Entrepreneurship

Risk Pooling for Entrepreneurs, Part II

12.28.06 | Comments

Looking over the edge, originally uploaded by Räubertochter

As follow up to my Exit Fund idea, Isabel Wang proposed a private exchange that enables entrepreneurs to trade equity. I think it’s a fascinating idea, likely one that’s been tossed around before (anyone?). Of course there’s a ton of hurdles including pricing/valuation, securities regulations, and others that I’m not even imagining, but it sure would be interesting. Part of me feels an early-stage exchange (or rather, the act of exchanging equity at an early stage) is antithetical to the very notion of entrepreneurship, which often demands an “all-in” approach. Another part of me believes risk-pooling could be an enormous boon to the startup community, whether it’s in the form of a private exchange or a selective pooling instrument such as the Exit Fund.

A college acquaintance of mine works at a later-stage investment firm that purportedly looks down on Ivy-league educated entrepreneurs. The opportunity cost for such an individual is simply too high for a rational Ivy-leaguer, they claim, to choose the field. It’s probably too high for most folks - forget about degrees. Failure means a blank slate with a mound of debt (which is exactly why entrepreneurs are such mavericks!). Angel and institutional investment options help spread risk, and so might a private exchange or Exit Fund-type instrument.

Here’s the relevant comments discussion, and my follow up, from Isabel’s post on the topic:

Hi Matt,

I’ve been reading HBS professor Andrew McAfee’s old posts on “emergent” versus “imposed” systems. For instance, Yahoo! originally took an “imposed” approach to classifying sites into editor-selected categories, but del.icio.us is totally emergent and gives each user the ability to apply whatever tags he’d like to each page he bookmarks.

I wonder what Andrew (who’s a big fan of emergence) would say about the chicken and egg of a startup equity exchange. Is it better to have a highly respected selection committee, or might it be possible to open up the whole system to the wisdom of the crowd?

1. X, a startup CEO, signs up; no commitment is required at this point. He is only asked to list other startups he’d be willing to trade shares with.

2. Companies listed by X are invited to participate. They invite others they feel are worthy. Inviters remain anonymous.

3. Using Swaptree-like technology (TechCrunch says its algorithm can generate matches for up to a 4-way exchange), startup CEOs are matched with investment partners. Participants can accept or decline any trades. They are alerted whenever new opportunities come up (due to new signups, or people updating their wish lists or putting shares they own on the market).

What do you think??

Posted by: Isabel Wang | December 27, 2006 at 05:16 PM

______________________

Isabel:

It’s a great debate. I don’t think the two approaches are mutually exclusive. It would seem the methodology described above makes a selection committee of two (i.e. two entrepreneurs need to agree to swap in order for a trade to occur), therefore benefiting from “emergence” only insofar as the initial filter step which requires 1 vote. That being said, I like the idea of enabling entrepreneurs to trade their equity in just such a way - as you put it, a “private exchange.” Of course, pricing, security regulations, and other complexities would need to be addressed.

This notion of actively trading equity is somewhat different from the idea of a one-time contribution to a pool. I suspect a small group of experienced startup investors/executives would better select, and attract more promising startups, than a selection committee “of the crowd.” My friend, Rob May, at Businesspundit.com, has written extensively re the wisdom of crowds and ran an interesting experiment that enabled crowds to formulate a business, share equity, and run with it. The results hardened his view of group wisdom. Here’s a link to a post of his re the topic:

http://www.businesspundit.com/50226711/antisocial_media.php

He quotes Andy Rutledge, who writes, “Excellence is not the sum of opinions. Excellence is not born of consensus.” I generally agree. There’s a reason that venture investors stratify dramatically, with the top group of firms earning returns far and away ahead of the rest of the crowd.

Best,
Matt

And here’s my original post on the topic: “The Exit Fund” - Risk Management for Risk Takers

Viewing 3 Comments

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    Hi Matt,

    I'm not 100% sure I agree with Rob. Microchunking didn't work in his case, but crowds don't *always* produce mediocre work. For instance, most of the drawings on http://www.thesheepmarket.com/ are really awful, but the project as a whole is way cool. As Jeff Howe writes in his Wired article (http://www.wired.com/wired/archive/14.06/crowds...), crowdsourcing requires different skills compared with traditional management. The crowdsourcer will only be able to create value if he's successful in setting up filters for sifting through contributions from the masses.

    But back to Swaptree (which has been in private beta for ages!) and the entrepreneur exchange, When you join Swaptree, it asks you to submit two lists: books/CDs/games that you own and want to give up, and items you're willing to accept in exchange. The system scans all users' haves and wants and is able to offer multi-lateral trades. For instance

    A sends item to B
    B sends item to C
    C sends item to A

    As I'm typing, though, I'm realizing that this concept might not work for startups. Swaptree assumes that all used CDs have equal value, but the same can't be said of Web 2.0 companies. I doubt any group of participants will be able to agree on giving their shares 100% equal valuation.

    -Isabel
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    Isabel:

    So glad you pointed me to thesheepmarket. What a fantastic project, and a terrific way to purchase some unique stamps!

    Having heard a ton of startups voice valuation expectations (including the startup I worked at prior to Chrysalis), you're dead on in suspecting that agreement on parity would be a difficult hurdle. I'd think one could remedy the issue by creating a pooled partnership that requires applicants be at a certain stage (say, less than one year old) and accept parity at the point of application, knowing that only promising startups would be chosen by an experienced committee. There's no reason, though, that a group "exchange" couldn't be managed with appropriate bid/ask tools.

    Best,
    Matt
    • ^
    • v
    Isabel,
    Re: microchunking, I agree that crowds can sometimes do cool stuff, but what's cool and what's profitable are two very different things. Most web2.0 companies are doing something cool, but only a small percentage are going to be able to effectively monetize their offerings.

    The biggest problem with crowds is that crowds need an incentive to take the project seriously. Whether or not to buy a stock has much more serious consequences than whether or not to vote for a story on Digg. That's why the former decision is taken more seriously than the latter, and why WoC works for markets better than for news aggregators.

    Anyway, I love the idea of a private entrepreneur exchange. It allows entrepreneurs to diversify and spread some risk around. As a side result, I think you would find that the cross ownership aspects would encourage entrepreneurs to help each other by sharing ideas, contacts, etc, which could in turn improve the likelihood of success.

    There would probably be several conditions that would need to be imposed - one of which would be a limitation on #of "shareholders" in order to bypass accredited investor SEC regulations. The other would be a requirement of maximum disclosure - biz plans, resumes, financial status, etc. so that entrepreneurs could value the companies accurately when they trade equity. I would be more than happy to give up 5% of my startup for to get a couple of collective percentage points in other ones.

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