Venture Capitalists don’t like deals where their money is used to buy the shares owned by founders and other early investors. They like their money to go “into building the company” – ie, towards hiring people, building a product, etc. Unless, that is, they are desparate to get in on the deal.

In August, The New York Times had a report on how such “founder sales” deals were becoming more common in the US. Companies like eHarmony, Webroot Software, Fastclick, etc., have witnessed the founders “using venture deals to cash out some of their equity without the bother of a public offering or an acquisition”. Woodside Fund partner Thomas Shields pointed out in the article that a founder is typically “stock rich but cash poor”. Shields feels such a situation is actually bad for the company as a whole since such a founder “might be overly conservative in his or her business decisions for fear of losing everything.” “If you can give these guys a little bit of liquidity so they’re comfortable taking more risk, but not so much that they’re not hungry anymore, then it can be a very good thing.”

In response to the NYT article in August 2005, I had said the following on my blog:

What Shields says makes a lot of sense. So much so that I think it might be a good idea for VCs to actually insist on “limited founder sales” when they invest in a company. I think this will help reduce the all-too-famailiar clashes between founders and their VC backers post the initial honeymoon period. Letting the founders take “a little bit off the table” reduces their risk in doing what VCs want all their investee companies to do: grow faster.

Now, in a new essay titled “The Venture Capital squeeze”, Paul Graham – a co-founder of ViaWeb (acquired by Yahoo for $50 million) – warns VCs that “if (they) are frightened at the idea of letting founders partially cash out, let me tell them something still more frightening: you are now competing directly with Google.” Click Here to read Graham’s very interesting article that is attracting a lot of attention.

Back in the Indian context, M&As have remained the main source of exits for VCs here for a long time. While Google and Yahoo! may not be acquiring too many companies in India, we are witnessing global tech majors – from Flextronics and to IBM – becoming more active acquirers here. So, would we start witnessing more founder sales in Indian VC deals as well? While I’m convinced it would be a good trend, the question is whether the demand for early-stage investments too high (compared to supply), for local VCs to “allow” this?