There Is Such a Thing as Too Much Incentive for Entrepreneurs
Published by David Spotts,
Many entrepreneurs have their entire net worth tied up in their companies. For a long time, this is exactly what most venture investors wanted: more to gain (and lose) means a stronger incentive, greater focus, and better performance - right?
No. In many cases this lack of diversification is overkill and actually hampers performance.
First, a lack of diversification exacerbates the fundamental difference in economic incentive between entrepreneur and investor: when all your money is tied up in a startup, you're happy with a "meager" 1-2X return. (Let's say you earn $4 million after 5 years on the $100K you put in; assuming you give up $500K in total salary, this is a 100% CAGR). But venture capitalists need to target a 10X return and gladly tolerate a higher chance of failure in exchange for a greater expected payoff.
Simply put, a complete lack of diversification incents entrepreneurs to prioritize exit probability above expected value because of diminishing marginal utility and loss-aversion.
Second, research suggests that high-powered incentives can undermine performance in cognitively complex environments. Behavioral economist Dan Ariely has conducted a set of experiments to gauge the relationships between economic incentives and performance. In one experiment, he offered participants payments for pressing alternating keys on a keyboard; in another, he offered payment for math problems - and, in both he varied the incentive so that participants could earn either up to $30 or up to $300. For key-pressing, stronger incentives led to better performance. For math problems, incentives decreased performance.
Ariely's interpretation is that simple tasks requiring no cognitive engagement respond as expected to increased incentives, while cognitively complex tasks peak and then show decreasing performance, as increasing incentive distracts from cognitive performance. Other experiments showed the same result - that very strong incentives actually undermine performance - undermining the traditional assumption that stronger incentives always lead to better performance.
Both rationales for diversifying early apply most strongly to founders without other assets. Taking a small amount of money off the table aligns incentives much better to focus on making a big, world-changing impact. And diversifying also can remove the performance-destroying stress that comes with overly strong incentives.
When is a secondary offering a bad idea? Most cases boil down to signaling, where the founder's desire to sell signals a belief that the company is over-valued, or of a lack of commitment:
•When a founder wants to liquidate more than 20% of her shares
•When a founder who is already financially secure wants to liquidate shares
•When a founder wants to sell during down or flat rounds - unless the amount is small and aims to cover a very specific liability
•When a founder seems to be more focused on money than building the company
To be clear, aligning incentives remains critical to startup success; my argument is simply that a modicum of diversification helps both entrepreneurs and investors. Taking money off the table isn't about getting rich, it's about freeing entrepreneurs to focus on doing something great - not just good enough.
The traditional mentality is beginning to change among investors, but it's far from extinct. I certainly wouldn't mention taking money off the table until your investors know you well and you're raising an up-round: it suggests you're thinking about how to cash out, and would raise red flags. But when your company is doing well, a reasonable investor should be able to recognize why your diversification helps you both.