Loading...
Loading...
Founders are expected to put on a tough face. They take on massive risk, responsibility, and leadership roles, when they choose to found a company.
On the one hand, like any leader, a founder needs to be the torchbearer for their business. On the other hand, no amount of confidence justifies 99% financial exposure to a single asset. To refuse to diversify is a grand gesture that may be romanticized by the risk seeking startup industry. But it is excessively risky for founders.
But at some point, “walking the walk” needs to be balanced with reason. A secondary sale can reduce exposure, but it’s not an option for most founder equity positions. And secondary transactions are very limited in size, relative to a founder’s holdings.
Rationally, a founder should diversify at least a small portion of their startup equity. But how do they balance their own responsibility with the social expectation of 100% exposure? What is the right balance between self-preservation and self-sacrifice, when it comes to startup stock?
It’s the founder’s job and responsibility to convey the utmost confidence and belief in the company, because they are the foundation of the startup. Investors, employees, customers, and more are looking to the founder. From this perspective, a founder should carry a huge portion of the business until complete exit, as to project the greatest possible confidence. Startup company equity gets built around high-conviction founders.
On the other hand, if a founder has 90 or 95% of their net worth in their business, it shouldn’t impact their motivation. Furthermore, their investors should be able to analyze the facts and accept this reality. Especially if the diversification is of the cashless sort, like equity pooling.
The “prize” for the founder is large. If the business ends up failing, having 5% of their founder stock in an equity pool would guarantee a respectable outcome, from many years of hard work.
This makes a lot of sense. A small diversified outcome in the face of failure is much more positively impactful than retaining a little more of a very large exit. From this perspective, a founder should always be inclined to diversify a small bit of their equity.
But for a variety of reasons, the founder has trouble doing this.
There’s the emotional angle. They’ve sacrificed so much to get the company to this point, that every bit of equity is precious to them. They understand quite well what they’ve had to fight for to build and retain and they are hesitant to give anything up. It’s hard to trade those shares for anything, except an exit.
There’s the signaling angle. Even if a founder is acting rationally in hedging their risk, they may worry about the signal they give off to their constituents. In reality, a founder should always be expected to take responsible steps to protect their wealth and their family. So long as their deep dedication to the business is not compromised.
But in reality, founders may worry about how they may be perceived. Even if they have perfectly logical explanations for their actions and even if such judgments are unfair.
Another source of tension lies in how founders utilize their option pools, to attract and retain talent.
On the one hand, founders want to drive alignment with their top employees and the business. They want these people to be wedded to the business’ success and to share in its upside. From that perspective — the options are to drive alignment with the business, not just an economic benefit.
On the other hand, options themselves are an imperfect incentive mechanism.
Many non-founders don’t value the equity as much as the founder does, yet the founder must give it away as a matter of course.
Furthermore, a founder cares deeply about employee retention, yet giving away a single, concentrated position invariably leads an employee to overexposure. Many executives would more appreciate having a portfolio of options, rather than those of the single company they work at. And having substantial representations from that company within that portfolio should be enough to align the executive or employee.
At the end of the day, the startup ecosystem is full of incentive systems that are lacking in nuance. And the founders and employees suffer from this.
Founders don’t need 100% exposure, to care just as deeply about their business. And employee grants don’t need to be 100% concentrated positions either. If anything, some diversification would make both founders and employees more at-ease and more aligned with building great companies, vs. worrying excessively about their downside.
The best startups notice and exploit a nuanced point of view about a market, product, or industry.
Founders should realize that there is a nuanced decision to make, concerning their own exposure. And the extent to which they disagree is the extent to which they’ve been socialized by the venture ecosystem to accept more risk than is necessary.
By being aware and honest about these tensions, founders are better positioned to advocate for their own safety and well-being, even at the expense of some of the stubborn and dogged optimism that they have grown accustomed to carrying.
Most VCs are “founder friendly” for the sake of marketing. In terms of how they actually do business, they are often ruthless and one way in which this manifests itself is putting pressure on founders to be all-or-nothing. In reality, this is detrimental to themselves and the whole ecosystem, in the face of alternatives.
Fortunately, good VCs don’t accept the status quo as a given. They are open to new investments and ideas that have rational and strategic merit.
They can apply this paradigm to exploring new investments and to their own industry as well. There are things that can be changed and improved and if anyone can realize the truth of this particular reality, it's the perceptive VCs themselves.
One of the most overdone and stagnant ideas in startups is that of founder and employee exposure.
Yes, VCs often need founders to shoot for the moon, to make the economics of their fund work out. And yes, to create this alignment, they should want their founders to be highly-incentivized and exposed to their business.
That said, “founder alignment” has for too long been approached with blunt tools. In the modern startup economy, a more nuanced application of VC/founder alignment is more appropriate. And it would lead to both greater startup outcomes, as well as a more ethical and responsible industry.
The headline says it all. Founders should have more safety, if it will keep them just as motivated to build great companies.
If a founder has 95% of his net worth instead of 99% of his net worth in his startup, he does not care any less about the company.
If anything, we can make the rational, bold, risk-seeking decisions around company growth that the VCs want him or her to make. Instead of fearing and protecting against downside.
Now, a VC might think “but if they take home too much cash, that could ruin alignment. There’s no way to make our founders more ‘investor-like’ in their approach to growing their businesses, without demotivating them financially.”
We partially agree.
Substantial cash liquidity can alter the motivation of a founder to his company, even if he holds meaningful net worth in it. There may not be the same hunger, after taking home lots of cash.
But if the diversification is cashless, the issue falls away. We are left with greater founder safety and wellbeing, without any of the negative incentives or misalignments.
If a founder puts 5-10% of his stake into similarly promising companies, his bank account and monthly cashflow stay the same. He is still grinding it out at the company, hungry to grow the business and earn his paycheck. He doesn’t have a liquid safety net to pull from.
Even if there are near-term exits in his diversified holdings, they are relatively minor events. The founder would not expect to see large exits for many years from their other private market bets, and even when they do, it would be against a position that was only worth about 1% of their equity, or far less.
It’s the kind of money that helps with school tuition and mortgages, not second homes and boats.
And this is exactly where we want founders to be safest. Keeping a financially stable, functional, and happy home. Being able to take care of their loved ones, while being dedicated to a risky and demanding job. To be able to “go big” and not feel as if they may have nothing to show for their efforts but a low salary and many missed family events.
If one takes the time to think through “what could go wrong”, if a founder was to diversify a few points of their holdings with other similar companies, in a cash-free way — one would struggle to come up with anything meaningful.
One can throw out broad platitudes like “founders should be all-in”, but that misses the nuance of why a founder should be all in, and more importantly it dismisses the human element as well.
If a founder can be safer and more motivated without harming alignment, one is being a good person and staying on the right side of history, by enabling that. Especially when they hold a position of relative power, to a founder who may be afraid to pick up his head and ask to do this, even though its right for his or her family.
History judges people by major moral decisions that one had the power to make. Helping startup founders and employees be safer, amidst a growing affordability crisis, is a mantle that VCs should pick up.
The industry needs to hear from their investors and boards that “we see you. We know you care about the company. We understand that this won’t make you care less. We want you to be as safe as possible, along a risky journey”.
If VCs can stand against the truisms and assumptions of their own industry, as they have collectively done across many others, then we can build a startup ecosystem that produces more success, while keeping its participants safer.
Aaron is a Chief Investment Officer & Co-Founder at Aption. Prior to Aption, Aaron was an experienced and accomplished VC, serving as a General Partner with Aleph, and prior to that, as an investor with Insight Partners.