The Secret About Rich Founders And Ferraris

By now, the outrage machine is in full bore over the shutdown of Valley darling Secret . The once high-flying app, which allowed you to anonymously share details with your friends and the wider world, eventually sputtered in its growth, leading its founders to shut it down yesterday.

Startups fail all the time, but what made this one special was that the founders, David Byttow and Chrys Bader-Wechseler, had previously received $3 million dollars apiece through a mechanism known as a secondary sale in their $25 million Series B fundraise last July. Byttow in particular used the money to buy a (red!) Ferrari, which the New York Times reported yesterday is now “gone.”

Job firings while the CEO drives away in a (non-existent now) (red!) Ferrari is perfect fodder for a press corp concerned about problems with founders and how much startups are a rich man’s game. There are now wide demands in the press and particularly on Twitter for the co-founders to return their millions to investors as a sign of, I guess, repentance.

I say, screw them all and keep the goods.

Secondary sales are a key and common part of the venture capital landscape today. No VC was harmed in the making of this Secret production, and frankly, I can only get so outraged about VCs losing money through their own decision-making (how many of them own Ferraris Teslas exactly? How many of them are red?)

Secondary sales are pretty simple to understand. When a company raises funding, that funding goes directly to the company as cash on the balance sheet, which is why it is known as primary. Secondary is when a founder or even other employees sell part of their personal shares in the company at the price of the round. That money doesn’t go to the company but into the seller’s pockets.

In private equity buyouts, much of the money invested in a company may actually be secondary dollars if a founder bootstrapped a business and still owns all or virtually all of its stock. Such a deal has to balance investors’ desire to take ownership with the need to put money on the balance sheet to give the company fuel to grow. Thus, there is an intricate art to getting the primary and secondary capital levels right to generate the highest return on the investment and ensure that the founder agrees to the deal.

Such deals are certainly less common in the high-growth startup space, but they have become more popular. Just in the last few years, Snapchat’s founders each pulled out $10 million in secondary and Foursquare’s founders took out $4.6 million. Other companies like Groupon and Zynga have seen these secondary rounds as well, although often at later stages.

While investors partially use this mechanism in order to get additional equity – particularly in the high-priced rounds typical of social networking startups – the key reason for these secondary sales is incentive alignment. Investors believe that giving founders these millions will make them work harder toward a much more massive outcome.

I see people sometimes describe these dollars as allowing a founder to live more comfortably so they don’t have to think about rent or putting food on the table. This is wrong. These dollars are meant to make a founder feel rich and successful early, so they get a taste of what they might feel like if their company goes up another 100x. Byttow bought a (red!) Ferrari, and so did Snapchat founder Evan Spiegel when he got his secondary sale (also red!). Think of it as cocaine – once you have it once, you want even more of it later.

For the best companies, the demand for a secondary sale often comes more from investors than it does from founders. It’s easy to see why. Founders, if they truly believe in the growth trajectory of their company, are selling their stake at potentially a 99% discount from what they think it is worth. Speigel’s $10 million of secondary shares just two years ago are potentially worth around $200 million right now. What a ripoff!

Investors rely on the arrogance of their founders to make this all work. When you are playing at these leagues, no one wants to be the guy that only made $5 or $10 million on their successful social startup. Investors are also trying to preclude an early acquisition sale, since there is a status difference between a founder selling their shares for $50 million in an acquisition and getting $2 billion or more at an IPO.

That brings us back to Secret. When investors gave the founders secondary, they believed the company could potentially be worth billions, but also understood that it could go belly up. Founder secondary was a means of ensuring that the founders would push the company into the stratosphere or die trying. Well, they died. This is what deal making is in VC. It’s hard for me to see how sophisticated and experienced firms like Index and Redpoint were somehow duped in all of this.

If there is something to be outraged by, it is the gross inequality of the treatment of founders and early startup employees. Founders are considered indispensable, and thus need to be purchased to ensure they stay the full course. That is the complete opposite treatment of startup employees, who these days have seen their shares completely locked up by their companies with few options for liquidity.

If we are going to complain about Secret and secondary, complain that more employees didn’t receive it. That inequality is the true secret about secondaries and (red!) Ferraris.