Morning Markets: Is it bad when founders take lots of money off the table? Maybe. Also, listen to our podcast.
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That a founder had managed to extract $700 million from his firm before a major liquidity event for investors (a sale, or an IPO) was eye-catching. Even more, Neumann had come under fire earlier for buying buildings and leasing them to WeWork. He’s reversed that position since it became publicly known, but this week’s news added to an existing strain of market criticism regarding the co-working giant.
WeWork, which calls itself The We Company now, is highly-valued, quickly-growing, and controversially valued according to skeptics. To the company’s credit, its bonds have recovered value recently, the firm is looking to secure debt financing ahead of its IPO, and thinks that it can go public soon — or at least soon-ish; why else file for a public offering? — all positive signs.
My current position on the matter is that it’s hard to tell from WeWork’s released financial results how well the firm is doing. What portion of its stated losses may stem from operating costs and not capital expenditure costs is not clear; Netflix, for example, is profitable on an operating basis but is starkly cash flow negative due to content creation costs. Perhaps WeWork isn’t as unprofitable as some thought. And, doubling revenue from a nearly one billion dollar base to nearly two billion in 2018 is impressive.
But taking as much money off the table as Neumann has feels odd, even provided that the $700 million figure is only a percentage of the company’s current private valuation (h/t Hunter Walk). Let’s talk about why.
We’ll start with an analogy.
It’s perfectly fine in poker to win lots of money. But, it’s poor etiquette to leave a table (the game) after a big hand. If you win a lot of money in a big hand, sticking around for a bit afterward is considered normal manners.
There are worse breaches of etiquette. In poker, “going south” is the act of removing chips (money) from the table (the game) while play continues. It’s banned in every poker game worth playing in. Going south, removing chips (money) from your stack is a way to lower your risk at the table (the game) during play (when the game is still afoot).
Hold that idea in your mind. Now, let’s talk about startups (the game), and your ownership interest in the business (chips, roughly).
Private-market investors talk about the need for ‘aligned incentives,’ the idea that the various members of a startup should be rewarded for the same profitable event. Say, an IPO or an acquisition.
The idea is simpler if we use an example. If a founder and her investors each own half of their company, both groups have the same incentives for the company’s success. If a company was one-third owned by founders, one-third by employees, and one-third by investors, each group would have an equal incentive for the firm to succeed. Thus, everyone rows (in theory) in the same direction.
But if a founder’s stake falls too low, they might care less about an eventual large exit that would make other, larger shareholders lots of money and little for themselves. This concept, in reverse, is why startups provide pieces of equity to employees; such grants or stock options align employee incentives along the same axis as investors and founders, who always own more of the company.
Make sense? Now, when I was learning about venture capital, founders selling some of their shares (chips) before an exit (while the game is still on) was considered very poor form. It’s the startup equivalent of going south, and it’s called a ‘secondary sale.’ (In startup funding rounds, new shares are created which are ‘primary;’ secondary sales involve the sale of extant shares by existing shareholders).
A secondary sale by a founder, say, lowers their stake in the business. It also lowers their risk by allowing them to take some of their profits (chips) early (off the table) before other players (investors) can cash in.
In the past, a founder selling shares before a major liquidity event was considered a negative signal. Why would the founder not want to hold onto their shares which should be worth more later, after the founder put in more work? Are they less convinced about their company’s future? You get the idea.
The exception to this is what I call the “small win solution.” I heard or read it explained like this: Founders should keep their incentives aligned, but, really, you can’t stop an entrepreneur from making their first million. Thus if a founder sold a small amount of stock (chips) in their company (the game) while other investors (players, in our analogy) stayed in to say, buy a house, that would be allowed.
But that was it. A small amount in dollar terms, and in terms of the founder’s stake in the company.
Back To WeWork
You can argue in the case of WeWork that Neumann is not selling too much of his stake in percentage terms. Given that WeWork is so valuable (dozens of billions of dollars), his $700 million in aggregate secondary and secondary-ish transactions could be a small amount of his personal stake. But in dollar terms, it’s a lot.
It’s an interesting argument. And, given that Justyn has raised $111.5 million and I have raised zero, I defer a bit to his in-market experience here. Regardless, we live in interesting times.
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Featured Image: Dom Guzman