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December 24, 2006

Founder sales gets formalized

San Francisco Chronicle (via Venture Beat) reports on how The Founders Fund has formalized the process of a partial buyout of founders by VC investors through a new class of founder stock called the "FF Class" Stock. (See my earlier posts on this topic here and here.)
Inspired by his personal frustrations as a startup founder, (Sean Parker) came up with a novel arrangement that he hopes will benefit other founders as they build their companies: a new type of stock that allows founders to cash out a small percentage of their stake in a funding round so they don't have to wait until the company is sold or goes public.

Pell, who maxed out credit cards, deferred salary and considered taking out a second mortgage until he could raise serious money and interest from the right investors, says he's relieved that he and his fellow founders don't have to feel rushed to sell the company to get some return on their investment of energy, time and money.

"There is often a tension between venture capitalists and founders. The venture capitalist wants the founders to starve and to have no cash liquidity until the very end. Of course, the founders, unlike the venture capitalists, are putting all of their eggs in one basket," Pell said. "Sean came up with the idea of allowing founders to sell small amounts of their shares along the way so you can have some life-changing effects and reduce your risk and everyone can be aligned for a home run."

Eric Olson weighs in with his support for FF Class stock.

I do think that there are clear benefits to investors especially in the new age of web start-ups where companies don’t need a lot, or any, outside capital to get things moving. The example I go to time and time again is Flickr.

VCs were looking to put money to work in Flickr previous to the Yahoo! acquisition and we all know that some money was left on the table by the founders. Can you blame them though? These were their options (simplified of course):

1. Let a VC or VCs take a bunch of the company away from us, sit on our board and decide where our baby should go and, since they’ll push us to a huge exit, we may possibly never make it and walk away with $0 (while the VC still has a number of portfolio companies and is diversified).
2. We can pocket $20+ million and get nice jobs at Yahoo! as well.

However, if a fund came in and allowed them to have some of their stock set aside and available to convert in a later round/issuance of stock for a small amount of liquidity they may have went for the big win and taken the VC money. In that case the founders would have probably made more and the VCs would have had a winning investment.

With more companies able to start up with no outside investment VCs will need to start innovating and providing incentives to entrepreneurs to get the best deals.

Arun Natarajan is the Founder of Venture Intelligence, the leading provider of information and networking services to the private equity and venture capital ecosystem in India. View free samples of Venture Intelligence newsletters and reports.