One of the most common mistakes in Silicon Valley

A scene from "Silicon Valley," season 3, episode 8.
Source: HBO
A scene from "Silicon Valley," season 3, episode 8.

Spoiler alert: It is not possible to review and comment on Episode 8 of the HBO show "Silicon Valley," which aired on Sunday, without revealing some critical plot twists. You are forewarned.

Episode 8: Bachman's Earning's Over-Ride which aired June 12 focuses on the hot topic of startup executives selling shares in the secondary market. Ehrlich Bachman (T.J. Miller), the person who incubated Pied Piper in his home, has run in to some financial difficulties and needs liquidity.

To pay off his debts, he sells his holdings in Pied Piper (10 percent) to Laurie Bream (Suzanne Cryer), the head of Raviga Capital and the main investor in Pied Piper. There are many wonderful subtleties to explore in this plot twist.

First, the storyline of an early founder selling shares due to financial liquidity and thus losing out on a fortune is an all too common occurrence in Silicon Valley. The most famous example would be Ronald Wayne, the third co-founder of Apple. Ron was a partner of Steve Jobs and Steve Wozniak and owned 10 percent of Apple.

However, since Apple was originally a partnership in which all partners would be exposed to liabilities, Ron Wayne was worried that his financial assets would be exposed – Jobs and Wozniak had no financial assets to speak of at that point. To protect himself, Ron sold his stake back to Jobs and Wozniak for $800.

Infosys, the big Indian IT company, had seven founders. Six stayed with the company and helped build it to billions of value but the 7th folder (Ashok Arora) left the company early and sold his stake thus leaving billions on the table.

Second, the concepts of Right of First Refusal (ROFR) and majority board approval for equity transactions are brought to light in this episode. Erhlich wanted to originally sell half his shares (5 percent) for $5 million to eccentric billionaire Russ Hanneman (Chris Diamantopoulos) but when he tried to get the transaction approved, Bream objected.

Due to the way the documents were structured at Pied Piper, Raviga Capital had ROFR which means any founder hoping to sell his/her shares needs to first show the offer to Raviga and consummate the transaction with Raviga if it matches the price.

In addition, Pied Piper had also agreed to a clause that required board approval for any secondary transaction and since Bream controlled the board there was no way for Ehrlich to sell his shares to anybody but her. This is a hot topic in Silicon Valley. As private valuations have soared for unicorns, many common shareholders have tried to sell some of their holdings in the secondary market.

To control the flow of shares and to limit these transactions, many companies have added the clause that approval from the majority of the board is required for ownership transfer. While there are some creative ways around these restrictions, for the most part these clauses have made it very hard for secondary transactions to happen.

The third plot element this episode explores is the negative PR repercussions when a founder or early investor tries to sell their shares. Pied Piper is trying to hire a senior PR person but he is spooked about taking the job when he hears that an early investor in Pied Piper has sold his shares. In Silicon Valley where the only thing faster than the speed of light is the dissemination of rumors, there is extreme sensitivity to these kind of signaling effects.

Social proof drives a lot of financial transactions in technology. People pile into some deals if a certain group of marquee names are investing and conversely people scramble away if they hear some folks are selling. Investor behavior on AngelList is more similar to teenage girls forming cliques than the sage wisdom and objectivity of Warren Buffet.

Best Media Appearance: Emily Chang of Bloomberg TV

Real life Silicon Valley executive cameos: Mark Pincus of Zynga, Dick Costolo of Twitter, Jeremy Stoppelman of Yelp and Nirav Tolia of Nextdoor.

Commentary by Venky Ganesan, a managing director at Menlo Ventures and the chair-elect of the National Venture Capital Association (NVCA). Follow him on Twitter @venkyganesan.

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