When the potential acquisition of a start-up is heavily tied to the financial wellbeing of its founder, it can make the business vulnerable to deals that devalue the company.
According to a new paper out of Yeshiva University, founders naturally own a large portion of the equity in their companies in the early stages, making their net-worth heavily tied to a single, rather illiquid asset. And, in these cases, founders may be temped to push for deals that provide them with ample financial security, or so-called “beach money,” but are not the best option for the company in the long-run.
This eventuality stings the venture capital investors looking to be rewarded for the risks they took in allocating to early-stage start-ups, the paper said.
Part of the standard venture capital-backed business model is that the founder receives a less than impressive salary, with the hope that they’ll be more than compensated when the company is acquired by another entity or goes public. This hope pushes founders to manage the business in a way that will maximize that potential payout down the road, the paper said.
But the expectation that the business will eventually go public, or unlock its equity in some other way, can cause a form of opportunism that cuts its growth potential off too early, it noted.
“When a successful startup receives an acquisition offer that is below the expected value of the business, founders with a large equity stake may be motivated to accept it,” the paper said. “Founders can’t diversify their financial risks like VCs can, because their equity is concentrated in one company, rather than spread across a portfolio of companies. An acquisition that isn’t [expected value]-maximizing for shareholders could give founders more risk-adjusted value than remaining independent would.”
These acquisitions where the founder is well taken care of, while the VC doesn’t see maximum benefit, are “beach money exits,” the paper said.
But VCs do make attempts to guard against this possibility within their contracts with investee companies, it said.
“First, before VCs agree to invest, they screen for founders who have ambitions for the business beyond the first beach money offer and a business plan that suits the term of their investment,” the paper said. “Then they monitor founders to ensure that they are focused on building value rather than courting acquirers.”
After that, often VCs will attempt to insert veto rights on certain or all types of exits, as well as appoint independent directors agreed upon with the founders who will arbitrate in the case of disputes. The paper noted that these types of precautions are not just meant to prevent early exits, but that issue is among the many reasons why they make good sense for VCs.
Actually enforcing vetos, or otherwise preventing company founders from exiting can prove problematic even after taking these steps, the paper noted.
In a legal sense, a beach money exit could appear to be a breach of a founder’s fiduciary duty. However, due to a given exit scenario’s highly subjective nature, this would be difficult to prove, the paper said.
Ultimately, these premature exits have the potential to mute the future innovation of which a company might otherwise be capable, the paper noted.
In these situations VCs are hampered by their lack of the specific knowledge needed to fully harness the future potential of an enterprise, which ultimately stifles innovation, the paper concluded.
This paper was written by Matthew Wansley, assistant professor of law at the university’s Cardozo Law School. It is forthcoming in the Journal of Corporation Law.