"Surround yourself with people trying to shape the future....... In fact, betting your future on old-line companies is riskier than joining with entrepreneurs and startups."__Cathie Wood.
First-loss investment is an innovative way comparing to conventional ones. Apparently, there are quite several pros to this protocol. The most appealing feature is safety and the speed of compounding the AUM. However, after it became so well-known, it seems not as effective as it used to be when it debuted to the markets years ago. The opposite side of the operation, the emerging fund managers, apt to have such concerns: 1. Is it the same safe for the fund managers as they are for the investors? 2. Is it tolerant enough for some unfavored situation to keep the operation sustainable? 3. Is there going to be endless legal costs and harassment if any dispute arises between the manager and the investor? 4. Is it helpful for track record building at all? Etc. The question marks could be a long list.
It makes a lot of sense when money prevails everything, especially in the dialogue between the investors and the new fund managers. This operation's logic is based on a provision that there are not so many options the startups can find in the market. It is still true in today's market. However, we will discuss a new practice that might last longer and release more power of innovation from qualified startups.
It is all known the case between Resolute and Cathie Wood. They are now in the middle of struggling with the new balance of the stakes for ARK Invest. Although it will be settled and won't interrupt the operation as most people expected, it gives us some chance to rethink the setup of the operation between the investing partner and the fund managers.
It is common to make a contract between parties, but nobody knows what will change in the future, so every party tries their best to pursue their then-current goals and protect themselves. In this sense, some clauses may not be 100% fair for temporary reasons but still get consent. That's what happened in Cathie Wood's case, as well as most cases in first-loss negotiations. Things change. Sometimes just like Cathie Wood's case when the fund gets bigger and bigger. It makes more sense for the investor to think about more stake, but it is also true that the fund manager becomes more influential and even more fatally powerful for fund management. Any clause that is cutting edge for the real willingness for any party signing the contract will become unrealistic. So taking advantage of the situation is not a good solution at any time. The best practice is to take as many scenarios as possible into consideration when negotiating. In this sense, the following scheme might be a better clue for long-term collaboration between the first-loss investors and startup fund managers.
No matter what kind of collaboration, it is, in fact, forming up a company. The core part of the issue is to decide how much stake each side should take and how many responsibilities to match with the stake. In the first-loss cases, investors usually have a two-fold purpose. One side is to invest safely; the other side is to help their fund AUM grow by asking the fund managers security deposit. On the opposite, the startup fund managers' concerns usually focus on two points. One is the security deposit's safety; the other is the reasonable tolerance based on same page knowledge and judgment when volatility happens. This might be solved by consenting on a timeframe for the fund management's goal plus many details on risk management. This is all based on the presumption that both parties are sincere and honest for the collaboration...
An example solution is to form up a fund underneath the first-loss investor's current fund so that the new operation may help the mother fund's AUM accumulation. The investor and the manager may invest in the fund according to the principal and security proportion. In the new sub-fund, the investor may take a 40-60% stake, and both parties sign contract with the agreement on fund development goal and quantitative check/review method, annual growth requirement, default penalty, termination clauses, agreement on operational cost source and limitation, withdrawal process, phases or timeframes for fund management goals implementation, and the responsibilities that the manager will have on business development. Etc. This framework fits those fund managers with an entrepreneur spirit and leaves enough outgrowing spaces that benefit both parties.
Comparing with the old version, this solution helps the first-loss investors release more possibilities for rapidly growing their AUM. (by adding more forces in business development). Meanwhile, they can still keep the bottom-line of risk management as a core feature. The startup fund managers, on the other side, get more space in management and secures a seamless business development, which is basic for a sound long term operation.
Business success is based on sharing and collaboration. It's tough for fund managers to get off the ground if he/she insists on 100% control of the fund and don't want to share an extra penny to the people who helped in the early stage. It might be similar for the first-loss investors.
If you want the carriage to run faster, you may need to loosen the reins slightly.