Entrepreneurs turn partners with the new VC fund in town!
Upside ventures, the new venture capital fund started by Kent Goldman has an innovative way to incentivize its entrepreneurs. Mr. Goldman is promising the start-up founders investment profits, in addition to the usual expert advice and network contacts. The founders of the companies that Upside ventures invests in will receive a cut of the profits earned by the fund, Mr. Goldman said.
This type of strategy was never heard of before in the venture capital industry before. Mr. Goldman stumbled upon this compensation structure over his years of experience dealing with entrepreneurs wanting to partner with investors in their new investment deals. Mr. Goldman also elaborates that the point of this structure is to encourage collaboration among entrepreneurs in which he invests.
If this venture capital tastes success with this strategy, this would be the birth of a new compensation structure that would be used in the industry and not long before this structure would make its way into the Harvard Business case study analysis. Kent Goldman, prior to Upside ventures, worked with First Round Capital for close to 5 years. He previously also worked for Yahoo in mergers and acquisitions. With the experience that Mr. Goldman has gathered under his belt, I hope this strategy would kick off!
What do you monkeys think of this strategy? Any thoughts?
It's interesting in concept but I'd to see how the economics change to the entrepreneur. The founders should have a pretty significant equity stake regardless so I suppose mitigating some of the single investment risk occurs (because instead of only being invested in one company the founders now have some risk spread out over, let's just say 10 portfolio investments) but most entrepreneurs believe in their company/idea and actually want the concentration risk so they're not going to want to give up significant equity in their company in exchange for a stake in the larger VC fund, and the VC fund isn't going to give anything away for free.
Like I said, interesting but I'd like to see the details. I know the First Round guys have hit a few homers over the years and Kopelman's a stud down in Philly so best of luck to Goldman.
Dingdong08 - thank you for your input!
It does sound interesting. However, I don't think the fund intends to take away greater portions of the equity. From what I understand, the fund is giving the investment profits in addition to the existent VC strategies. It does sound advantageous to the entrepreneurs than to the VC partners.
Why would the venture capital guys go for such a strategy? As discussed, may be we need to wait and see the future for this strategy!
Any good VC will admit that they can be wrong, so I preface this comment with the full understanding that I don't know everything and I could indeed be wrong.
But...
This won't work. What this equates to is giving the entrepreneur founders a piece of the carry, and this simply creates a misalignment of incentives.
Think of it this way. On average, the Fund only keeps about 20% of the profit anyway. So of the 20%, you're distributing a portion to the founders. No way the fund is giving up more than 5% to entrepreneurs because VCs don't hate money and it's already risky as it is. But lets assume for argument sake that they are willing to give up 10% of their carry to the entrepreneur team.
Let's do the math here (disregarding management fees, hurdles, waterfall structure, GP commit, preferences, etc):
Lets say their fund is hard-capped at $100 M and is fully subscribed. They do 5 investments, at $20 M each. Let's say 4 of the 5 returns it's money after a few years for a 1x exit (these are essentially failures). No carry is generated, for partners or entrepreneurs. That means that so far, capital returned to LPs is $80 M. Lets say that the 5th company is a big success, and the fund exits the investment for $200 M, or 10x. Total return is now $280 M, or a gross return of 2.8x. Not too shabby considering the other investments.
Because $100 M was invested, only $180 M of the $280 M is eligible for carried interest. Of that $180 M, 80%, or $144 M goes to the LPs immediately. The remaining $36 M goes to the GPs. Only, in this scenario, half of that, or $18 M, goes to the entrepreneurs also. Great deal for the entrepreneurs! Except that means that $18 M is now distributed over 5 teams of entrepreneurs. Assuming 2 entrepreneurs per team, you are distributing profits from one good investment to 10 people. So you're essentially giving away $1.8 M to each entrepreneur (assuming 10% of the GP carry which is overly generous), whether they did their job or not. The entrepreneurs of company five don't care about the $1.8 M though. Why? Because they probably owned somewhere between 40% to 80% of their company, which means together they are worth from $80 M to $160 M after the exit.
So what did we learn? We learned that this fund plans on giving money to entrepreneurs to "motivate" them. Um... don't entrepreneurs already have a stake in the upside??? OF COURSE THEY DO. Their stake is WAY more than some small portion of 20% of whatever profits the fund can scrounge up in an increasingly competitive space. Entrepreneur motivation should be built in.
If you're asking "why does this create a misalignment of incentives though?" or "what's the downside of getting more money?", then listen: If you care about the $1.8 M that much, then you likely don't have a long term, passionate approach to your own company. You can call it insurance, but if you are getting VC backing, chances are you have already proved a great deal about yourself and your company, so why not shoot for the stars? I know entrepreneurs who have passed on MUCH larger exits at 100% ownership because they believe in their company. Fault them if you like, but Snapchat did just that (for better or for worse). It happens because real upside is real. $1.8 M is nothing, though it's far more than what this firm will actually offer the entrepreneurs.
This sounds like a gimmick to me. It sounds like a ploy to weasel into deals but I can say this with absolute confidence: my shop would never consider this model. LPs will hate it, GPs will hate it, and it will attract the wrong entrepreneurs. Period.
Mr. Manager - Thank you for your thoughts!
I was also wondering on these lines as to why would LPs or GPs follow this strategy. You have cleared that up!!
Also, no way on earth LPs agree to increase carry for the entrepreneurs. Have you talked to an LP lately. Not happening.
It seems like a mixed bag to me. On one hand, you might take away some "pressure" of the owners of the companies because they're going to get a bag of money virtually regardless. On the other hand, it might make the VC company much more attractive and thus get both better leverage in negotiations and get better prospective companies on the negotiation table. If that really is the upside for the VC company, it seems that this would be a great way to get better investments for them.
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