The All-In Dilution from an Outside CEO: Just Make Sure You Do the Math

GoogleGuysFirst, before we get into the math and the pie chart below, let me be clear: I am in NO way against bringing in an outside CEO to run your SaaS company.  #1: If you lack CEO skills on your team, you should do this on Day 1.  #2:  And even if you have enough CEO skills, and you can’t get the company to the next level — you should bring in an Outside CEO.  It’s far better, as we know, to own 1% of something successful than 10% of something with no liquidity ever or 100% of something that fails.

It’s Scenario #2 I want to analyze.  When you have something, some traction and success … but you decide to bring in the Outside CEO.

It may be a great idea.  I just want you to think a little about the Dilution.  Because, if you are in SaaS, and you are raising, or have raised, venture capital — the Dilution from this hire Will {Probably} Be Epic.  So just make sure that’s a better call than bringing in a COO (or other senior help) to help you be a better CEO.

Why is it so massively dilutive?

Let’s analyze it.  The Outside CEO will want 6-8% of the company to join, that’s pretty standard.  OK, you say.  That’s a lot, but I can handle it.  All that means is my stock is also diluted 6-8%.  {I seem to remember Eduardo made the same calculation in The Social Network}.  But, it’s not that simple.

Because here’s what will happen:

  • The Outside CEO will, explicitly or implicitly, get anti-dilution protection on that 6-8%.  At least through the next VC round.  Always.  Because he or she will say, “Happy to join, but I need to raise $5m/$10m/$20m/[insert number here] in the next 12 months to scale, and I need my equity to be calculated after that round.”  Fair enough.
  • Then, because the CEO has antidilution protection, and also because they have no big history or basis in the company — they Will Raise As Much Capital As Possible.  At least an “extra round” worth of capital — or more.  This is exactly what you would do, if you were them.  Indeed, this is what I would do, if you brought me in.  In fact, in SaaS, you can consume so much capital as you scale, if you want to, that in the end, the Outside CEO will sell 80-85% of the company if you have real success.  You can’t really sell more than this, because you need room for the Outside CEO’s 6-8%, and all the Rest of the Employees.  But as long as the Outside CEO can keep his/her 6-8%, he/she will sell all the rest.  There’s a bit of a check-and-balance here in that valuations have to grow, but it’s only a modest check, because you won’t skip a round with an Outside CEO.
  • The Outside CEO will also want to increase the size of the option pool in year one to both bring in more hires (not a bad thing), and avoid personal dilution on this.  So you’ll get more diluted from this too than you likely would if you were running the shop, although it may be nominal.
  • Then, the Outside CEO will want to bring in His/Her New, BigCo VPs.  4-5 of these VPs — The Entourage – all of whom will be strong, at least on paper.  All of whom have lots of experience scaling businesses (a good thing).  And each of whom will get at least 1% of the company and some implicit protection from the CEO.  So that’s another 5%.

So what’s left?  That’s the rub.  Here’s about how it will end up looking in most VC-backed SaaS companies, not immediately, but a few years after the Outside CEO joins, unless the valuations are somehow astronomical:

Screen Shot 2013-01-08 at 2.15.35 PM

It might look a little better … maybe … but it also might look even worse.  You can see real world examples for Eloqua, Jive, Cornerstone OnDemand, Splunk and more here.

So the net effect, from Raising Maximum Capital, adding All the BigCo VPs, adding the Anti-Dilution Protected Outside CEO, etc. … means everyone else is left with 8% in this model.  Everyone else, all together.

And that may be OK.  It may be the right answer.

If you have a Billion Dollar+ Exit – indeed it probably will be great.  That’s $80m+ or more to spread around to Everyone Else.  But as we know, that’s not the most likely outcome, statistically speaking at least.

Here’s my only point.  At some point, you may think about bringing in an Outside CEO if you do SaaS long enough.  At least a little, at least as an idea.  We’ve all been there.

And The Outside CEO: if it’s the right decision, do it, and never look back.  Just beyond the other Pros and Cons — understand the math so you also make a rational, not an emotional, decision.  It’s going to be a lot, lot cheaper to bring a strong COO to help you be a Great CEO than an Outside CEO.   So just make sure the expense pencils out.

3 comments

  1. Pingback: Career Advice: When They Replace the CEO At Your Company, It’s Time To Move On « SmoothSpan Blog

  2. This is incredible insight. I like how you highlighted the real world examples. Thank you.

    It seems in most cases the VC forces the Founding-CEO to bring in the Outside-CEO. Do you know why this happens and how to avoid it?

  3. I think it’s actually pretty uncommon today as long as things go reasonably well. It’s a change from X years ago. Most SaaS VCs now want the founder CEO to take it all the way, if they can. More thoughts here: http://saastr.wordpress.com/2012/12/19/heading-into-2013-thoughts-on-ways-the-start-up-world-is-so-much-better/

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