Don Dodge, a startup veteran and current Microsoft exec, writes about novel incentive alignment schemes as a method to weather financial storms in his blog post on the New England Venture Summit meeting.

John Giannuzzi of Sherbrooke Capital introduced an interesting concept for aligning the interests of VCs with entrepreneurs. Sherbrooke asks its founder entrepreneurs to invest with them and invest 10% of the first round capital raised. For example, if a company is raising $2M, the founders would take $200K of the round, with 15% ($30K) up front and the balance financed over time. The company issues a 3 year note to the founders for the remaining $170K. If the founders meet their projections at the end of year one they get one third of the note forgiven and get the stock for free. If they miss their numbers they would pay for the stock…just like the VC. If the founders meet their projections in all three years they get the entire note forgiven and keep the stock for free. In essence the founders get to own 10% of the round for 15 cents on the dollar if they meet their targets. If they don’t meet their targets they get to buy the stock at the same price as the VCs.

It’s an interesting way to incentivize (yes I know its not a word) founders to build the company and push fundraising rounds. It cuts into the VC’s investment somewhat but if it works as an alignment tool, it’s obviously worth much more than the cost. I’m curious to know how this and other alignment schemes work.

Don goes on to describe early liquidation as an effective way to reduce anxiety and align financial interests, as used by the Founders Fund:

Founders Fund has a completely different approach, allowing founders to cash in some of their stock in the first funding round. Founders Fund, as the name implies, is a VC firm started by founders of startup companies. Peter Thiel and two other PayPal principals, along with Sean Parker (Napster, Plaxo, Facebook) are the partners at Founders Fund, and each has been through all the phases of starting a company. They feel that investor’s interests are more aligned if the founders have some money on the side so they aren’t compelled to accept the first exit opportunity that comes along. They feel the startup founders will be more willing to hang in there for a longer period of time and hold out for a bigger exit.

Of course a fund called the “Founders Fund” is obviously going to skew interest away from institutional investors. I see the motivation, but the downside might be that founders will be content with whatever they get in the first round and lose the “hunger” that comes with poverty. On the other side, there is something to be said for rewarding early funding rounds.

Alignment of interests financially is always interesting, and I’ll post more examples as I find them.