. Adam owns 900,000 of them, which gives him the same 45% stake. But he also has $500,000 in cash. Bill has 900,000 options, and $400,000 in cash. And Bubbl has $100,000 in cash, which it got paid by Bill when Bill exercised his options.

Now, let’s take our first step into the world of evil, and suppose that Adam doesn’t feel any particular need to look out for Bill’s interests. Bill isn’t a shareholder yet: he just has options. So instead of letting Bill exercise some of his options, Adam decides to sell the full stake to Charles himself. His shareholding drops to 800,000 shares, he gets $1 million from Charles, and he ends up with a 40% fully-diluted stake in the company, compared to the 50% stake that Bill will have when he exercises his options.

Adam’s choices here are pretty clear. He can make sure that Charles’s $1 million stays in the company, take no cash for himself, and end up with a 45.45% stake. He can put just $100,000 of Charles’s money in the company, take $500,000 of it for himself, and still end up with a very similar 45% stake. Or, he can take all of Charles’s $1 million in cash for himself, and end up with just 40% of Bubbl.

Or, Adam could get really evil. This time, Bubbl issues 200,000 shares to Charles in return for $1.2 million. Bubbl then has $1.2 million in the bank, and distributes all of that money to its shareholders, as a dividend. Now remember that Bill only has options: he doesn’t have any shares. The only shareholders, right now, are Adam, with 1 million, and Charles, with 200,000. So Adam gets $1 million of the dividend, while Charles gets $200,000 of his own money back.

The net result for Charles is the same: he’s spent $1 million in total, and received 200,000 shares. But Adam is sitting pretty: he has 45.45% of the company, plus $1 million in cash.

This is a much better option, for Adam, than the other three: he manages to maximize his fully-diluted shareholding in the company, and get $1 million in cash. Adam has cashed out, here, but has also kept all of his shares: a classic case of having his cake and eating it. And Bill, of course, gets nothing: no cash, and no cash in Bubbl’s bank account, either. In fact, he’s been diluted. If Adam just sold some of his shares to Charles, then Bill would retain his 50% stake in the company after he exercised his options. But this way, Bill gets diluted down to a 45.45% stake.

Essentially, Adam is taking money from Charles, and he’s taking equity from Bill. At least Charles is getting something in return: Bill isn’t.

Which explains what Palihapitiya was thinking when he wrote this:

I would implore you to not take the easy way out. Treat your employees the same as you’d treat yourself. Do things that you will be proud of and can defend to anyone including your Board, employees, prospective hires etc. In such a competitive hiring market, you are competing with not just your obvious competitors, but also any successful tech company who is also looking for great talent. A principle that treats your employees as well as you’d treat yourself is a huge strategy for differentiation, retention and long term happiness of the exact types of people you will need to be successful. In contrast, if you are viewed as self-dealing and shady, it will only hurt your long term prospects.

It was only two months ago that Chesky was forced to grovel to the public, admitting that he had “really screwed things up” when a woman’s apartment was ransacked by Airbnb guests. He’d learned, he said, that “you should always uphold your values and trust your instincts”. One’s forced to wonder, given the structure of this latest round, just how long that lesson lasted.

Update: Palihapitiya has now written a follow-up letter to Kara Swisher, “prepared in discussion with Chesky and Airbnb’s board”, in which he says that he will participate in the round after all, in return for promises from Chesky to allow employees to cash out in future. In contrast to the original letter, it’s full of jargon (“strategic intent to balance employee and founder liquidity which will align long term interests”) and seems to represent the triumph of greed over principle.

COMMENT

Felix, nice article. This kind of behavior is becoming more and more common in Silicon Valley deals. I wrote up my own experience with an acquisition where there were some questionable aspects to the deal. http://www.mischievous.org/2011/10/quest ions-of-fairness-in-silic.html

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Skype’s options plan and Silicon Valley norms

Felix Salmon
Jul 7, 2011 14:50 UTC

Steven Davidoff has published two recent columns on l’affaire Skype. The first takes a familiar position: that Silver Lake isn’t evil, it’s just a private-equity shop. I would however take issue with this:

The easy lesson here is the need to carefully read contracts before you agree to them and hire a lawyer if you don’t understand them. The language Mr. Lee complains about was certainly legalese but heralded caution.

Remember the language he’s talking about here. It’s one sentence of an 11-page stock option grant agreement, buried in a paragraph about IPOs:

If, in connection with the termination of a Participant’s Employment, the Ordinary Shares issued to such Participant pursuant to the exercise of the Option or issuable to such Participant pursuant to any portion of the Option that is then vested are to be repurchased, the Participant shall be required to exercise his or her vested Option and any Ordinary Shares issued in connection with such exercise shall be subject to the repurchase and other provisions in the Management Partnership agreement.

Yes, this is legalese. And what’s more, it doesn’t actually explain what Skype is doing; it just refers to some other, presumably equally unreadable, agreement. But here’s the thing: if you did read this sentence carefully, it still wouldn’t raise any red flags. Because it looks very much like something which is standard practice in Silicon Valley: when you leave a company, you need to exercise your vested options very quickly — normally within three months. If you don’t, then the company can claw them back.

So when Davidoff says that Lee’s failure to carefully read his contract is “baffling,” he’s being too harsh. Even a careful reader would have missed this one. And that’s why Skype was evil. If they’re going to have aggressive clawback provisions in their contract, they shouldn’t bury them in incomprehensible legalese: they should be open about what they’re doing.

Davidoff followed up his first column with a second one which only served to make everything worse. The headline: “Skype Not Alone When It Comes to Options.” And here’s the little summary you get in your RSS feed:

Silver Lake may have imposed a greater penalty, but LinkedIn, Google and others in Silicon Valley have similar requirements for vested options.

Um, what? This is simply not true. Silicon Valley standard practice is clear: you have every opportunity to exercise your vested options when you leave a company. Skype took that opportunity away. That’s not “similar” at all. Being able to exercise your options when you leave is always better than not being able to exercise your options when you leave. It has, if you’ll excuse me, option value. But Davidoff contrives to believe that standard Silicon Valley options language “is no worse than the legalese in the Skype documents that Mr. Lee complained about”.

He’s doubly wrong here. For one thing, standard Silicon Valley options language, while not exactly plain English, is still vaguely comprehensible. It gives a clear deadline of three months after you stop being employed at a company, and says that options expire at that point. On the saying-what-they-mean front alone, Silicon Valley companies win here.

And more substantively, those companies are giving exiting employees the opportunity to share in some of the growth they’ve helped to achieve.

Davidoff is underwhelmed:

This provision forces former employees to exercise their options while the company is still private and the true value unknown. In addition, the fair market value of the option may be very low and at or near the exercise price. It certainly isn’t at the initial public offering price.

Given the risks involved, employees are likely not to want to pay the exercise price out of their own pocket.

It’s hard to know where to start here. Silicon Valley companies might be private, but that doesn’t mean they’re unvalued. They tend to raise multiple rounds of capital at steadily increasing valuations; if you’ve stayed at the company long enough to see a new fundraising round, then automatically your options are in the money. And increasingly equity in these companies is priced on private markets like SecondMarket and SharesPost. It’s true that the price of the equity isn’t the IPO price, but then again the price of a company’s equity is almost never the IPO price. (Employees in Pandora, for instance, are unlikely to get the IPO price for their options, even after it has gone public.)

And certainly options are risky assets. Everybody in Silicon Valley knows that. When you leave a company, you have a 3-month-long opportunity to buy stock in a private company at a level which is probably a very good price. Many people in Silicon Valley would jump at that opportunity, especially if they’re senior enough that they have a bunch of cash lying around. Certainly some employees will pass. But that’s the employee’s choice. It’s clearly better to have the choice than to not have the choice.

Yee Lee thought he had the choice — and decided he wanted to exercise his options. He knew the rules, knew he had to make his choice quickly, and made that choice. He informed Skype’s HR department of what he wanted to do, in a more than timely manner — and then spent a month going back and forth with them, before learning that Skype was refusing to let him exercise his options at all.

Davidoff’s second column seems to be aimed at unnamed “commentators” who don’t understand Silicon Valley standard practice, and who think that vested options can be held in perpetuity after you’ve left the company. That’s not the case. But that hardly makes Google as bad as Skype. Not even close.

COMMENT

I’ve been subject to repurchase agreements in at least two startups, and I’ve always had to either sign a separate repurchase agreement, or the repurchase language was included in the stock grant documents.

In the Skype case, it *appears* as if the only details on repurchases are in the management partnership agreement. If the employee was also given a copy of that agreement, then perhaps you could argue that he should have understood it. Otherwise, I’d agree that the whole thing is very deceptive.

Realistically, for documents this complex, employees should have been given a summary as well.

BTW, repurchases are not always at FMV. The agreements I participated in were at the exercise price, not FMV. They existed because I was granted shares, not options, and the repurchase agreement effectively implemented standard vesting by granting repurchase rights at the initial price over shares that hadn’t vested.

In any event, I’d agree with Mr Salmon that Skype is being outrageous here, and that its behavior and terms are well outside of SV norms.

And for $1M? Skype’s new owners are crazy. They’ve basically labeled themselves as dishonest, and it will definitely cause them recruitment problems going forward, at least among those not desperate for a job.

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