Thinking About Thinking

Founder Liquidity

Posted in Venture Capital by larrycheng on December 15, 2009

The sentiment towards founder liquidity among investors seems to swing back and forth like a pendulum.  Founder liquidity refers to instances when an investor invests capital to buy shares directly from a founder rather than or in conjunction with investing capital that goes into the company for traditional working capital purposes.  When capital goes to a founder rather than into the company, there is typically neither an economic benefit or an economic cost to the company (though there may be non-economic benefits and costs). 

Why would an investor be willing to use their capital for founder liquidity?  Typically it’s because they want more ownership in a company that already has sufficient working capital.  By acquiring shares directly from the founder, they can increase their ownership without increasing the post-money value of the company.  Often times, founder liquidity is used for more mature companies that are profitable and hence the only opportunity for a new investor to gain an ownership stake is by providing the founder or other shareholders with liquidity. 

Why don’t investors want to use their capital for founder liquidity?  The drawback of using capital for founder liquidity is that the capital does not go into the company and therefore has no impact on helping the company to grow.  Using a limited resource like capital in a non-accretive way is viewed quite negatively in bad economic times when capital is scarce or in situations where the company might need more working capital in the future.  Another issue related to founder liquidity is whether it impacts the motivation of the founder or is viewed negatively by other employee/management shareholders who do not get liquidity themselves. 

Why do founders want liquidity?  The most common reason is that they have bootstrapped the company, taken on substantial personal debt, and have foregone all other forms of wealth accumulation to take the company to it’s current state.  By taking some liquidity, they can strengthen their personal balance sheet and “go for a bigger win” at the company.  Other times founders want liquidity because they are no longer actively involved with the company and are seeking to clearly separate from the company.  In this instance, it’s of value to the company and investors to not have any possible dissident shareholders involved as well. 

What’s my take on founder liquidity?  Using capital for founder liquidity is a viable use of proceeds for more mature companies but it has to be done in a disciplined way.  It has to be the right kind of company and, as importantly, the right type of founder.  The right kind of company is one that does not need additional working capital and is highly predictable in nature.  The right kind of founder is one whose focus, energy, and motivation will remain productive and positive despite a suddenly improved personal balance sheet.  The two must be in place: right company, right founder.   

I have seen a number of examples where founder liquidity has been a positive instrument for all parties involved.  So, I have and will continue to support using capital for founder liquidity in very specific instances.  That being said, I think a great predictor of success for a growth stage company is when a founder who could take liquidity – chooses not to.  There may be no more significant of a vote of confidence a founder can give his or her investors than to forego liquidity and press ahead.  While I don’t know for sure, I doubt that luminary founders like Steve Jobs (Apple), Jeff Bezos (Amazon.com) or Larry & Sergei (Google) took liquidity while their companies were private.  If true, it’s a fact pattern worth emulating because in their case, it turned out to be the best financial decision they could have possibly made.