Jan 30, 2010

Venture Innovation, or why the First Round Capital Entrepreneur's Exchange fund is good

There is an amazing wealth of innovation around early stage venture financing, most of which developed in just the past few years.

There are new models of creating companies out of innovation: Seed Camp, Y Combinator, Tech Stars are just three, all with different foci and core strengths.

Then there are new sources of financing - groups or people that literally didn't exist as early stage financiers just a few years ago: O'Reilly AlphaTech Ventures, True Ventures, Jeff Clavier, First Round, Ron Conway & Co., Roger Ehrenberg, Chris Sacca, Dave McClure, TAG/Saul and Robin Klein etc. I call these "quasi institutions" because while in some cases they are or have traditional ventures partnerships, they act very entrepreneurially - they move fast, they move often, they are heavily collaborative, they focus on the seed, they are very active, they have alot of fun. In many cases they are run by operational entrepreneurs themselves. Their existence alone is innovative.

Then there are new economic models - Founders Collective being the most prominent now, ("None of us have ever been bankers. We like products and building stuff. We show up on time and don't email during meetings").

On top of this framework First Round announced last week that they have set up an "exchange fund" for founders of companies they have invested in. Josh Kopelman writes that the fund will:

"allow First Round Capital entrepreneurs to contribute a small piece of the stock they own in their company -- and share in the upside of all the other companies."
I don't know any details of this "exchange fund" and absent those it's hard to know how it will work, but in any event I think this has the potential to be truly disruptive and innovative for at least five reasons:

(1) Removes some entrepreneurial stress. Again, Kopelman: "When I was an entrepreneur, I remember the feeling of having all my eggs in one basket -- and it is our hope that this fund will remove some of that stress." The idea being that removing some of this stress can lead to the companies these entrepreneurs run executing better and more efficiently.

(2) Promotes more effective sharing and collaboration amongst the First Round companies. I think FR is better than most at providing opportunities for their companies to collaborate, yet this now creates a framework for these activities. Of course you are going to work harder and help your neighborly First Round company - there are shared economic benefits. Every entrepreneur in the portfolio now acts as a part time EIR.

(3) Strengthens the First Round brand and reputation. Yes, they are a solid team. With a great set of companies. And track record. Now when they invest in your company you have an opportunity to share in the greater network. Competitive differentiation.

(4) Incentivizes (sic) the First Round team to continue to be great investors. For now not only their reputations and money are on the line, but they themselves need to work harder to ensure their portfolio is filled with great companies. If not, the value of the exchange fund is diluted. This it the most interesting to me - part of their business is now tied directly to their entrepreneurs' collective success. Josh writes that the fund is for the benefit of their companies - it is, of course - but FR just put into place a structure that I think will make the FR team work harder, and better. Brand equity is hard to build, and even easier to lose. They've now got a pool of founders' equity that they can enhance, or devalue. Talk about putting yourself on the line.

(5) Venture funds by structure are money managers. They get paid to manage a pool of money and then get a piece of the upside on the returns of that money. Very simple, well known. As a result, there is no inherent value in a fund qua fund - it's a collection of assets the value of which is driven by the partner's track records and reputation. But with the exchange fund, First Round as an institution above and beyond the asset management has value. The decision a founder makes to take money from First Round may be driven in part by this exchange fund, and how well it may do.

There are undoubtedly issues with this exchange fund. But, it's a great example of a virtuous circle - each component of the program strengthens and enhances each other. Founders may want to take money from First Round because of the program; the companies in the portfolio have incentives to collaborate more efficiently; the First Round team has to work harder to ensure the collection of companies is quality; the whole brand is enhanced.

In short, innovative.

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