DealBook: In Venture Capital Deals, Not Every Founder Will Be a Zuckerberg

Harry Campbell

It’s the dream of entrepreneurs to sell their company for millions of dollars. But the dirty secret of venture capital is that the dream can be dashed as the venture capitalists make millions in a sale, leaving the founders with nothing.

A recent Delaware court case arising from the 2011 sale of Bloodhound Technologies illustrates how this happens.

Bloodhound was founded in the mid-1990s by Joseph A. Carsanaro to create fraud-monitoring software for health care claims. After several years of going it alone with a handful of colleagues, Mr. Carsanaro was able to raise Bloodhound’s first venture capital round for $1.9 million in 1999, followed by a second $3.1 million round in 2000.

When the Internet bubble burst, the company underwent rocky times. It was then that the venture capitalists seized control. Mr. Carsanaro was pushed out as chief executive. By 2000, he was gone from the company, as were four other members of his founding team.

For the next decade, Bloodhound recovered and slowly grew, raising seven more rounds of financing. In April 2011, the company was sold for $82.5 million. It was a time for Mr. Carsanaro and his founding team to celebrate their millionaire status.

But venture capital investments are structured to ensure that the venture capitalists are paid before founders and employees. When venture capitalists invest, they typically demand preferred shares that accrue a yearly dividend of about 8 percent. The dividend goes unpaid until the company is sold. In a sale, the original amount and the interest all come due. It must be paid out before the common shares, which are typically held by the founders and other employees.

The requirement that the venture capitalist be paid first, and with interest, can sometimes hit founders and employees in a brutal manner, as Mr. Carsanaro and his colleagues discovered.

The venture capitalists took almost all of the sale price. Bloodhound also paid a $15 million bonus to its current management team. The five founders of Bloodhound were paid in total less than $36,000. One received all of $99.

There is not much information on payouts to founders and employees when a company backed by venture capital is sold. But from the few studies on the subject, it appears that the situation involving Bloodhound is all too common.

The most recent study, by Profs. Brian J. Broughman and Jesse M. Fried, found that among a sample of venture capital deals, the common investors in roughly half the cases were entitled to nothing when the company was sold, even when the sale was for tens of millions. And in all but one instance, the majority of the sale proceeds went to the venture capitalists and other holders of preferred shares.

An unpublished study by Shikhar Ghosh at the Harvard Business School found that three out of four companies backed by venture capital did not return the investment. Again, it is in these cases where the founders and employees typically are entitled to receive no payment.

For those entrepreneurs who think they will be the next Mark Zuckerberg and ride their company to riches, think again. A number of studies have found that most chief executives of companies that take venture capital investments end up being replaced.

These are the successful businesses. The rule of thumb among venture capitalists is that some 20 percent to 30 percent of companies fail, returning nothing to any investor, including the venture capitalists.

The Bloodhound case is a reminder that the founders of start-ups backed by venture capital often end up nothing like Mr. Zuckerberg. Instead, they find themselves thrown out and without significant profits even if their company is sold.

Venture capitalists will argue that this is the price to pay to get their money and services. Cash is king, and in order to survive, venture capitalists will demand a high price and return.

Yet entrepreneurs can protect themselves. Professors Broughman and Fried found in their study that founders who negotiated greater control rights ended up receiving on average $3.7 million more. They did this even when the common shareholders were not entitled to a dime. By negotiating board seats or other representation, the founders were able to ensure that a sale happened only with their approval and a demand for some payment in return.

In other words, the rights negotiated by entrepreneurs when taking venture capital money really matter. Many entrepreneurs are so excited to get money that they don’t push for such rights or just don’t know to ask. Yet those who negotiate to keep a say in their company have a future, while those who don’t are more likely to be tossed aside. And it can be that this happens even in lucrative situations. Remember that Mr. Zuckerberg would have been forced by his venture capital investors to sell Facebook had he not kept control.

In the case of Bloodhound, its founders were pushed out of the company about eight years before the sale. During that time, they lacked control or ability to stop the venture capitalists from financing the company on the venture capitalists’ terms. The only substantial communication the founders had after they left was when they found out that the company had been sold for a huge price and that they would receive almost nothing.

The five founders sued in Delaware court, claiming that Bloodhound’s board and the venture capitalists had structured later rounds to favor themselves and dilute the payout of the founders. In a motion, the defendants countered that they acted fairly and that the plaintiffs’ claims were untimely because they were brought years later.

J. Travis Laster, vice chancellor of the Delaware Chancery Court, found that the claims that the venture capitalist had favored themselves to the detriment of the founders could be a viable claim claim if the facts they stated were true.

If Bloodhound’s founders are successful in their lawsuit, the case could change practices. It might require boards that take venture capital money to consider the founders and their interests before taking the next round. This could force boards to lean against diluting the payout of the founders and employees to avoid litigation.

Yet even if Bloodhound’s founders prevail, other entrepreneurs will sometimes find that their company is sold with nothing going to them. The sad reality is that there are times when the price demanded by the venture capitalists for the company to survive means that the founders will lose. Let’s face it, sometimes the company survives only because of that money and the skill and effort that the venture capitalists put in. This may have been the case in Bloodhound.

But the Bloodhound case publicizes this practice and will perhaps push boards to think harder before the founders are discarded. This may foster caution among venture capitalists, but the only thing that will truly save entrepreneurs is negotiating harder in the beginning. They may otherwise find themselves like the Bloodhound founders, left with nothing.

Bits Blog: For Zuckerberg, a Big Payout From Facebook Stock

Paul Sakuma/Associated Press Mark Zuckerberg, Facebook’s co-founder and chief executive.

Facebook shares may have been on a roller coaster ride in the year since they made their debut on Wall Street, but they haven’t been too shabby for its top executives. Mark Zuckerberg exercised stock options worth $2.3 billion, according to a proxy statement filed with the Securities and Exchange Commission late Friday — and sold about half, to cover his tax bill.

Sheryl Sandberg, the company’s chief operating officer, retained her spot as the company’s best-paid executive for two consecutive years. She received total compensation of about $26 million in 2012, down slightly from nearly $31 million the year before.

Mike Schroepfer, the engineering chief of the company, had almost $21 million in compensation, while Mr. Zuckerberg claimed a far more modest package of just under $2 million last year.

The proxy statement reported that Mr. Zuckerberg had spent $1.2 million on chartered aircraft for his personal travel.

Ms. Sandberg had vested stocks worth over $820 million, while David A. Ebersman, who as chief financial officer led the company’s public offering in May, had vested options worth just over $100 million.

Facebook came out of the box in May at $38 a share, and its value sank sharply over the next several months. It closed on Friday at $26.85.

The company also announced that Jim Breyer of Accel Partners, an early investor who personally made more than $100 million from his sale of Facebook stock, was leaving the board. He was one of the most prescient venture capitalists to back Facebook and had served as a director since 2005. He was recently elected a fellow of the Harvard Corporation, a governing board of the university.

Zuckerberg Visits Russia and Meets With Medvedev

MOSCOW — The hoodie stayed back at the hotel when Mark Zuckerberg, the founder of Facebook, met Russia’s prime minister and former president, Dmitri A. Medvedev, on Monday.

“Good conversation with Prime Minister Medvedev,” Mr. Zuckerman wrote on his Facebook wall beside a picture of the two, in suits and grinning, at the Russian leader’s residence outside Moscow.

Mr. Zuckerberg also visited Red Square — in his hoodie — ate at McDonald’s and helped judge a competition for Russian programmers under way in Moscow in his first visit to Russia, a country that is in important ways pivotal for Facebook.

One of Google’s founders, Sergey Brin, is Russian by birth. For Facebook, the tie is more oblique: The country is an important test case for the balancing act Facebook is undertaking as a new media company in countries that are important commercially but have traditionally heavily regulated their old media, if not censored it. And two of Facebook’s largest investors are Russian.

Mr. Zuckerberg and Mr. Medvedev talked about Facebook’s role in politics, though only jokingly in reference to its importance in the American presidential campaign, according to Mr. Medvedev’s press office.

They also discussed copyright rules and high-tech business. Mr. Zuckerberg gave the Russian leader a T-shirt; the meeting lasted about 20 minutes.

Facebook, in Russia as elsewhere, plays a double role as a tool for posting silly party pictures and a tool for political organizing.

Facebook played an integral role in political dissent in Russia last winter, allowing street protests to coalesce when handing out fliers or posting notices on corkboards would not have worked.

Russia is also home to two large and early Facebook investors, Alisher Usmanov, a steel tycoon, and Yuri Milner, an expert on monetizing social network traffic in emerging markets. The two partly cashed out in the initial public offering of Facebook stock earlier this year but still own billions of dollars’ worth of shares.

More Russians are online today than Germans, making Russia the largest Internet market in Europe. Russians also, strangely, have spent more freely relative to their income than Americans on virtual products, like special powers for online games, making their country a useful market for testing revenue streams other than advertising.

Earlier this month, in another step deeper into the Russian market, Facebook made a deal with one of Russia’s mobile phone operators, Beeline, to provide a free application to subscribers.

The Russian government, led by Mr. Medvedev, a technology lover, has embraced the Internet for its commercial potential even as it has been subtly trying to rein in the politics.

Such features as most-viewed lists of blogs, for example, are frowned on at Russian-run sites beholden to the Kremlin, lest a critical text go viral based on user approval.

In its prospectus for the initial public offering, Facebook had cautioned of the business risk of being banned from foreign markets, as it has been in China by the “Great Firewall.”

For now, Russia’s Internet is mostly unfettered.

In that spirit, pictures of the Facebook founder’s dog, Beast, which he posts on his Facebook page, became the topic of conversation in an episode Mr. Zuckerberg filmed for a Russian late-night comedy show on Monday.