Peter Rip’s Getting a Line on Alignment suggests that venture capitalist’s should consider helping their portfolio company founders embrace high risk by putting some money in the founder’s pockets.
While an entrepreneur may be happy to sell his company for $50 million, his investors may want to take the risk of turning the company into a $1 billion business. The investors are glad to take this risk because they are managing a portfolio of investments while the founder has all of his eggs in a single basket (his company). Putting some money in the founder’s pocket will help him take more risk.
The Founder’s Fund
Here’s a crazy idea. What if VCs offered the founders of all of their portfolio companies the opportunity to put 25% of their stock into a single pool (let’s call this pool the “Founder’s Fund”). Then the Founder’s Fund is split up among all the founders that contributed. This allows company founders to diversify some of their stock across their VC’s entire portfolio. (There are lots of non-trivial issues that I am not going to address like pricing the stock correctly, taxes, and accounting.)
Peter Rip suggested putting cash in a founder’s pockets to help him embrace risk. But investors like to see their cash “go to work” in the company, not “go to work” in the founder’s pockets. The Founder’s Fund aligns the investors and the entrepreneurs while putting all of the investor’s money “to work” in the company. And there is no reason VCs couldn’t put some cash in the founder’s pockets and let them invest in the Founder’s Fund.
(Update: There is venture fund that specializes in buying out founder’s equity. I can’t remember the name right now.)
Different Interests
The world does not revolve around aligning interests. If it did, we would all be doing the same thing. People do business because they have different interests.
If I sell you my car, it is because I no longer want to own it while you do want to own it. We have different but complementary interests. Different but complementary interests are as important as aligned interests in any negotiation or joint venture. Getting to Yes is my favorite negotiation book and covers these topics and more.
VCs and entrepreneurs have different risk interests. Entrepreneurs are supposed to embrace high risk and hopefully reap the concomitant high rewards. VCs embrace less risk because they are diversified across a portfolio. Limited Partners who invest in venture capital funds take on even less risk and their returns are therefore lower.
This is quite brilliant. I guess some founders could see it as a drag on their potential and the vc would then be adversely affected in its ability to attract some deals. I think it should be closer to 5% and the vc would have to offer it without exception.
nivi, i have the beginning of a business plan for a fund that would enable both founders and employees to diversify the financial risk associated with choosing serial entrepreneurship as a long-term career path. let me know if you’d like to discuss. you can bounce it off of scott ring at bvp.
I agree. This is a clever approach to solve the problem. We can’t continue to overlook the total disparity between vcs and entrepreneurs. The system is broken and it needs fixing. With Nivi’s solution cash isn’t exported out of the investee company, yet the founders still get a degree of diversification (which makes it better than a straight cash out).
All of this discussion, of course, needs to be steered towards venture capitalists, and the magnitude of benefits that risk alignment makes available for them. Everyone understands that if changes are made, then founders will be more comfortable taking more risk (which might translate into better portfolio performance), but here’s another important benefit that the “founder’s pool” can accrue to the venture capitalists.
Quite fundamentally, we can changing the way we think about vc financing; away from it being a straight injection of cash, and towards thinking of it as a “financing package” which includes other securities, and perhaps fringe benefits.
VCc need to compete and differentiate their money. If they have another dimension to their “product”, it just gives them more bargaining strength for negotiate better deals. It’s like employers differentiating themselves by emphasizing the complete spectrum of the remuneration package (rather than salary).
For vcs, it’s not just the amount of money available, it’s not just how much “value add” you can offer, it’s the “risk profile of the financing package” you can offer to your entrepreneurs.
For example: Bessemer can do an early stage deal, but the financing package they offer includes complementary securities (like interests in other Bessemer investees). For entrepreneurs, they get the money, but they also benefit from an improved personal finance risk profile – making Bessemer financeer of first choice.
The point is: Entrepreneurs diversifying their risk is good for venture capitalists.
fascinating post Nivi -
This is very similar to what I’m doing with Remote IQ; the intended result is a portfolio of startups and founders that share equity; a web2 incubator if you like that builds and spreads risk across multiple “investment products” for which we plan to attract VC interest. Likewise we offer VC’s the option of either spread risk in Remote IQ, or direct investment in our startups once they’ve proven themselves in Alpha.
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Nivi,
check out this article from wired http://www.wired.com/wired/archive/13.04/pension.html its about someone doing the same sort of thing for apiring artists so that they can have a pension fund.
Edwyn
I had blogged about the same issue, as well as the responses I got from the VC community.
http://csertoglu.typepad.com/sortipreneur/2005/05/what_drives_ven.html
Nivi,
There was something like this back in 2000–I think it was called an exchange fund, but it was for companies that had been bought or gone public and the execs or founders were locked up. They were able to do tax-free exchange of stocks with other execs in the fund, so everyone would get some diversification without having to tax a tax hit in doing it.
But doing it sooner and making the founder almost a limited parter is a great idea. Really great.
Two words: adverse selection.
However, in the scheme that you imply, where a VC does this for every founder that they’ve invested in (mandatory!) that problem goes away. You may be on to something here.