Digg is dead. Sure, the company won’t be disappearing today,
tomorrow or next week, but to anyone who lived through the first .com
bust, the writing is on the wall: the company’s redesign woes and
yesterday’s 37% staff reduction don’t bode well for its future prospects.

For Digg to survive and thrive once again, it’s going to have to beat the kind of odds that few companies do.

Perhaps one of the most intriguing aspects of Digg’s rise and fall that hasn’t been discussed much is founder cash outs. As the Web 2.0 boom got underway and startups like Digg were wooed by VCs competing to invest, the idea that VCs could and should provide liquidity for founders became more commonplace.

The logic was simple: going public wasn’t an option for most of these young, fast-growing startups, so it might be good to let founders looking to take some money off of the table do so by selling some of their shares in a big investment round. In many cases, this also made sense from a shareholder structure standpoint, as founders held a large portion of the young company’s outstanding stock, and buying founder stock could potentially reduce the amount of dilution required.

One of the founders who was rumored to have taken money off the table in this fashion was Digg’s Kevin Rose. While, to the best of my knowledge this was never confirmed, there were numerous reports that Rose had sold millions of dollars worth of stock to Digg investors in multiple financing rounds. Rose’s investments as an angel (he has put money into numerous startups, including Twitter and Foursquare) might lend some credence to those claims.

If we assume that Rose took money off the table as being accurate, and couple them with the fact that Rose increased his activities outside of Digg until he took the reigns as Digg’s CEO again in April 2010, there’s an interesting question: is there a possible relationship between Digg’s current woes and the founder’s level of investment and involvement?

More broadly, do VCs shoot themselves in the foot when they allow founders to cash out before their startups do? While we have no way of knowing if Rose took money off the table, or how much, we do know that Rose was instrumental in Digg’s early success. He had an idea and vision, and he executed on it. For better or worse, he became the face of Digg, and for a time, it appeared he could do no wrong in the eyes of the Digg community. Certainly, Rose has always seemed to be more in tune with members of the Digg community than anyone else who has served at the company’s helm.

One might very well argue that as Rose disengaged from Digg and became involved in other ventures, Digg lost an important part of its secret sauce: the influence of its founder. Whether or not Rose’s disengagement was due to the fact that he was financially comfortable, it’s hard not to think that founders like Rose might lose a bit of their fire or become distracted by other entrepreneurial callings once they have some cash in their pockets.

With Digg as a possible real-world example of this, VCs might want to look at this more closely when the third internet startup boom hits. The landscape for venture capital is as complicated and challenging as it has ever been, and while there may be good reasons to provide for some level of founder liquidity, it’s unclear whether companies will be any better off for the practice, at least as it was implemented during the heady days of Web 2.0.

Photo credit: Joi via Flickr.