Olson’s Observations

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Archive for the ‘Fixing the VC Model’ Category

College Debt Waivers: A Possible VC Innovation

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IdeasI read an interesting post by my friend Ed Kohler of Technology Evangelist today (you may remember all of the video he and his team shot for TECH cocktail 2 - thanks again guys!). Ed wonders whether a lot of budding entrepreneurs never get to carry out their business dreams because they need to pay off educational debt.

The story that Ed thinks may be the case all to often is as follows: Student has a great idea but has to put it off in order to take a “safe” job that allows him/her to whittle down their debt. While he/she works this safe job they may meet someone, get married, have kids, take out a mortgage, etc. which forces him/her to further put off their idea since they now have dependents and a mortgage and maybe even have some debt from school left. The dream is crushed and the world is left with one less exciting idea.

Ed sees this as an opportunity for VCs to innovate. He suggests VCs find exceptional students with good ideas coming out of school and offer to:

  1. Pay off their debt
  2. Pay them a salary - maybe $30,000/year
  3. Cover their housing

The VC would get equity in the new venture as usual and would shell out $100,000 per student on average according to Ed which, if even a few of the companies made it would be a good deal for the VCs.

I think Ed’s idea is a great one and very innovative. I have no doubt that a lot of ideas go to waste each day due to college debt and this would help to alleviate that problem. The ideas that are saved could also end up as huge wins for the VCs that came with low investment cost. Everyone wins. However, there are a couple issues to consider.

  1. VC Fund Sizes
  2. Inexperienced Entrepreneurs

VCs have differing fund sizes and numbers of partners so not all VCs will be able to put small amounts like we’re talking about to work. Perhaps angel networks and angels in general are in a better position to take this innovation and run with it. They can generally put smaller amounts of money to work and don’t have other constraints that come with a VC fund.

Since the entrepreneurs will be very inexperienced good advice will be very useful. Investors that try this innovative approach will need to be able to advise and mentor the entrepreneurs they pluck out of their cap and gowns. The better the investor can mentor and provide connections to the entrepreneur the higher likelihood the venture will succeed.

All in all I think finding students just out of school and taking care of their debt in exchange for equity in their company is a great idea. It allows good students to become entrepreneurs. Investors will see more deal flow. More interesting ideas will come to light and benefit the world.

As always, I would love to get a discussion going on this topic. The more we can talk through new ideas and refine them the better.

Photo Credit: KrassyCanDoIt on flickr

Written by Eric Olson

January 3rd, 2007 at 10:25 pm

FF Class Stock - Partial Founder Buyout is Alive

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Founders Fund LogoMy friend Noam Wasserman (check out his blog for more great founder research) sent me a note last night with a link to a piece about a new class of stock called FF stock that the guys at the Founder’s Fund have started to work into their term sheets. Noam sent the article my way because we have talked a lot about the idea of partial founder buyouts as a way to better align the interests of VCs and entrepreneurs and FF class stock is an attempt at making partial founder buyout a reality.

Soon after I saw Noam’s note I caught my friend Fraser Kelton’s piece on FF stock and knew I had to put some of my own thoughts together so here we go!

First off, it is great to see innovation in early stage investing starting to become more commonplace. It is no surprise to me that the Founders Fund is leading the charge on this. The Founders Fund, for those who don’t know, is a VC fund in which all the investment professionals were entrepreneurs and in some cases still are. The Founders Fund team is responsible for founding companies like LinkedIn, Facebook and Paypal.

The latest innovation the Founders Fund has implemented is the idea of FF class stock. The basic idea is this: FF stock is convertible to any future class of stock during a new issuance of stock. Let’s say there is a new issuance of stock in a company due to a funding round. At that point the founders can convert their FF stock, if they choose, and sell it to investors. I am sure there is more legalese involved (a lot more no doubt) but that’s the basic idea (check out VentureBeat for more).

FF stock allows entrepreneurs to partially cash out early on to make their lives a little more comfortable. I would argue that partial liquidity early on affords entrepreneurs the ability to focus more on the company and go for the big win which is exactly what VCs want to do. Interests are aligned. Case closed, right?

Well, as I have talked about in the past there are some investors who don’t like the idea of partial founder buyout/FF class stock. Their main argument, from what I have seen, is that entrepreneurs will be less hungry if they are able to partially cash out early. That may be true for some but I think most entrepreneurs are in the game to see their baby succeed and are able to keep their eye on the prize regardless of what else is going on.

What other issues could investors have? It seems that investors may not like that fact that entrepreneurs would be able to cash out before them. It also looks like investors don’t see upside for themselves in the PFB equation. These thoughts were expressed in comment on this post. The comment, shown below in full, was written by an angel investor.

The reasons why founders are jazzed about FF class stock are obvious, but so are the reasons why investors are opposed to them. As an angel investor, I think it is ridiculous to allow even a small liquidity event for founders before investors with cash in the deal receive anything.

Founders, by the way, take salaries and benefits along the way. If investors have to wait on an exit for some “comfort”, why should founders or management be relieved early? Ah…yes, greed.

I do think that there are clear benefits to investors especially in the new age of web start-ups where companies don’t need a lot, or any, outside capital to get things moving. The example I go to time and time again is Flickr.

VCs were looking to put money to work in Flickr previous to the Yahoo! acquisition and we all know that some money was left on the table by the founders. Can you blame them though? These were their options (simplified of course):

  1. Let a VC or VCs take a bunch of the company away from us, sit on our board and decide where our baby should go and, since they’ll push us to a huge exit, we may possibly never make it and walk away with $0 (while the VC still has a number of portfolio companies and is diversified).
  2. We can pocket $20+ million and get nice jobs at Yahoo! as well.

However, if a fund came in and allowed them to have some of their stock set aside and available to convert in a later round/issuance of stock for a small amount of liquidity they may have went for the big win and taken the VC money. In that case the founders would have probably made more and the VCs would have had a winning investment.

With more companies able to start up with no outside investment VCs will need to start innovating and providing incentives to entrepreneurs to get the best deals. However, entrepreneurs should be careful as there are implications for them as well.

Fraser points out the million-dollar-Saturn incident and I’ll quote the VentureBeat anecdote as Fraser did to illustrate the point.

The founder of Viaweb, a Paul Graham company, cashed out in order to buy his wife a Saturn car. It became known later as the “million-dollar-Saturn,” because of the worth that stock would have been had he kept it.

There are always pros and cons to any innovation and they come from both sides of the fence but, all in all, I love to see innovation happening in early stage investing. I can’t wait to see how FF stock plays out over time and whether or not it finds its’ way into more term sheets.

Written by Eric Olson

December 20th, 2006 at 1:59 pm

Is the VC Model Broken?

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Broken DollarThe subject of whether or not the VC model is broken has come up again so I thought I would weigh in. This time the New York Times started the discussion with an article discussing Sevin Rosen’s decision to abort the process of raising their 10th fund. The reason for the cancellation of Sevin’s 10th fund is summed up in a quote from General Partner Steve Dow:

“The traditional venture model seems to us to be broken…”

This is very interesting and intriguing for a couple of reasons.

  1. Sevin Rosen is a very respected firm that has been around for a long time (25 years or so) so hearing them say that the VC is broken means a lot more to people than Fraser and I talking about it.
  2. The firm had already taken somewhere between $250mm and $300mm in commitments for their fund meaning they had a lot of management fees coming to them.

Of course there are a lot of VCs who don’t think the model is broken. One of the first VCs to respond was Fred Wilson. Fred’s conclusion was that the VC model is not broken but just a model that needs to be tweaked. His suggested tweaks, which he says a lot of VCs, including himself, are already employing are as follows:

  • Raise smaller funds.
  • Do less “hard tech” and more “soft tech”
  • Figure out how to make great returns on $100mm to $250mm exits
  • Limit our IPOs to our very best companies

I totally agree with Fred on those points. In fact, I have talked about the benefit of smaller funds before (check out my post on <$100mm funds for more). However, I think that the New York Times article is referring to the “traditional VC model” which is… well, I don’t really know. My guess is that most people would disagree on what the traditional model actually is.

I think that the traditional model the New York Times was referring to is large funds looking to put a lot of money to work into companies that will generate high 9 to 10 figure returns through IPOs. This is exactly the opposite of what Fred calls for which leads me to this statement:

Perhaps Fred doesn’t think the VC model is broken because he is, in fact, one of the “new school” innovative VCs.

I happen to believe Fred is very innovative and what seems so natural to him doesn’t come natural to others.

VC funds themselves are not the only piece of early stage investing that is going through some changes. There are also other innovative trends happening now that are changing the game. One of those trends comes in the form of “advisory capitalists” or ACs. ACs put time to work instead of (or along with in some cases) money for a share of the company. They are basically a hybrid between a VC and a consultant.

There are some problems with ACs though like the fact that they probably won’t be able to put up money when the company needs it leaving the ACs piece of the pie vulnerable to serious dilution. However, the idea is interesting and new and that’s a good thing (check out my previous article on ACs). If you would like to read more about the innovative things that are happening in early stage investing please see Fraser Kelton’s post from earlier in the week that includes a nice summary of the new ideas including ACs.

In the end of the day there is definitely one thing that everyone can agree on though: It is a very exciting time for early stage investing. I, for one, am excited to continue watching the progression while hopefully contributing to it as well.

Update: It seems as if the reason Sevin Rosen gave for halting their latest fund (VC model is broken, etc.) has come into question.  VentureBeat is reporting that Sevin Rosen may have orchestrated a snow job on the New York Times and that the real reason for the halting of fund X was due to internal personnel issues.  Either way - discussing the venture model and how it may be tweaked to perform better is still important.

Written by Eric Olson

October 11th, 2006 at 9:49 pm

The Founder Discount

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Empty PocketsThe latest podcast in Pascal Levensohn’s VC-IO entrepreneur series came out today and the subject matter was CEO compensation and the founder discount. Compensation in start-ups is something I am very interested in and, as long time readers know, I have talked about ways compensation could be structured differently to better align entrepreneurs with VCs (the previous link is to the first in a string of “fixing the VC model” posts). Little did I know that there was a man by the name of Noam Wasserman, Harvard Business School professor and blogger (I am now subscribed to his feed), who has done a lot of research in this area.

The fifteen minute discussion that ensues between Noam and Pascal on the podcast covers a lot of material so I will highlight some key points here although I suggest listening to the whole thing if you can.

  • Difference in (cash) comp between founders and non-founder averages $30k per year in the non-founders favor
  • This gap persists in booms and busts
  • There are some voluntary (take a pay cut to keep the burn rate down) and some non-voluntary (board won’t give founder CEOs a raise since they know the founder doesn’t have any ground to stand on because the business is their “baby’) reasons for this gap
  • As the company grows the gap starts to disappear
  • About 50% of CEOs in the study make the same or less than one of their subordinates and almost all of the 50% are founder CEOs
  • Non-founder CEOs are less aligned with investor interests
  • Equity is an important thing to consider but these findings take equity into account

As Pascal asks in the podcast - Why should we care about this? Isn’t this what being an entrepreneur is about? Taking pay cuts to work on your “baby” and to gain on the upside of your equity stake? At first blush caring about this may seem silly but when you look deeper you can see that there are significant issues brought on by compensation.

Founders will eventually be faced with hiring non-founders that get paid more than they do at which point they will begin to wonder why they are worried about saving that extra $30k for the company. The founders can also become distracted by their lack of pay and begin to lose focus on the business. In these cases, if the founders were just paid adequately they would be able to focus more on the business and less on how they are going to pay their bills and whether or not they may ever see any upside on their equity stake (this could be another case for partial founder buyout although PFB has its’ drawbacks as well).

Founder compensation definitely plays a role in how a company will move forward and I know I will continue reading Noam’s blog for the latest in compensation and other studies on how non-founders and founders differ.

Noam’s latest paper on founder/CEO compensation can be found in the October 2006 issue of the Academy of Management Journal and is one of a series of papers dealing with the differences between founders and non-founders.

Written by Eric Olson

October 10th, 2006 at 9:20 pm

Fixing the VC Model: GP Ownership

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MoneyIt occurred to me while writing the piece below on the current state of the IPO market that VCs could differentiate themselves by putting in more of their own money into their funds than the traditional 1%. This would lessen the desire to place money into investments solely to gain more management fees (it should be pointed out that most VCs strike it rich from making good investments and not on management fees). It would also align firms more closely with the entrepreneurs they work with. Some VC firms, like MK Capital, are already doing this (MK is the largest investor in their own fund) and it seems to be working great for them. Love to hear your thoughts on this.

Written by Eric Olson

August 3rd, 2006 at 1:14 am

Posted in Fixing the VC Model, VC


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I read a great post today by Matt McCall of Portage Ventures. The post was titled “The Angelitis Blues” and focused on how seed round deal structures can really affect future professional VC funding rounds. Apparently this is becoming a bigger issue in the new “low cost” start-up market. Matt mentions that he and his partners at Portage had to walk away from three deals recently because of the deal pricing discrepancy issue. Essentially what had happened was the entrepreneurs had priced their previous angel rounds too high and did not want to go through a down round.

This is something that I had not thought of when going through my previous “Fixing the VC Model” posts. I had focused a lot on how cheap it was to build companies, the disconnect between the mega VC funds and entrepreneurs needs and how more angel funded companies could be a good thing for entrepreneurs. In reading Matt’s post the hole in my thoughts (one of them at least) was brought to light. I had failed to discuss how angel funded rounds, if not structured properly, could potentially impede a company’s ability to raise money from a professional VC.

I will quote Matt’s example so you can get an idea of the problem:

The company raises the first $500k at a $5M post-$. They grow and need more capital to ramp sales/marketing, so they raise the next $500k at a $10-15M post-$. At this point, the company is probably doing $1-3M in annual sales and growing linearly. The entrepreneur decides it is time to raise a venture round now, and goes to market with a $5M raise at $20M pre-$ valuation ($25M post-$). This is where the disconnect hits.

A company that is growing linearly (say $1-2m going to $3-5m this/next year in revenue) is going to be valued at a $3-7m pre-$ valuation. (I will write about different pricing approaches coming up.) The revenue often does not ramp as quickly as the entrepreneur expects (plans from two years ago had probably shown revenue of $10M vs. the actual $2M). Angels, being less price sensitive, had been willing to invest at the higher valuations. However, when the company needs more capital to scale (and is tired of living off of $500k rounds), it is forced to go to the professional venture community.

Matt provides one possible answer to this dilemma saying that entrepreneurs should use a convertible debt structure for their angel rounds. This will allow the money to convert to the professional VC round when it is raised. The angels may push back on this for various reasons but if they go for it it will ensure the entrepreneur is not stuck in the future. Entrepreneurs should heed this advice and really think past the dollars when considering their initial funding rounds (and all financings for that matter). Thanks for bringing this up Matt. I look forward to some more posts on Angelitis soon!

Written by Eric Olson

March 14th, 2006 at 10:53 pm

Posted in Fixing the VC Model, VC

Advisory Capitalists?

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Stowe Boyd brought up an interesting notion of Advisory Capitalists (or ACs) last week and it had created a lot of stir with people on both sides of the coin chiming in to flush the idea out. One of the more interesting chime-ins was Fraser Kelton’s. Fraser brings up the idea that VCs could add advisory services to their offering as a happy medium to either VCs or ACs. I liked this idea enough to comment on Frraser’s piece. Here are my comments:

Another great piece of writing Fraser. Well done. I had commented on Fred’s [Fred Wilson] article in agreement that money (”skin in the game”) is important to the VC/entrepreneur relationship. However, I should have thought things through a bit more and I would like to think that if I had I would have come up with your argument. VCs could easily add some of these “advisory” services into their current offering mostly untilizing staff they already have. I think as the VC space becomes more competitive for deal flow you will see some of these advisory services enter into funding offerings.

Another intersting thing that advisory services could do is bring a tier 2 VCs to the top tier. There are some good tier 2 VCs that just don’t have the reputation or track record of people like DFJ simply because they are too new. If these firms began to add advisory services to their offering they may be able to break out of the tier 2 level sooner and compete with the big guys for deals potentially shaking up the landscape in a way that not only benefits the tier 2 VCs but also benefits entrepreneurs.

I think there are some very hands on VCs out there now already adding in advisory services without calling them by that name. When I think of these individuals and how they are able to get such great investments things start to make a lot of sense.

There are a lot of great hands on investors out there that are, in a sense, adding a lot of advising time in with their cash investment. I believe that most of the better VCs are doing this and it is why they are in the positions that they are. Entrepreneurs are getting smarter about capital all the time. They know that they need not only the cash but a partner that will stick with them for the long haul through the good times and the bad. As more and more entrepreneurs figure out that VC isn’t all about the money, more VCs with advisory capacity will appear but the guys that have been doing it all along will still have a good stronghold.

On a side note: It was mentioned that ACs alone would not have the capital to put up once an entrepreneur needed it. This is probably the case (depending on the AC of course) considering that they are only individuals while VCs have a lot of money raised from their Limited Partners to put to work. It was also noted that ACs may not want to part with their vaulable advice for such a small portion of the company. This is especially important considering that ACs would not have the cash to continually participate in subsequent funding rounds leaving their positions to get diluted even further.

Let’s also remember that the VCs are not bad guys. A lot of them are great guys who really want to help companies out. Yes, they are worried about losing investments but it should be noted that a lot of times they are managing money for foundations, non-profits, pension funds and college endowments so the more money they can make the more these institutions will be able to help people (and, of course, the more money they make for themselves as well).

Written by Eric Olson

February 27th, 2006 at 2:43 pm

Posted in Fixing the VC Model, VC