‘Development capital’ – money invested in a business to support and accelerate its growth – is one of the principal uses of private equity and venture capital (‘VC’) funding, alongside financing management buy-outs.
When considering development capital opportunities, investors will traditionally express concern if an entrepreneur or members of the management team also want to take some cash out of the business at the same time. In theory, this makes sense: investors want the team focused on building capital value for a future exit; they don’t want this motivation eroded by a large financial cushion.
Taking the money
The issue was raised in the (recent) VC funding of Snapchat, an early-stage mobile file sharing app in which $20m cash was paid to the co-founders. In a recent CNN Money article, Dan Primack called this an act of ‘desperate lunacy’ on the part of Snapchat’s new investors.
While the sums involved are large, for an early-stage investment, the tensions in this deal are no different to those in any other:
Financial security Vs Loss of motivation – Mature investors recognise that hard-working entrepreneurial teams, which might have been paying themselves little or nothing over the past few years, might need relatively modest sums of cash for entirely sensible reasons – such as repaying part of the second mortgage they took out to finance the business in the first place! It’s not necessarily a bad thing for a team to be able to worry less about their own personal financial situation, provided they’re still motivated to build the value of the business. It’s not clear how focused the average twenty-something will be with a $10m windfall.
Operating Risk – in the media:tech space there is always a risk that a company will go from boom to bust overnight. By taking some money off the table at an early-stage, the founder is redistributing risk to the VC investor and creating more of an equal playing field. Don’t forget that the founder will have most (if not all) of his eggs in a single basket, whereas the VC benefits from a portfolio of different investments with different risk profiles.
Exit Risk – In response to the weak initial performance of Facebook shares following its IPO, a number of companies delayed or cancelled their own IPO plans (e.g. the US online travel service Kayak). The uncertainty surrounding public equity markets increases the risk attached to this exit route for a VC investment. However, this risk impacts founders and VCs alike and does not necessarily justify a significant cash payment to the founder.
Competition for Investments – The simple lack of attractive deals in the current climate has predictably boosted the bargaining power of the founders of high-growth businesses. VCs may feel they need to offer such terms to get a seat at the table.
So how much is too much?
The answer is always ‘it depends’ – not least on the personal circumstances of the managers in question. Using cash out to pay off a second mortgage is very different to using it to buy a second Aston Martin.
But as a general rule of thumb, a 50%/50% split in a private equity (rather than venture capital) transaction strikes many as a sensible starting place, where investors can feel management teams are being appropriately rewarded for performance to date but retain material ‘skin in the game’ for the future.
- Taking money out at an early-stage will help to reduce the risks associated with a start-up dependent on a particular technology or trend. However, VCs should be wary as their own exit strategy looks increasingly volatile.
- The combination of more sophisticated founders and fewer attractive opportunities is giving founders the bargaining power to demand early-stage cash pay-outs.