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Snapchat's liquidity trap

June 26, 2013: 11:46 AM ET

Snapchat_logoSome founder liquidity for startups can be helpful. Too much, however, misaligns interests.

FORTUNE -- One of the most notable changes in VC financings over the past five years has been the widespread adoption of founder liquidity.

For the uninitiated, these are deals in which some of the new capital is used to buy shares from company founders, rather than to help grow the company. Oftentimes these transactions make pragmatic sense – particularly for older companies where founders have taken below-market salaries for years and literally are having trouble paying the mortgage. A bit of reward for past hard work/company success, and the idea that a founder can be more focused if not having to fret over personal finances.

But sometimes such deals also are excessive, and not in the best interest of the VC fund limited partners who actually are footing the bill.

All of this brings us back to Snapchat, which recently raised $60 million in VC funding led by Institutional Venture Partners. TechCrunch and others now are reporting that the total round actually was $80 million, including a pair of $10 million checks made out directly to the company's two, twenty-something founders. Sorry, but this is desperate lunacy.

Before continuing, let me be clear that I don't necessarily blame Snapchat's founders for taking the money. After all, that's the kind of money that can set them up for life, even if Snapchat were to disappear tomorrow.

And that's really the problem, isn't it? This isn't about paying the mortgage. It's about getting crazy rich today, off of a company that has yet to generate a dime in revenue (rather than putting that money directly into the company's coffers).

The LP-VC-founder alignment has now been skewed, because only the last part of that triangle is now in the money. Let's assume, for a moment, that IVP contributed $70 million and now holds an 8% stake in Snapchat. And let's further assume that it only has a 20% carry. By my calculations, Snapchat would have to sell for nearly $1.2 billion in order for LPs, in aggregate, to earn $20 million in profit from the deal (i.e., what the founders already got). And remember that Tumblr – another pre-revenue company whose main selling point also was explosive user growth – just went to Yahoo (YHOO) for $100 million less.

[Note: It is likely that the VCs have liquidation preferences on their investment, or at least on the first $60 million (since the other $20 million is likely common stock). At industry-standard 1x, my math still holds. Anything above that gets a bit trickier].

I know there are some who say, "Well, it's the price IVP had to pay in order to get into the deal." And others who argue "Well, if you don't give it to them now they'll just want to sell quickly."

Those notions should scare the hell out of venture capitalists. Why do your founders feel so strongly about banking huge checks today, if they believe in their company's future? And don't I want entrepreneurs building for the long-term, rather than ones just waiting for the first decent exit opportunity? Entrepreneurs who care as much about their vision for its own sake, as they do for the dollars that vision can represent?

Again, I have not discussed this particular situation with either IVP or Snapchat's founders. So my comments are more general than specific, with Snapchat serving mostly as an anecdotal placeholder. But I think VCs in general have gotten a bit too comfortable handing out millions of LP dollars to individuals who don't really need it. Maybe that's because certain VCs no longer view $10 million as the fortune it really is…

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About This Author
Dan Primack
Dan Primack
Senior Editor, Fortune

Dan Primack joined Fortune.com in September 2010 to cover deals and dealmakers, from Wall Street to Sand Hill Road. Previously, Dan was an editor-at-large with Thomson Reuters, where he launched both peHUB.com and the peHUB Wire email service. In a past journalistic life, Dan ran a community paper in Roxbury, Massachusetts. He currently lives just outside of Boston.

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