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Fixing the Venture Capital Model: Part 2

Posted on January 22, 2006

For those of you that have not been following the comments on my first “Fixing the VC Model” piece there has been a great discussion going on. Jeff Clavier commented first and mentioned that partial founder buyout won’t really work with small deals. This is a very good point. For example, if an angel or very early stage VC wants to place $500K into a company then the partial founder buyout (PFB) would not be big enough to align the entrepreneurs interests with the VCs. So, if PFB were to be inserted into a deal, the deal would really have to be larger than $5mm or so but that $5mm could also be spread among a syndicate of investors making it an aggregate deal total.

The next piece of the conversation was lead by Adam. Adam brought up two very good points that VCs would probably consider before using PFB:

1. Control over the founders: Many VCs may believe they’ll lose some control/power once they provide the founders with a $3mm safety net.

2. Company Growth: $3mm may be better off growing the company instead of sitting in the bank.

I will talk about the last point first. First of all, let’s disregard the fact that a company can be overcapitalized killing it from within and say that, in our example, the company could use the $10mm effectively. With that said, I agree that $3mm would probably be put to better use growing the company than sitting in the founders bank account when you look only at the surface. However, when you start to dig deeper one can see that the company could possibly grow more than it would have otherwise with the extra $3mm in the founders bank account because the founders would be more willing to take chances.

On to the point about control. I mentioned to Adam that the VCs would end up with more control relating to their percent ownership in the company which he of course knew. Adam then followed up clarifying that he agreed and actually was referring to the control that VCs have over entrepreneurs. Adam and I both agree that control of the company and not control of the entrepreneurs should be what VCs strive for. I think that there are a lot of VCs out there who do not look to control entrepreneurs but there probably are quite a few that do and would, therefore, oppose PFB. This control issue is something that needs to be looked at if the VC model is ever going to align itself more with entrepreneurs.

I hope that this sum up of the conversation has helped to catch everyone up on the issues with PFB. Please be on the look out for Part 3 of my Fixing the Venture Capital Model series which I will hopefully post sometime this week. In Part 3 I will look at the Venture Capital fund structure to see if it is cauing some of the static between entrepreneurs and VCs. Until then, keep the comments coming. I think this conversation is good for the start-up community and will hopefully be a small step toward effecting the change that I think most of us want to see.

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