In case it wasn’t obvious, being an entrepreneur is risky business. Even those that get investments have a relatively small likelihood of a successful exit. So early-stage investment firm First Round Capital has a plan to alleviate some of the risk: an entrepreneur’s exchange fund.
For those not aware, an exchange fund in this regard is exactly what it sounds like: company founders are given the option to give up a small piece of the stock they own in their venture in exchange for a piece of the action of the larger pool of all the First Round portfolio companies that choose to participate. Basically, this allows these entrepreneurs to diversify their own holdings without having to sell any stock. More importantly, it lowers their risk of walking away with nothing while adding an incentive to see other companies in the portfolio succeed.
As First Round managing director Josh Kopelman writes, “One of the benefits of having a fairly large portfolio is that our portfolio companies can offer a lot of value to each other. Whether it is sharing interview techniques, technical management strategies, sales leads, perspectives on the advertising market, or doing deals – it is always great to see portfolio companies helping each other succeed.” And with this exchange fund, all of these companies have more reason than ever to help each other out.
Kopelman notes that First Round itself doesn’t receive any financial benefit from the establishment of this fund.
First Round’s portfolio includes companies like Get Satisfaction, Gnip, Mashery, RockYou, StumbleUpon, Wikia, Xmarks, Xobni, and many others. Notably, their portfolio also contains two hot location properties right now: SimpleGeo and Hot Potato. And they participated in mobile payment company Square’s big first round.
[photo: flickr/michael spencer]
How is this a good idea? Only losers would considering offering a share of their company into the pool. And by the game theory, the pool itself is composed of losers, hence the pool would self-destruct over time.
Except you don’t know if you are a winner or a loser at the time you give up a share…. only after an exit.
Maybe so, but I wonder if this applies to employees that hold stock with their employer, such as facebook. I could certainly see someone putting a percentage of their paper value into a fund while holding onto the majority of their ownership in a promising company.
I love the concept of camaraderie this could create as well.
So you are trading one piece of illiquid asset based on artificial valuation for a share of pool of illiquid assets. That doesn’t solve the fundamental issue: liquidity. If you do that, all you get is more correlation, ie: more headache.
have to agree, that this is a good idea, in that this type of activity already currently happens, a vc will suggest to another company its invested in to use the service of another company. Sometimes bringing a lot of these so called loser companies, figuring out how to leverage them for the success of the whole, may work out.
Not really. Since you can’t predict winners well enough, the optimal cooperative strategy is to opt-in. Virtually all will benefit.
Actually from the perspective of the entrepreneur, there are two cases:
1. Your own company is a loser. In this case, my statement is true: that if you join the pool, then you are a loser. Nobody benefited from the failure. And that your membership in the pool is wasted.
2. Your own company is a winner, and you joined the pool. In this case, your success is carved up by other loser’s ownship stake.
So in either case, you lose by participation in the pool.
Now, on the other side of the coin, if others in the pool end up being winners(probabilistically rare), then you won’t feel like a winner, trust me. To an entrepreneur, nothing feels worse than to leech off of other’s work. And the winnnings again will be shared amongst all pool members.
So both sides of the coin is bearish for the entrepreneurs.
This is not true for the venture capitalists. This provides semi-liquidity for those who made the wrong bets to use their failed illiquid assets as baits to trade for better alternatives. In that case, it is about risk mitigation of the losers for the venture capitalists.
What about the ability to share resources, high level business development and JV’s with other companies who are participating in this portfolio. Count me in on this deal… How do I sign up?
I agree; I have enough time keeping up with my own company. This also doesn’t seem like a very good idea from the perspective of the VC or public policy. That’s because the whole country is facing a problem of “heads I won; takes you lose” — rewards being decoupled from risk typically via diversification.
Failure isn’t bad because we learn. But by removing or lessening the sting we’re less likely to get the point: the lessons disappear. If a company that has a culture of working six hours a day, five days a week, and paying high salaries to founders who have no real revenue predictably croaks why should the founders — the lousy manages — benefit form companies that work 18×7 and use their funds wisely?
As for partnerships that’s different. There’s nothing stopping young companies from partnering with one another, except a frequent lack of desire to do so and sometimes the time to negotiate and close deals. Still, this doesn’t address that issue at all.
If any startup founder is so sure of their company’s prospects as to judge their chance of success as greater than the average, they are likely not very realistic (in light of history), and since realism is correlated with intellect, only the dumb founders will choose *not* to participate, and since intellect is correlated with winning, the pool will be composed only of the winners.
Such reasoning is silly.
Really? So by your logic, the ones with intellect are realistic, and because of that they realize that they are not above the average, thus they must average out with other founders to mitigate the risks away?
Please, if you believe that’s the logic that entrepreneurs believe in, then you are not an entrepreneur.
You are missing the main benefits of an exchange fund. It’s not about instant liquidity; it’s about diversification and creating a very strong network. When you start a company, or for that matter 5 years later, you don’t know what the outcome will be, neither does the VC, that’s why you need to be a diehard optimist. All companies have risk that founders and VCs cannot control or anticipate. Maybe Google decides to enter the phone business, maybe there’s a banking crisis, or maybe you located your servers in Haiti to save money – these are the reason you diversify. Diversification of under 10% of your holdings in a start up is rational, this way your big upside is still with your company. If a founder wanted to diversify with 40% of his holdings I would agree it’s probably a junk company, but 8% is smart. Further, if a smart VC like First Round just invested it’s been well vetted. In fact, a good VC would never let a founder diversify if the company wasn’t performing but if the company had created value for the investors then it’s a smart thing for a VC to allow. And if a company is a ‘sure bet’ the inside investors would buy the stock (they rarely buy the common). Companies that join exchange funds still have great prospects and still have risks, pooling that risk is smart and rational. I may be biased because I created 4 exchange funds (ebexchangefunds.com) but I do consider myself a bit of an expert on this topic; I have a common stock position in over 100 companies, I started multiple venture backed companies and I’ve personally invested in over a dozen companies. I can tell you that it is VERY hard to know which ones will hit and knowing that you will have a ‘soft landing’ makes swinging for the fences that much easier.
This is a great concept. I would be curious to know on which basis the share swap occurs?
a bit off topic, but is googl.com / search box down? or is it for florida users? or for users using firefox? or is it just me?
Google works fine for me.
I also have a maybe-off-topic question too. My old Dell workstation keeps making a loud buzzing noise when I power it up. Should I buy a new power supply for it, or invest in one of the new Lenovo desktops? I’ll be paying with some savings from last year’s company bonus, if that makes a difference to anyone.
Sounds like a great idea to me. The killer problem with all such exchange funds is establishing a fair valuation, since each entrepreneur thinks their baby is the best.
By having a common investor, that may get rid of that problem somewhat.
Yes Paul, its off topic.
Well following the logic of the first comment, depending on the quantity of dumb money, this could be a great idea
Josh is the founder and managing partner of First Round Capita, not the marketing director. Though he is a marketing genius.
For entrepreneurs who want some diversification, and potential access to early liquidity (since it takes at leat 5 to 7 years for a startup to reach that point typically), it is actually a very interesting idea.
heh yeah my bad on that typo. didn’t mean to demote him :)
@Jeff,
How is this good? So, the founder gets more of nothing, and less control in his company?
@Tim
I have not had a chance to chat with my friend (and mentor) Josh about this program, so I don’t have the details, but I can only assume that it allows founders of FRC companies to place a small amount (a few percentage points?) of their share ownership in this common pool. Small enough that it would not have an impact on control thresholds.
And I also assume that it is entirely voluntary, so if you don’t want to participate, you don’t have to.
F’ing brilliant.
As someone in the First Round Capital portfolio, I think this is fantastic. We’ve already placed significant bets on ourselves, so why not our friends and portfolio siblings? FRC has had some great exits recently, not the least of which was Mint.
It’d be great to be “rooting” for each other by putting our money where our mouths are.
Fantastic, Matt. So to the question above, does it apply to employees with stock options as well or what are the participation limits?
To be 100% honest, I don’t know. This program is brand new, and it’s not something that I’m THAT familiar with, so I don’t know all the intricacies.
But you should try and become a portfolio company!
Flying solo at the moment but doing a lot of advising and angel investing. I’ll definitely be looking forward to hearing more. Thanks and best of luck!
This is a fantastic idea. I applaud @firstcapital for making this real. I am a co-founder in a self and friends financed start-up, Voottoo. Given that we spend a bunch of money in our own start-ups, a group of us got thinking. A few of us entrepreneur friends founding different companies are looking into the idea of pooling equal amounts of money and dishing out funds to all our start-ups as a way to diversify our risks. We all get small stakes in each others’ companies – the company still gets the investment.
That really cool
Not an original idea (not even for techcrunch):
http://www.techcrunch.com/2008/04/16/eb-exchange-funds-provides-safety-net-for-entrepreneurs/
Brilliant idea
is a domain portfolio startup a liquid asset?
Kinda cool, but if you didn’t believe with all of your heart that your start-up was the best bet, then you should just go to work for the other guys.
it’s a great idea and something. i proposed it to my last investors but they had no interest. founders of companies put all their eggs in one basket; this helps them diversify, and in some cases, get a bit of liquidity sooner when another company in the portfolio gets liquid.
It also gets portfolio companies pulling for each other–every bit helps.
I’d be excited about getting First Round Capital involved in any company I was a part of, and this sounds like a great value-add for their entrepreneurs in their portfolio! Josh Kopelman has had personal success as an entrepreneur and a proven track record with the FRC fund. Any entrepreneur who chooses to diversify by exchanging a small percentage of his or her holdings from participation in an exchange fund — with companies vetted by Kopelman and his colleagues at FRC — is not only realistic, but SMART. How many VC-backed companies out of 100 actually get to the exit stage in 5 to 7 years? 10%-30%, right? Sure, every entrepreneur wants, hopes, and expects to be the exception and not the rule, but even a killer idea, great team, and adequate funding don’t ensure success. Sure, die-hard optimism is important, but so is the ability to make good decisions regarding risk!
If hotpotato (Alexa ranking: 198k) and simplegeo (Alexa ranking: 146k) are two hot location properties right now, then the Twalky (http://www.twalky.com) platform (Alexa ranking: 79k) is even hotter based on Alexa ranking.
The Twalky platform is currently in private beta but some of the applications that are built on top of this platform is open to the public like TwalkyEvents (an iphone app that locates events around you through GPS technology) and Innovation Movement Network (a prize-winning app sponsored by 2010 Consumer Electronic Show).
Based on Twalky platform, anyone can built applications with real-time streams of anything (like places, events, people) so watch out for more apps coming from twalky soon.
Maples now admits that his hobby is more of an obsession, and he’s changing the name of his fund to mark the milestone. Goodbye, Maples Investments