Founders Fund aims to reinvent VC model

The Founders Fund—the San Francisco-based early stage investor founded by the co-founders of PayPal—announced last week that it raised a $220 million first institutional fund, beating the $120 million initial target that it set more than eight months ago.

The managing partners declined to comment on what institutions they tapped for the new fund, citing confidentially agreements. But the money came from foundations and endowments, says Managing Partner Ken Howery, who was co-founder of PayPal and that company’s first CFO.

The Founders Fund’s new fund is larger than the $50 million that the group raised from individuals, including the firm’s co-founders, in January 2005.

The second fund, much like the first, will focus on early stage Internet startups in Silicon Valley, but will also consider other technologies in other locations.

The Founders Fund refers to itself as a non-traditional investment group, in part, because of its philosophy of giving entrepreneurs more say in the evolution of their startups than other venture firms are known to do.

In announcing the fund in a conference call with journalists last week, the managing partners made disparaging comments about the venture capital industry. Managing Partner Sean Parker—who co-founded Napster—accused other firms of “bad behavior” that cost company founders. “I can’t point to anything specifically,” he said. “Most of this stuff doesn’t happen out in the open, it happens behind closes doors. What you hear is mostly rumor and it creates a healthy suspicion by the entrepreneurs.”

Managing Partner Peter Thiel—another co-founder of PayPal and a early investor in the social networking site Facebook—pointed to complicated deal structures as a way that VCs harm entrepreneurs. “People are trying to extract as much as they can from a pie rather than make a larger pie,” he says. “You want to have some preference rights, but you don’t want all kinds of weird legal bells and whistles that misalign incentives. When things go wrong, all kinds of things unravel because of this.”

The firm tries to ensure its incentives are aligned with the incentives of the founders it backs. Toward that end, it does not set a requirement of how much equity it needs to hold in a company to make an investment. It has also created a classification of stock, which it calls “Series FF,” to helps founders retain some degree of liquidity through the financing process.

The firm looks for founders who make good teams, preferably people who have worked together for some time. “Are these people who just met each other at the slot machine in Las Vegas and want to get married?” Thiel says he asks of teams looking for financing. “Sometimes you can hit the jackpot, but it’s risky.”

The firm cited poor industry-wide returns as one of the reasons it developed what it believes to be a particularly pro-entrepreneur approach. “The venture capital industry is at a major transition point and we remain extremely bullish about technology,” Thiel says. “Venture capital hasn’t made money for 10 years and this run is almost at an end.”

Thiel cites aggregate industry returns data to support his claim of poor fund performance.

“If you look at VC funds since 1998, maybe most of them aren’t underwater, but you would have done better putting your money in treasury bills,” he says. “A lot of the more sophisticated limited partners we talked to clearly shared the view that there is something broke. The drought’s been going on for a while and people are questioning if there shouldn’t be some kind of structural change.”

Thiel, Howery and another PayPal co-founder, Luke Nosek, the firm’s fourth managing partner, sold PayPal, an online payment provider, to eBay in 2002 for about $1.5 billion.

Since them, in addition to Facebook, Thiel has made early stage investments in several Internet startups, including Slide, LinkedIn, Friendster and IronPort. Slide, LinkedIn and IronPort were each founded by former colleagues of Thiel’s from PayPal. Fortune magazine recently reported that PayPal alumni have founded or invested in dozens of startups with an aggregate value, according to Thiel, of about $30 billion, which was possibly one of the Founders Fund’s major selling points with institutional investors in raising its second fund.

The Founders Fund portfolio includes Facebook, Slide, IronPort and PowerSet, among others. It has also backed “a handful” of Facebook application companies.