Obtaining alignment among the various parts of a company, particularly between company founders and investors, is a never-ending topic.  Two items have caught my eye this month that relate to this issue and may help spread some enlightened thinking about investor alignment.

First, Fred Wilson, a venture capitalist at Union Square Ventures and the king of venture-bloggers, wrote a post on April 11 that begins, “Possibly the most interesting conversation I’ve been having with entrepreneurs lately is how they can keep their companies independent without having to go public and turn their cap tables into a casino”.  He is wrestling with the idea of how to support founders that don’t want to exit their company as required by their professional investors.  Check out his post here.  Below, I have some tips for business owners and entrepreneurs on how to avoid some of these problems and achieve a higher state of investor alignment.

Also, an article in the April 2012 issue of Wired titled “For High Tech Companies, Going Public Sucks” by Felix Salmon.  Salmon writes, “From the time that VCs invest in a company, they have five years—10 at the most—to sell their entire position, hopefully for many times more than their original investment. After that, it doesn’t matter to them whether the company survives a year or a century.  To put it another way, the VC model is based on creating wealth for investors, not on building successful businesses. You buy into a company early on and sell out a few years later; if you pick well, you can make lots of money. But your profits don’t accrue to the company itself, which could implode after your exit for all you care. Silicon Valley is full of venture capitalists who have become dynastically wealthy off the backs of companies that no longer exist.”

I am pleased to see the mainstream venture community focusing on this issue.  At my investment fund, Greybull Stewardship, I have intentionally constructed my fund to be a friendly investor to business owners that want to keep their companies independent and not be forced into a sale or an IPO.  The problems described by Wilson and Salmon are not the fault of the well-intentioned investment professionals, it is because of the limitations and restrictions of their fund structures.  The legal structure of Greybull Stewardship is “evergreen” whereby the fund may exist in perpetuity and not force an investment to be sold.  Also, the structure allows us to invest in flow-through tax entities such as limited liability companies so that investors can earn tax-efficient returns without exiting the company (an issue that Wilson refers to in his post).

Here are some tips that, in my opinion, help business owners better enable alignment with outside investors:

1)  Avoid C Corporations.  Because of the tax inefficiences of distributing profits out of a C Corporation (dividends are double-taxed), this causes everyone (except the founders sometimes) to focus the company on an exit strategy so they can receive a financial return on their investment.   With investors having no other way to receive cash back other than an exit, the founders and managers will not win the argument to stay independent and not exit.  Unfortunately, most professional investment funds by venture capitalists and private equity firms can only invest in C Corporations to avoid having business income flow up to their non-profit investors (university endownments, pension funds, etc.).  If possible, I recommend finding investors that prefer flow-through tax entities because it allows for better alignment later on.

2)  Pay close attention to the exit timeframe required by your investors.  Ask your potential venture capital or private equity when they raised the fund they are investing now.  They usually need to return that capital to their investors 10 years after raising it, so you can get a good idea whether you’ll have 5 years (or 2 years) before the investors will start forcing you into an exit strategy.

Related Posts:

• Founder Regrets Sale to Traditional Private Equity – April 25, 2012
• C Corporation Business Owners at Risk of Losing Millions — April 22, 2012
• Tax Free Entities Supported by Greybull Stewardship — April 22, 2012