Understandably, my entrepreneur friends have been abuzz over the rumored founders buyout at Automattic, the company which runs the popular open source blogging platform Wordpress.com. After supposedly turning down a $200 million acquisition, the company is rumored to have accepted a large new follow-on investment led by existing investor Polaris Ventures, largely as buyout of founders’ positions.

Regardless of the authenticity of specific rumors here, it’s worth delving into a few industry points in order to frame an appropriate discussion of dealmaking. I’ll offer notes that hopefully lend clarity to the above.

First, understand the stakeholders’ objectives. There’s no hard and fast rule for returns that a venture firm must meet in order to qualify as “extremely successful” or “top quartile” (the latter, obviously a derivative of peer performance).  Investment horizons, vintage years, and the amount of capital under management complicate matters but let’s assume for the sake of discussion that 3x paid in capital represents an aggressive, high bar benchmark.  Fred Wilson has some interesting data posted on historical returns.

Acknowledging that the industry is a “hits business,” relying on a few big hits to accommodate some flops and so-so’s, the hits have to get REALLY big in order to reach our benchmark.  Some overly simplified math: consider 15 investments for a $100 million fund, of which a third hit, a third simply return capital, and a third return nothing. Assuming invested capital is evenly split amongst portfolio companies (certainly an inaccuracy, but let’s keep things simple), the winners must then each return a little north of $50 million in order to hit your 3x benchmark. Remember, the venture firm doesn’t own 100% of each company. It might own 20%, so each of those five companies that hit needs to reach a $250 million+ liquidity event.  Again, lots of details missing here but in broad strokes, a telling picture. Now consider a $1 billion venture fund, the kind Polaris raised last year and which invested a month or so post-close in Automattic. Despite the outstanding result that a $200 million acquisition offer might seem approximately a year and a half after a tiny (reportedly, $1.1 million) initial institutional investment in the business at what must have been a much lower valuation, it might not be deemed big enough to represent a landmark investment for an enormous fund.  Unquestionably, though, it represents a life-changing amount to a founder that still holds even a small piece of the pie.  And interestingly, it might be meaningful to smaller funds that have co-invested in a deal, thus creating a misalignment of interests even amongst co-investors.

A buyout might align such interests.  Moreover, as firms become better management team recruiters (Polaris has been particularly progressive in this regard), the resultant “hunger dilution” that a senior team buyout precipitates might seem a little less worrisome.  High-class problems, indeed.

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Photo credit: Treasure Chest May Be, originally uploaded by mimi.simpson

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