The “FF class” of stock, for founders who want cash early

(Updated with more details on how FF works)

A form venture capital funding in Silicon Valley is getting increased interest from founders of start-ups.

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It is called the “FF class” of stock, for founders who want to cash out a small percentage of their stake in a company so they don’t have to wait until the company is sold or goes public.

This practice is not entirely new. Many founders through the decades, including at Intuit years ago and Jonathan Abrams at Friendster more recently, have sold shares in their company to their venture backers and gotten cash to enjoy life a little more. But with the favorable start-up climate now, VCs are doing more to accommodate founders, entrepreneurs are getting more sophisticated, hearing more about these sorts of terms, and increasingly asking for them.

The practice is mentioned in the SF Chronicle story by Jessica Guynn, about the Sean Parker of the Founders Fund (the fund’s partners pictured above) and his decision to devise such a stock for Barney Pell, founder of young search start-up Powerset:

Inspired by his personal frustrations as a startup founder, Parker came up with a novel arrangement that he hopes will benefit other founders as they build their companies: a new type of stock that allows founders to cash out a small percentage of their stake in a funding round so they don’t have to wait until the company is sold or goes public.

Pell, who maxed out credit cards, deferred salary and considered taking out a second mortgage until he could raise serious money and interest from the right investors, says he’s relieved that he and his fellow founders don’t have to feel rushed to sell the company to get some return on their investment of energy, time and money.

This Powerset iteration was put together by attorney Steve Venuto, of Orrick, and VentureBeat has been told that Fenwick & West and Wilson Sonsini have also given thumbs up to the practice. Venuto was also the lawyer of Facebook, another company backed by the Founders Fund’s Peter Thiel. (Someone told us Venuto also the only lawyer in the valley who can code, but we haven’t confirmed that.)

The amount of the cash-out is capped to between 10 and 15 percent, depending on the round. It should also be used with caution, because it means you get less as a founder when the company does get sold or go public. There’s a story we’ve heard about the founder of Viaweb, a Paul Graham company, who cashed out in order to buy his wife a Saturn car. It became known later as the “million-dollar-Saturn,” because of the worth that stock would have been had he kept it.

Thestock also lets the investors cash out too, allowing venture capitalists take some money out of the company during a subsequent higher-value round.

The stock type is also significant because a new law, 409A, forces companies to grant options at their fair market price. This brought more scrutiny on the cash-out process. We ran this by Gordy Davidson, of Fenwick & West, who explained the challenge as follows. If a VC buys shares from a founder for $1 each, to let the founder cash out, this effectively establishes a fair market price for the shares. All option grants going forward must thus be granted at $1. This may not be good, because companies may have been able to grant options to employees at 10 cents had no such price been set (this lower price is desirable, because it gives greater upside). The trick is to turn the founders stock into “preferred” shares, which can get around that problem. That, in turn, has some tax implications, but of course — with good lawyers — there are even ways around that.

So here’s how Parker and Venuto structured the FF class (Parker and Thiel named it “FF’ and the name stuck): The FF has a single preference clause that distinguishes it from all other stock. It is convertible to any future class of stock, when certain conditions are true. For example, the holder of FF can convert it into say, a Series B class of stock and sell it to investors, at which point it takes on all the rights and preferences of Series B stock. But it can only be done during the new issuance of that Series B, and only when that Series B is sold to investors; you can’t convert randomly.

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Parker tells VentureBeat he spent nine months thinking about how to align founders’ interests more closely with venture capitalists, and this is what he came up with. The stock was first used at Powerset, and has since been used at a secretive companies Philotic in Berkeley, and David Sack’s Geni (no web sites).

[Pictured above is Ken Howery (left), Peter Thiel (middle) and Sean Parker (right). Photo by Chron’s Katy Raddatz]