Putting Founders First
Entrepreneurs have long complained that investors don't understand them. Venture capitalists, they gripe, are impatient control freaks, more focused on their eventual cash-out than the steps necessary to get there. VCs, of course, have issues of their own, grousing that business owners lack the experience and fiscal discipline needed to build successful companies.
Like a peace negotiator stepping into the breach, Founders Fund, a venture capital firm in San Francisco, aims to build a bridge between these often hostile parties. Launched two years ago by three founders of PayPal--Peter Thiel, Ken Howery, and Luke Nosek--the $50 million fund holds stakes in 15 companies, many of them founded by PayPal alumni, including Facebook, the well-known social networking site; Geni, a social networking site for people researching their genealogies; and Ironport, a spam-filtering company that agreed to be acquired by Cisco (NASDAQ:CSCO) in January for $830 million. But while Founders Fund aims to make money, it also harbors larger ambitions: to transform the relationship between entrepreneurs and investors. "We hope we will be an example for the rest of the valley," says Nosek, 31, one of the firm's managing partners.
That's easy enough to say. But the Founders Fund is backing up its words with some action, altering some of the fundamental rules of venture investing. The firm's biggest innovation is the way it awards shares to the founders of companies in which it invests. In the typical venture capital deal, investors put money in and founders can't take any money out until the VC's investment is recouped with an IPO or a sale. Why? Venture capitalists believe that a hungry CEO is a more effective CEO. Let a founder take some cash out early, they argue, and you risk diminishing his commitment and drive.
This has long been a sore point among business owners, who often have their entire net worth tied up in their companies--not to mention loads of credit card debt they'd be delighted to settle--but not a lot of cash on hand. To address that concern, the Founders Fund has created a new type of preferred stock, called Series FF. It gives entrepreneurs far more flexibility by allowing owners to convert their FF shares into subsequent offerings of preferred stock. Say a company in which Founders Fund has invested is successful and ready for a second round of financing. When that happens, the FF stockholder can convert his shares and sell them to the investors. There are some restrictions--the conversion can be done only when the new shares are issued and there are caps on the amount that can be converted. Still, the arrangement lets owners sell a portion of their stakes without being forced to wait for an initial public offering or sale of the company.
Barney Pell, founder and chief executive of San Francisco-based Powerset, an Internet search firm that raised $12 million last year (the bulk of it from the Founders Fund and another venture firm), thinks that's a big deal. In fact, his company was the first test case for the FF shares. Pell maxed out his credit cards when founding Powerset; he says the knowledge that he can get some cash in a subsequent round of financing goes a long way toward reducing the anxiety that's part of founding a company. "They really think like founders and they really want to help the company," he says of his investors.
The Founders Fund shares were created just months ago, so the firm does not yet have a track record. But the program is a radical departure from the way venture investments typically are structured, says Josh Lerner, a professor of investment banking at Harvard Business School who focuses on venture capital. In the rare instances in which a CEO does cash out early, it's usually because the relationship with investors has gone awry and the investors have chosen to buy the CEO out ahead of schedule. The issue for investors, Lerner says, is whether diluting an entrepreneur's financial risk also dilutes his drive to succeed: "It's a really interesting question, and it's not one with an easy answer."
But the principals at the Founders Fund believe the arrangement will give them an edge in securing the best deals. And that's no small thing. The investment world has grown increasingly competitive, with private equity players, venture capitalists, and individual angel investors often chasing after the same companies. At the same time, particularly with the Web 2.0 companies in which Founders Fund specializes, there's been a boomlet of new companies with relatively low capital needs without a correspondingly booming market for initial public offerings. As a result, says Howery, PayPal's former chief financial officer, "the top entrepreneurs can take money from whomever they want and they don't want second-class treatment."
Howery and his partners also believe that their fund is different because it is run by former entrepreneurs--people who truly understand the difficulties of running a start-up. Indeed, PayPal's is a classic entrepreneurial success story. Thiel and Max Levchin (now CEO of Slide, a start-up backed by Founders Fund) came up with the idea in 1998 and assembled a team of recent college grads. They gained customers by paying $10 bonuses for new accounts and quickly burned through a lot of cash. By early 2000, PayPal was losing $10 million a month and on the verge of going out of business. Still, it raised $100 million in venture capital--just days before the Nasdaq stock market began its plunge. The following year, PayPal filed for an initial public offering, and when it did go public in February 2002, its shares soared 55 percent. Several months later, eBay agreed to buy the company for $1.5 billion, and Thiel and his co-founders became gazillionaires before the age of 35.
That experience resonates, says Darren Rush, chief executive of Koders, a Santa Monica-based search engine for software developers. Rush received an investment from a group led by Founders Fund last April (before the development of the FF shares). "There is cultural compatibility," he says. Suneet Wadhwa, co-founder and CEO of Engage, an Internet dating site, feels similarly. At 39, he already has had one success as co-founder of Snapfish, which was snapped up by Hewlett-Packard (NYSE:HPQ) in 2005. So when he began trying to raise $1.1 million in seed-round financing for Engage in June 2005, he had a lot of options. Why Founders Fund? Simple, says Wadhwa. "They've been there before."
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