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When capital goes to founders, not the firm
August 5, 2005
By Gary Rivlin

When Neil Clark Warren and Greg Forgatch, founders of dating site eHarmony, were making the rounds last fall looking to raise venture capital, they weren't merely seeking money to bankroll a big TV marketing blitz.

They also wanted to raise money--lots of it--to put into their own pockets and the pockets of the company's early investors and some of its employees.

Rather than wait for eHarmony to go public, which might never happen, or for some bigger company to acquire it, which also might not happen, the company's founders decided to look for venture capitalists willing to cash out some of the stake they and others held in the company.

They had no trouble finding eager venture investors, even though a big chunk of the investment would end up paying for vacation homes and other personal luxuries, rather than building the company.

To many venture capitalists, this kind of deal, known as a "founder sale," is generally viewed as a necessary evil, the price of admission for doing a deal with a hot property. An investor would much prefer to see his or her investment used to create a new product, hire new talent or build a sales team--something that would increase a company's odds of succeeding.

To Forgatch, chief executive of eHarmony, pocketing some cash is only fair.

"We wanted people to be able to take a little bit off the table for all they've accomplished, and we've accomplished," he said. "People have worked very hard."

Of course, most people in start-ups work hard, and many do it in hopes of the big payout. Sometimes they're lucky enough to work for a company like Google, where a tiny stake in a privately held company turns into company stock worth millions. But sometimes, years of hard work, long nights and frenzied deadlines amount to little more than a regular salary and a modest stake in a 401(k).

Increasingly, entrepreneurs are looking to reduce that risk. They're using venture deals to cash out some of their equity without the bother of a public offering or an acquisition. Other recent examples of such deals have involved the anti-spyware company Webroot Software, based in Boulder, Colo., and Fastclick, an Internet advertising company based in Santa Barbara, Calif.

"We're starting to see a lot of deals being structured so that they involve founder sales," said Scott Dettmer, a founding partner at the Silicon Valley law firm Gunderson Dettmer, who has been advising venture capitalists since the 1980s.

The phenomenon isn't entirely new. John Doerr, a venture capitalist at Kleiner Perkins Caufield & Byers, notes that when he and his partners invested in Intuit, the business software maker, in the mid-1980s, "none of the money went into the company. It was all to buy founders' stock shares."

"We always prefer that the money be used to build the company," Doerr said. But the desire to own a piece of a hot company, he said, sometimes trumps that sentiment. Indeed, he said Kleiner Perkins was currently considering just such an investment in one enterprise.

Typically, the founders are the sole beneficiaries of these deals. Webroot, for instance, raised $108 million in venture capital last February. A large share of that money is being used to open offices around the globe, said Mike Irwin, Webroot's chief financial officer, and to expand the company's product offering.

But some of that $108 million--Irwin would not say how much--went directly to the company's two creators, Steve Thomas and Kristen Talley, who founded the company in 1997. They still own a share of Webroot but neither works for the company.

In eHarmony's case, 116 people benefited financially when the company, which was started in 1999, announced last December that it had raised $110 million. The word within the venture capital community is that less than $30 million of that sum went into the company coffers. Forgatch said that was inaccurate, but he would provide no specifics.

"It's not my place to talk about personal finances of 115 other people," he said.

Forgatch argues that the venture deal he helped to craft is good for the company, based in Pasadena, Calif., as well as for the people who benefited. And he may be right.

The transaction served as a kind of release valve that helped quiet the collective impulse among eHarmony insiders to see the company go public. An incremental payoff for their hard work, Forgatch said, "allows everyone to focus on the mission."

At least one venture capitalist, Thomas Shields, a partner at the Woodside Fund in Redwood Shores, Calif., sees merit in this argument. To Shields, a company founder who is "stock rich but cash poor" just might be overly conservative in his or her business decisions for fear of losing everything.

"If you can give these guys a little bit of liquidity so they're comfortable taking more risk, but not so much that they're not hungry anymore, then it can be a very good thing," Shields said. "You let them take a little bit off the table so they're playing with house money."




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