Entrepreneurs Need a Portfolio Effect Too
Posted by Bob Warfield on April 10, 2008
Fred Wilson has gotten me going today!
Startups involve tremendous uncertainty. The financial world for a long time has realized that an important tool to use in controlling risk is diversification. This is the so-called portfolio effect, and is the modern realization that you shouldn’t put all your eggs in one basket.
I was recently having a conversation with a CEO coach. He was helping out a CEO at a company I’m talking to. He commented that at this stage he had simply seen too many failure modes for startups, and hence, it would be very hard for him to choose a single company to work for. He was happy that he had created a portfolio effect for himself by serving as an advisor to multiple companies rather than focusing all his time on a single company.
Years ago, I worked on an idea I called the Enterpreneur’s Fund. The idea was that Entrepreneurs need a portfolio effect too. Most of the time, Enterpreneurs will have the ability to give away or sell a portion of their founder’s share. My idea was to get company founders to join a fund where they would contribute these shares to create a portfolio. Value of the shares would be determined by the last VC valuation with a proviso that it needed to be within the last 6 months and hence relatively current. This new “Fund” would act just like a VC fund. The participants would receive distributions as and if companies in the fund had liquidity events.
It seemed to me then and now that this was a good idea for entrepreneurs. I am not aware of anything like it in existence, though many entrepreneurs do get the opportunity to invest in their VC’s funds. What became of it? In essence, I don’t think most entrepreneurs understand diversification. They wanted to focus on evaluating every company in the fund before agreeing to contribute shares. Most all of them concluded that their own company was so much better that they would be carrying the fund and would get no value. Of course, they couldn’t all be right, but nearly all the entrepreneurs I talked to thought that way, and I eventually gave up on the idea. FWIW, the shares I would’ve contributed to the fund would have been quite valuable as my startup was acquired by Pure Atria.
The VC’s, OTOH, completely understand the value of a portfolio. They live and die on it. Very few of the deals they invest in succeed. I’ll argue they don’t understand another important component of Modern Portfolio Theory, though, and that is correlation. It isn’t enough to have a portfolio, it’s components must be as uncorrelated as possible. If you invest entirely in Web 2.0 startups, your portfolio is highly correlated and you have more risk. VC’s are well known for the Lemming tendencies. As soon as one firm hires an executive recruiter to be a general partner (as happened some years ago), the rest all followed suit.
But maybe there is an answer. Fred talks about being able to buy and sell stakes in companies before they are public. He mentions Goldman Sachs’ GS Tradable Unregistered Equity OTC Market. It’s a fascinating idea. Wall Street does a good job of “securitizing” the unsecuritized to make markets more liquid. Reducing the viscosity is often a good thing, and it would sure help here. Carving the deals up and spreading them around can reduce everyone’s risk substantially as well as providing some liquidity. It promotes scaling into and out of positions, another time honored Wall Street practice. And, it would let smaller firms lucky enough to land a winner, trade some of that stake for exposure to other near-winners they don’t have access to. In the end, it probably reduces returns a bit, but makes them less volatile.
Just don’t forget: Entrepreneurs need a portfolio effect too. Let them play and you’ll keep them focused a lot longer on what they do best.
See also What if the Chasm Has Moved? The discussion of conglomerates like Johnson and Johnson and GE is just another successful example of the portfolio effect.
Jeff Jarvis is on a similar vein with this post. In it, Jeff discusses Berkshire Hathaway-like conglomerates. Shades of my Johnson and Johns thoughts above.
It seems there is an active and thriving version of the Entrepreneur’s fund as reported in TechCrunch. It’s called the EB Exchange fund. It works like a VC fund in that the folks running the fund have a carried interest and “management fees.” Interesting. I prefer the idea of running it not-for-profit among the limiteds who are founders contributing stock. Still, it shows the idea is viable.