A central theme of this blog has been the way many Web 2.0 entrepreneurs and early stage investors are questioning the venture investment paradigm requiring "exits" in order to reward investors, founders and early-stage employees.
Among reasons to forgo a predetermined "exit strategy" are the following:
- the venture may grow better organically, putting capital to work only as needed, and may blossom on a timeline that may not mesh with the liquidity agenda of a given investment fund;
- certain investors, inclined to dis-engage from Wall Street or any investment ecosystem looking like a ponzi scheme, would just as soon have their capital returned from cash flow, and realize upside in the form of a steady annual return over the lifecycle of the venture (let's presume this could be 15-20 years); and
- founders have agendas for their ventures as well, and these are at least as compatible with fiduciary duties to investors as pushing an exit at a time that may not be in the interests of all shareholders, preferred and common alike.
There is a new puzzle, however, for the New Internet ventures and their backers who are inventing the new investment rationales: how best to reward early stage management who, culturally, expect (and deserve) equity-like upside if the venture succeeds? I'm referring here not so much to founders as to that class of seasoned management that tends to be recruited, still at an early stage, but after the startup has been validated (by customers, partners, revenue, or some combination of objective success other than profitability). This is a breed of management whose risk tolerance is higher than that typical of the professional executive class, who often display as much wanderlust as serial entrepreneurs.
One answer is straightforward: if management should be incentivized to cause the company to generate distributable cash, rather than to achieve an exit, the company's board can set up a profit sharing plan.
But here's a clever variation on the profit sharing concept that some early stage companies are adopting: a management incentive plan, structured like a change-in-control plan, that kicks in, not on a sale of the company, but on any declaration of dividends.
A typical "Management Change Of Control Incentive Plan" works like this: immediately prior to any sale of the company, but contingent on the sale closing, a bonus pool is established, in an amount equal to a percentage of the proceeds from the sale. Sometimes, the percentage of the proceeds increases as the base amount of the sale price increases (to incentivize management to drive the shareholder proceeds higher). "Proceeds" might typically be defined as "the sum of all cash and the fair market value of any securities, other property, or any other form of consideration paid by an acquirer of the Company to all holders of the Company's capital stock for the equity, assets or business of the Company" in connection with a change in control.
A "New Internet Company Management Equity-Participation Incentive Plan" works instead as follows: immediately prior to the declaration of any distribution, a bonus pool is established, in an amount equal to a percentage of the distribution. "Distribution" might be defined as "the sum of all cash and the fair market value of any securities, other property, or any other form of value distributed by the Company as a dividend on any class of the Company's capital stock."
An advantage of the New Internet Company Management Equity-Participation Incentive Plan, as distinct from a simple profit-sharing plan, is that management's reward is directly tied to events that cause and justify distributions of cash to shareholders (those profits needed for reinvestment in the business are not distributed, either to shareholders or to management). Whether payments under the New Internet Company Management Equity-Participation Incentive Plan would also be made on a change in control would depend, for the most part, on whether management had stock (whether subject to options or in the form of restricted stock), and, if so, whether those interests were too far behind preferred stock liquidation preferences as to represent upside.