EB Exchange Funds Provides Safety Net for Entrepreneurs

It’s well known that entrepreneurs are risk takers, but the continued activity of EB Exchange Funds (EB) – which allows startup founders to hedge their bets by pooling their shares together – goes to show that everyone has a conservative side.

The idea behind an EB Exchange Fund is simple: large shareholders from a diversified set of mid to late-stage companies each put 5-10% of their shares into a pot. They can then claim minority ownership of the entire fund in exchange for their contributions. And if several of the participating companies go belly-up, at least their founders can share in the success of those companies which exited successfully.

EB has been arranging these funds since before the first dot-com bust. EBX1 (each fund gets its own number) was established in 1999 for 11 early stage businesses. The first fund could have been a winner had not Zaffire, a hot optical networking company at the time, turned down a $6B acquisition offer and pushed for $8B from its prospective buyer (and this with only a $100M valuation when coming into the fund). But the bubble burst soon after and none of the EBX1 funds had extraordinary exits, so EB went on to form another fund in 2002. OpenTable, whose founders participated in EBX1, does however continue to do well and will probably IPO, making the fund worthwhile in the end.

EBX2 involved 26 later-stage companies that went on to have 15 exits and 6 liquidity events. One of those could have been Google. But EB founder Larry Albukerk didn’t agree with Sergey Brin that his company should be valued at $2B in 2002. It is hard to blame him; most everyone undervalued Google those days.

Five years passed before the third, and most recent, fund was established on the eve of 2007. EBX3 involves 30 even later-stage companies, two of which can be considered Web 2.0 plays. The names of the companies involved in an EB fund are rarely disclosed publicly, but we are told that 14% of EBX3’s companies provide online consumer services, 10% provide software as a service, and 27% produce other types of software. Other types of participating companies include medical device producers, financial services, media, and more.

EB Exchange Funds charges management fees in similar ways to more traditional venture funds. Its funds are designed to reward companies that succeed by not charging them the percentage fees that are imposed on companies without exits. While the system is a bit complex, EB basically makes a 85-15 VC-style split on liquidated shares.

The organization also picks suitable companies for its funds by piggybacking off investors and their due diligence. And it has safeguards in place so that if a company goes under or raises a down round within a year of joining, its founders are shown the door.

The idea of an exchange fund for entrepreneurs doesn’t come without concerns. Albukerk admits that venture capitalists are not always the most enthusiastic about having their startup founders effectively divest themselves of stakes in their companies. Because participation in an EB fund often requires the approval of one’s investors, the organization often must work with founders to allay the concerns of their investors.

The exchange funds are also not without competition, and from none other than the VCs themselves. With the surplus of money floating around private equity circles these days, VCs often offer to put money in the pockets of entrepreneurs for a chance to invest in their companies. Sometimes just as much money will go toward cash bonuses as goes toward companies themselves, all in an attempt to lure the best companies away from competing firms. This is a trend that Erick wrote about after interviewing the founder of TheFunded (coincidentally, EB Exchange Funds has also partnered with TheFunded).

EB Exchange Funds is looking to close its fourth fund with 30 companies by this coming June.