Why Founder Liquidity Is Good for Business
- The benefits and risks of taking liquidity for founders
- How to increase liquidity while growing your company
There is a pervasive narrative among the founder and investment community that it’s bad form for a founder to seek some personal liquidity as part of a transaction.
Investors and the market push this narrative, claiming that it looks bad for the business and leads you as a founder to be less motivated. It’s a common myth, and therefore a question we hear frequently from tech founders.
When Founder Liquidity Doesn’t Make Sense: When Enterprise Value Is Near Zero
Early in a business’s lifecycle, it doesn’t make much sense for an investor to provide liquidity to a founder. There is just too much uncertainty about the future of the business at an early stage, so investors are more comfortable putting money onto the company’s balance sheet than they are about providing liquidity to a founder. Hence the narrative.
(And that’s part of the cost of growing a fledgling company, right?) Early on, illiquidity can be a strong motivator to keep you focused on growing that asset.
That said, the dynamic changes when a founder successfully builds a highly valuable company.
Founder Liquidity Is Important When Enterprise Value Is Large
When you’ve successfully built a highly valuable company, the founder mentality typically changes from risk-seeking (e.g. "Let’s see how far we can take this") to risk-averse (e.g. “I need to protect the value I’ve already built”).
If you’re feeling risk-averse because most of your net worth is tied up in the value of your software business, then you’re likely less willing to take the risks necessary to take the business to its full potential. Which is, of course, bad for business.
Which is why at this inflection point, liquidity is a good thing, both for founders and for the business. When you can (at least to some degree) separate your personal financial success from that of your business, you can continue with an appropriate amount of risk-seeking behavior to realize a greater value for you and other stakeholders.
Ways to Increase Liquidity
So if liquidity can be beneficial for both founder and business, what is the best way to create it?
One option for a founder to de-risk their personal financial profile is to take cash out of the business as distributions. This is a simple solution, but you’ll want to weigh the tradeoffs of doing so. If your goal is long-term wealth, consider that taking cash out of the business can stunt growth, and in most cases $1 of distributions is worth less than $1 reinvested into the business.
Another approach would be to sell all or some of your business. This gives founders the opportunity to diversify their financial profile without stunting the growth of their business.
If you retain a percent ownership in the business, you can also participate in future upside. And because you’ve de-risked your personal financial profile, you’ll be more comfortable swinging for the fences.
How much of the business should you sell?
Your level of liquidity depends on how much of your business you sell as part of a full sale, majority, or minority transaction.
A full sale transaction means you’ll realize 100% liquidity and will also likely exit the business with no future upside. If you’re looking to fully diversify your wealth and ride off into the sunset, then a full sale transaction is appropriate.
In a majority sale, you sell most but not all of your equity (>50%). This is a great option for founders who are looking for significant liquidity but would also like some potential upside in the future of the business. It also gives founders a chance to, over time, step away from the business if they so desire.
In a minority sale, you sell less than half of your business. The resulting liquidity (though smaller than in a majority sale) can help you stay motivated to take risks, but the amount of control, upside, and risk you’ll retain will be greater. A minority sale also sets you up for more of a long-term role at the company.
(Keep in mind here that we’re referring to a minority sale where you receive secondary capital out of the business. Compare that to growth capital or venture capital where the money goes onto the balance sheet.)
It’s important to note that in pursuing a minority transaction, founders bring on a new investor who will be inclined to take risks. Investors are risk-seeking because they need to hit significant growth targets to make their initial investment worthwhile. As such, founders have all the more reason to de-risk their personal financial profile so they can be aligned with their investors.
Feeling the Benefits of Liquidity
Creating personal liquidity will help founders de-risk their personal financial profile, thereby enabling them to accept a healthy amount of risk in their business to maximize their opportunity.
Whether the correct path for realizing liquidity is a minority, majority, or full sale, an investment bank can help you prepare for and run the sales process. Learn more about how an investment bank can help you navigate liquidity and other exit issues founders face.