Cost #1 - Long-term Economic Cost
As I wrote about with the Tumblr acquisition we have a wealth creation problem. Tumblr and Waze didn't have 200 employees combined at the time of sale. The vast majority of the money goes to a very small number of individuals - founders and investors. There are a lot of people who make such a deal happen (the later stage employees and the hundreds of thousands of pensioners who combined participated during the investment stage), but they don't see a return commiserate for the level of exposure. I classified it as "Don't Hate the Player. Hate the Game," because in their positions, I'm not sure I would have done differently. Yet, while the gains from the sale don't sit under a mattress, the nature of the funds and the highly skewed distribution means that only wealth creation not job creation comes from these exits. Again, the players are optimizing for the current system, but the current system has serious flaws.
Cost #2 - Caveat Employee
Most employees at startups have some way to make money if the company exits. I can remember my first job. Today, the company would be called a tech startup, back then, though, it was just an internet company. Fresh from a liberal arts degree and despite four years hanging in proximity with business students, I still thought "ibanking" was some form of online bank initiative. Needless to say, I didn't really think much about stock options when I joined. The employees of today have greater access to information to understand options and valuations, but a great number of the best employees don't really know and/or the company keeps opaque the information they would need to understand what they have and could make.
When you are Snapchat or Fab, it's your insane growth that allows you have insane money available, but outside of a few rare cases (Google, Facebook, and Twitter) this money has some serious handcuffs - not for the founders as much as the rank and file employees. First, the founders. Virtually no company raises $100mm+ to put solely towards the business. Rounds like these, even if done by more classic venture firms (as opposed to private equity), have some private equity components to them, namely early shareholders cashing in - from founders to early investors. The percentage of one's holdings being cashed in is usually limited to keep the proverbial skin in the game, but the practice arguably does more harm than good.
If you are the founder of a stupid fast growth company kind of needs it, but doesn't REALLY need it or that much of it, e.g., Snapchat, you are absolutely going to sell some of your own shares (instead of issuing more or just using the money to fund growth). You've seen your value grow from very little, e.g., $10mm to $1bn, a 100x increase. The main reason for not wanting to sell would be if you were selling a large stake, and your shares only increased by a modest amount. Then, it makes sense to hold on longer and see if there is greater appreciation later.
In this hypothetical case meant to mirror Snapchat or Fab, let's assume 40% of the funds go towards buying shares from the founders/early investors. In the case of a $100mm round, that's $40mm, or 4% of the company. Let's also assume they get 80% of the $40mm, or $32mm to split. They now have $16mm in long-term capital gains income. More importantly, they still have a ton of equity still in the company, so their dreams of becoming multi-hundred millionaires or more are still in tact. If the percentage of money going to buy out existing founders is higher, or if the round is larger, the numbers are even more attractive all the way around. It's no inconceivable for instance that the CEO of Fab has taken out $30mm+ during the company's $310mm intake.
Now, back to the real problem. Putting that much money in is a risky bet, so those doing it want to maximize their chance for success. That means preference. And, it means that there exists a minimum floor the company must clear in order for everyone else to make any money. If someone puts in money at a $1bn valuation, they don't want the company to sell for $1bn, certainly not less than that, which is why there will be a notion of preference.
The employee's won't really know this. They just know the company had a value of around $50mm when they joined. They know that the company has a reported value of $1bn now, so conservatively they will assume their share is worth a minimum 10x when they joined. That's exactly what they hoped would happen, and it gets them excited to stay there. Even if the company doesn't grow or loses just a little value, they are still really excited. But therein lies the rub. What if the company pulls a Foursquare? What if they are still worth a good amount of money, but they haven't grown from the last time they took in money, or they haven't grown enough. Chances are the employees shares are actually worthless, even though the company has grown appreciable since they started.The REAL problem is motivation. Employees joined for the leaders and the idea. If things start to turn sour at this stage, how will the leader react? They have generally made enough money (tens of millions) that no matter what they say, deep down inside, the same hunger just isn't there. They don't NEED this to work out, whereas when they started, they did. It's a subtle mental shift, but sometimes that's all it takes for a founder to not try as hard, for a co-founder to walk away, or any number of scenarios where when the company needs to dig deepest, the spirit and ability to do so just isn't there. That's the real problem. Later stage, super high valuations mean bigger gambles, more restrictions, all while the founding team has enough money where feeling that hunger becomes harder and harder. It means employees have a harder time seeing the upside, even if the company appreciated greatly during their tenure. They are now in an some or nothing scenario, and the very people they need to see anything might not be able to give it their all.
