Ex-Googler builds new way to back entrepreneurs

SAN FRANCISCO -- Venture capitalists like to say they back entrepreneurs, but firms like Kleiner Perkins, and Sequoia Capital are built to invest in companies, not people.

Now there's a way to invest in individuals directly, rather than funding the businesses they are building.

Upstart, founded by former Google executive Dave Girouard and Thiel fellow Paul Gu, lets investors give money to entrepreneurs in return for a percentage of their future annual income, usually over five to 10 years. Other firms, including Pave and Cumulus Funding, are also doing this through what's known as personal income contracts or income share agreements.

Upstart and its rivals are part of a shift in the way start-ups get the money they need to grow. Regulators recently relaxed rules to allow more crowdfunding, which brings together large amounts of people, via the Internet, to support a project, business or cause.

Upstart takes the crowdfunding concept and applies it to individuals who are looking to raise money but also want to develop a network of contacts to help their career or their business thrive. It's a combination of the money-raising power of crowdfunding platform Kickstarter and the professional networking benefits of LinkedIn.

"VCs are fond of saying they invest in people, but that's rarely the case," said Rafe Furst, an angel investor who helped craft the first personal income contracts several years ago with attorney Orlando Medina. "There's a big difference in investing in the founder of a company rather than the company itself. The potential is huge."

Angel investors like Furst must gauge the likely success of a business that is just getting started, which is very difficult. Backing the person behind the start-up is less risky. If their business fails, they may join an established tech company and earn a solid income, while working on another start-up idea that could eventually succeed. Through a personal income contract, the backer of that entrepreneur still gets their share of the income.

"It's lower risk and potentially more lucrative to back the entrepreneur," said Furst, who is advising Pave. "Nine out of 10 quality entrepreneurs eventually succeed in some way."

Since Upstart got going early this year, it has handled more than 1,200 funding offers from backers to individuals (known as "upstarts") totaling almost $2.5 million, according to Girouard.

Upstart has raised more than $7 million from leading VCs including Google Ventures, Kleiner Perkins, Khosla Ventures, Google Executive Chairman Eric Schmidt, Salesforce founder Marc Benioff and Mark Cuban.

Girouard, who built Google's Apps and enterprise business, said his experience with the data-driven hiring process used by the Internet giant helped him come up with the idea for Upstart. And that's what persuaded Schmidt to invest, he added.

"Instead of relying on a bunch of VCs sitting on Sand Hill Road, we bring a lot more data to bear," Girouard said.

Upstart's technology sets a funding rate for each person who comes to the website looking to raise money. The firm crunches data to predict a person's future annual income and then discounts that number to set the rate.

A Harvard MBA graduate can raise about $18,000 for every 1% of their annual income they share over the next 10 years. Applicants with less-impressive backgrounds have to share more of their income to raise a similar amount.

Keith Rabois, a former PayPal and Square executive who is now at Khosla Ventures, sees Upstart as a new way for aspiring entrepreneurs to educate themselves. The current student loan system limits spending to accredited institutions, while money from Upstart could be spent on a boot camp to learn software development, he explained.

In addition to investing $1 million in Upstart as a business, through Khosla, Rabois said he has backed several individuals through the platform, including a recent university graduate from Florida.

Angel investor Eric Tilenius has backed 20 people through Upstart, including Rachel Honeth Kim, an alumni of social gaming company Zynga where Tilenius was a general manager, and Jordan Waxman, an entrepreneur in the fast-growing craft beer market.

Backing individuals through Upstart is a more stable investment strategy than venture capital - offering a higher chance of getting your money back but no chance of making 100 times your money, according to Rabois and Tilenius.

Returns are capped, meaning entrepreneurs never have to pay more than five times the amount they raised through Upstart. That's for a 10 year contract. Payments are capped at three times the amount raised for a five-year contract.

It's less risky for entrepreneurs too because they pay a percentage of their annual income, so if they have a lean year, the payments adjust lower. Payments can also be deferred and the term of the contract extends a year, according to Girouard.

"Most people who invest in start-ups are probably going to lose all their money. It's not something normal people should be doing and is borderline irrational," Rabois said. "Upstart should provide a more solid return, with some confidence in getting your money back plus interest."

For entrepreneurs, Upstart is a new way to raise money and also get access to potentially valuable networking opportunities.

Adam Steege, a 27 year-old who studied mechanical engineering at Columbia University, raised $60,000 on Upstart from backers including former surgeon David Silverman. Steege is using the money to fund his start-up Agile EndoSurgery, which is developing new laparoscopic surgical devices.

The money will support the company and pay Steege a salary while he looks for series A funding. Steege's 26 backers on Upstart also signed up to mentor him, which includes introducing him to potential business partners and other potential investors.

"I am in Durham, North Carolina, which has nowhere near as much of an investor network for medical technology as Massachusetts and California," Steege said. "Accessing those networks is what it's about. Some people use LinkedIn and send cold messages. No one likes getting those messages. This way is better."

Steege agreed to share just over 6% of his annual income over ten years, in return for the $60,000 he got through Upstart.

"It's a tax on your income, but I look at it as risk mitigation," Steege said, while arguing that taking on credit card debt to start the business would have been much riskier. "If it all goes wrong and I have to get a job somewhere else, I will have to pay some portion of that, but it will be a lower payment.

Silverman also sees Upstart as a less risky way to get involved in early-stage start-ups.

"You're not investing in a one-time deal. It's in a person's ability to perform over a ten-year period," Silverman said. "You have many shots at this person's productivity."

To be sure, Upstart is breaking new ground and not enough time has passed to see whether these investments will perform as expected. One potential problem is that really successful entrepreneurs may try to defer their income for a decade to avoid paying their backers.

"It's a good question and one we've thought about a lot," Girouard said. "There's no perfect answer, but we've structured our agreements to mitigate or minimize this potential effect."

A typical entrepreneur is sharing 2% to 4% of their annual income through Upstart, so it may not be worth the effort to defer that flow of money for a long period, he argued.

"If they were sharing 20% or even 10%, I think we'd have a much higher risk of that," Girouard said.

At this point, Girouard's main focus is on market adoption. "We're beginning to get critical mass," he said.