Venture Capital
Founders Get A Cure For The IPO Blues
Ari Weinberg, 09.13.02, 12:00 PM ET

Diversification. The word was repeated so often that it became a saving grace for those investors who heard the mantra and sold their stocks, moving capital into bonds, real estate or even hedge funds.

Heeding this advice, however, is next to impossible for venture-backed company founders who have much of their worth tied up in illiquid stock. They are the first in and are expected to be the last out. But when initial public offerings and mergers were frequent, payouts came quickly.

Still, the hot market had some founders eager to cash out prematurely. "Entrepreneurs ended up doing stupid things," says Joerg Sperling, a managing director with Ridgewood Capital in Palo Alto, Calif. They would cut side deals with undisclosed investors or overseas banks, compromising their company and backers for a quick buck. The primary alternative was to sell shares back to the venture investors--a less risky, but less lucrative option.

Now there is another option called an exchange fund. Developed by San Francisco-based EB Financial Group, an exchange fund is essentially a private-equity fund exclusively for founders, who "buy" into the fund with a small percentage of their restricted stock. Cash or stock is distributed to the 20 or so founders in each fund whenever a company is bought or goes public. The founders, like limited partners in most venture or private-equity funds, are not disclosed.

Unlike the black-market deals, exchange funds are endorsed by several top venture capital firms. EB, which originally stood for "eleven baskets," as in not putting your eggs into one basket, gets a percentage of each distribution--and they just closed their second fund.

Companies invited into a fund must have recent venture capital funding to provide a benchmark for valuation. That way there's no fuss about whose shares are really worth what and how much they'll get when the fund pays out.

EB Financial also takes a hard look at the liquidation preferences of that round to keep out companies with "vulture capitalists" writing terms that essentially minimize any return for founders and early backers. According to a managing director at EB Financial, the funds seek out companies backed by reputable venture firms and operating across many industries.

The exchange fund idea was first put together in late 1999 by Larry Albukerk, one of EB Financial's managing directors. As an entrepreneur and capital raiser, he saw that company founders with massive single-company stock risk, for the most part, were not allowed to diversify even the smallest portions in a beneficial way.

True, putting 5% of their founders' shares into a pool of illiquid investments isn't going to be a windfall right now, but the potential is great. "Each individual investment is equally risky, but spread across 19 other companies, the odds for good returns increase enormously," says Philip Levinson, a former company founder familiar with EB Financial.

"With the diversity they have created, there should be some early exits," says Ridgewood's Sperling. That would be a relief to hard-working founders who feel they've been on the short end of the stick since limited partners started putting the crimp on venture capital firms. VCs would sometimes provide loans or let founders trade in restricted shares for a stake in their larger funds. "That's not really happening any more," says Erik Wolfers, an Oakland-based financial advisor.

Much of the impetus for these funds came from founders' inability to capitalize on the eye-popping valuations their companies were getting from the market. Save their salary, it seemed like everyone was making money off the business except for them. Congress is even investigating whether banks like Citigroup inappropriately used IPO shares as tokens for the executives of top banking clients.

Now, with Wall Street preaching new religion on IPOs and mergers, founders and VCs are seeing their chance for even the slightest return pushed farther back. So, if an exchange fund lets founders hedge away some of their single-stock risk in a diversified fund, why aren't exchange funds popping up everywhere?

"There are tremendous legal and tax implications. EB got a pretty good jump on everybody," says Tim Grace, a venture director based in Sunnyvale, Calif., with Dutch electronics maker Philips

EB believes their head start will have its own rewards. Currently, they organize the funds pro bono and only see cash or stock when a fund company does. EB also does for-fee advisory work and private-equity charitable-giving valuation, but the exchange fund idea is their big bet.

"It couldn't be a better business for this time," says Alex Bernstein of Garage Technology Ventures in Palo Alto, Calif. But such ringing endorsements come with the caveat that returns could be slow if the market for venture-backed IPOs and mergers doesn't pick up.