Skype, Silver Lake, and fragile ecosystems

It looks like some evil things were done. Well, not that evil, but maybe some people who maybe deserved some money didn't get some money. Long story short, instead of paying employees with actual money — money that could be used to buy things — Skype granted them the option to buy the company's stocks. Stock options, if you will. Most startups have more potential than actual money. Stock options allow them to convert some of that future potential, the potential that they will eventually go public or be bought for hundreds of millions of dollars, for work today.  The company essentially gets to pay a worker less today and in exchange that worker gets the option to own a small fraction of the company, which they can in turn possibly sell for lots and lots of money, and become rich and buy mansions on warm, sandy beaches. Stock options are an essential part of the startup ecosystem. High-tech, growth-oriented startups don't exist in a vacuum. They depend on a veritable ecosystem or environment of other actors, institutions, norms and rule that help new firms get founded and existing firms grow. When one part of that ecosystem gets out of balance, it can destroy an entire eco-system.

What appears to have happened at Skype is that buried deep, deep, deep within the employees' contracts was a clause allowing the company to buy back those stocks, on demand, at their original price. Just before Microsoft finished acquiring the company, the company activated this clause, stripping many of their employees of millions of dollars worth of stock options. The details are not entirely clear at the moment, but it appears that this strategy was orchestrated by Silver Lake, a private equity company that had bought 65% of Skype for 1.9 billion dollars back in 2009 and has now just sold for 9 billion. This strategy means that Silver Lake's investment wasn't diluted by employee's stock options.

When these buyouts happen, employees maybe make a lot of money. Maybe some of these people quit their jobs to start their own company, financed through their stock earnings (Paypal got its start this way, so did Skype). Or maybe they use that money to become angel investors, investing in very early stage companies to help them get ready for growth. This helps perpetuate an entrepreneurial ecosystem. Successes produce more successes; the lucky ones become mentors and investors for new generations of entrepreneurs. When something like this whole Skype thing occur, it damages the ecosystem. I would imagine that things like this would make it much harder for small firms to attract the best people with stock options. There will be fewer angels and fewer entrepreneurial mentors.

Something very similar happened in Ottawa back in 2001 (Note, this discussion is coming from a chapter that I wrote in a forthcoming volume of Advances in the Study of Entrepreneurship, Innovation, and Economic Development, so you know, run down to your local library and camp out there till it comes out). Ottawa of course used to be the center of Canada's tech boom. Not only did large firms proposer there, but so too did smaller, entrepreneurial ones. Their growth was fed by the presence of a well-oiled network of entrepreneurial angels. Angel investors financed the early growth of the firm, and venture capitalists (some from Ottawa, even more from outside Ottawa) came in to catalyze their growth even further.

When the dot com crisis happened, a lot of these small, venture financed firms nose-dived in a hurry. Many venture capitalists quickly engineered the fire sale of these companies, and thanks to the structure of the deal they kept most of the money. The original entrepreneurs and the early stage angel investors either lost money or at the very best broke even. This has devastated Ottawa's entrepreneurial ecosystem and a decade later it still has yet to recover. Angels either lost money or their investments are still tied up in stalling companies. Entrepreneurs who were expecting a a big payout to either help them start a new firm or invest in others came away with nothing.

Here's what one angel investor in Ottawa told me:


The angel community in town, the word I could use to describe it is tired. There’s a lot of angels that made lots of investments over the last 10 or 15 years, not a lot of it is paid back yet. A lot of those investments still look really good but they’re still investments, not returns. So there’s a lot of people waiting on the sidelines now saying ‘I’ve put a lot of money into this and I’m going to wait until I get some return before I jump back into the pool.’ (Interview O125)

Three things happened in Ottawa. One, current angels lost their money and pulled back on future investments. Two, a new generation of angels were effectively nipped in the bud and never really developed. Three, and most importantly, the new generation of entrepreneurs lost trust in venture capitalists. I can't even count how many times I heard the phrase "vulture capitalist." They refuse to even consider talking to venture capitalists. In turn, this slows their growth substantially and reduces the chances that they'll be acquired, which in turn means that even fewer of them will be able to act as angels and investors for future entrepreneurs.

All of this is to say that entrepreneurial ecosystems are very fragile. Acts like using an obscure clause to claw back stock options at one company can reverberate for years. Now do I think that this one act will destroy the amazing ecosystem that is the Silicon Valley entrepreneurial scene? No. But I do think that for the next few years, employees will be less willing to accept stock options and demand more pay. This hurts the growth potential of very small firms, and may start a cycle the turns into something bigger.

The takeaway from this is that it's not just about the entrepreneurs. When talking about how to foster entrepreneurship and firm formation on a region, we also need to think about the employees who will sacrifice pay and stability to work at a startup. We need to think about the angels who provide them with early stage capital, and the venture capitalists who help them take it to the next level. These actors and more act in a complex economic and social network. This network is far easier to disrupt than it is to build.