Right Side Capital Management: A New Take on Angel Investing

Recently launched Right Side Capital Management is taking an entirely new, and in some ways radical, approach to angel and seed investing. The firm is aiming to allow startups to simply apply online for funding and receive an instant valuation and investment terms – without any pitch or in-person meeting. Companies would be initially screened by their responses to a handful of questions on two very simple forms. One form simply asks for resume-related information about the startup’s founders (things like education, management experience and technical expertise). The other form asks for information on the startup such as the industry, progress to date and financial information. Apparently the valuation algorithm they have developed will be able to provide “accurate results” for startups ranging from the idea to initial revenue stage that have raised less than $100,000 and are seeking a funding round of less than $500,000.

After the short forms are complete, Right Side Capital will invite select teams to complete long versions of the forms and submit a business plan, budget and other documents. Right Side expects to fund 25 to 50 percent of companies that make it through this stage and receive funding. In total, the firm expects to fund “hundreds” of startups per year.  After funding a company, Right Side acknowledges that it cannot provide intensive one-on-one support but will provide access to incubators and other angles. In the long-run it plans on establishing an internal advisory board of experts across operational and technical areas.

Even though the firm is new, Right Side is clearly serious about early stage investing; in fact they were part of a syndicate that recently provided $24 million in funding to TechStars startups (alongside firms such as Foundry Group, RRE Ventures and SoftBank Capital). The firm’s high-volume approach to vetting and investing in startups is definitely unique, especially for a firm that utilizes an otherwise traditional Limited Partner-backed fund structure.  The jury is clearly still out on the model because it’s so new and radical, but given what we know so far, I was able to see a number of positive and negatives as well. I also have some thoughts on the implications and questions for the future.

The Good:

Right Side makes it extremely easy for startups to apply for funding.  It can be daunting and confusing for startups to have to figure out how to begin their search for funding and what type of valuation to expect. Right Side would be an easy, risk-free place to start - if nothing at least startups gain a reference point on a valuation to build on.

No fees. This used to be a bigger problem than I think it is now, but its worth mentioning that Right Side does not employ a “pay to pitch” model – applying is completely free. I think this is a must have feature if they want the platform to succeed, but credit to them on resisting any temptation.

Support in areas such as marketing, finance and fundraising will eventually be provided by Right Side though an advisory board. This might be more beneficial than a traditional angel investment which might only provide one line of expertise. It’s not quite an incubator model, but you might eventually have many of the benefits incubators provide.  

No Board seat requirement. This is typical of most angel investments but it’s good to know Right Side will not push for a board seat. It gives startups a higher level of autonomy.

Focused approach. Right side is targeting specific characteristics which it presumably would not stray from because of the screening process/algorithm in place. We won’t know until some deal start being made but at least they will resist temptation to stray from their guidelines, something LPs might appreciate too.

The Bad:

No in-person meeting.  Managing Director Kevin Dick has said that no in-person interviews will be conducted “because they don’t contribute to better investment decisions.” Sure there is some truth to that statement (not all founders will be great interviewers), but isn’t so much of a startup’s success dependent on the drive and passion of the founders? How well can these factors be gauged without meeting a founder in person? Venture investors often say that they would rather back an “A” entrepreneur with a “B” idea versus a “B” entrepreneur with an “A” idea. It has to be near impossible to gauge the drive of an entrepreneur via an application and I think Right Side has the potential to miss out on excellent opportunities.

Valuation is formula based. Whatever their valuation tool spits out becomes the starting point for negotiations.  Determining the valuation for a seed round is very unscientific by nature because there usually is little to no cash flow. Usually, both sides, the entrepreneurs and investors, will have some insight that goes into a proposed valuation that isn’t captured via a metric or on an application. Sure, you are eliminating emotion at some levels, but at the same time, there might be something very valuable that might not be captured in the application form and therefore would not be compensated for in the valuation.

A significant cash investment would be required by founders. Right Side says that they want to make sure founders also take “substantial risk.” They are asking founders “to take at least a 50% pay cut compared to what they could make on the open market and put up a cash investment that is significant relative to their financial means.” I understand the need to align interests and the 50% pay cut is completely understandable for a startup. However, I wonder if Right Side loses any potential investments because founders don’t have much cash to put up. I know other angels would also require an investment by the founder, but Right Side screens for the amounts through their application without perhaps a full picture of each founder’s personal situation.

Implications:

I know a lot of people are probably thinking that if there was ever a sign of froth in the angel/seed market this might be it. After all, Right Side plans on funding hundreds of startups each year without even meeting most of the founders in person. It’s almost like a controlled, repeatable “spray and pray” model. The term “spray and pray” might sound like harsh criticism, but it’s not meant to be. Fundamentally, chances of a startup succeeding and reaching massive scale are slim, therefore you have to make lots of bets if you hope to eventually back a winner. I like to think of Right Side’s model more as reverse crowdfunding - instead of lots of people funding one idea, you have lots of ideas coming into one funding source.

Right Side’s model seems very intriguing to me and if successful, has the potential to shake up the industry. But we won’t know if the model works or not till it’s actually implemented. There are also some unanswered questions – like how much ownership would they ask for, exactly what rights will they ask for (preferred, first refusal, dilution protection, etc.) and will they be able to participate in follow-on rounds (you figure continuing to back winners is where they would best be able to achieve the most returns ). We also don’t know who the limited partners are or will be. I think it would be hard to convince traditional LPs to invest in a Right Side fund, especially the first time around. I wonder if other angles might be interested as a way to more easily diversify. Or perhaps venture firms might see participating as an LP as an opportunity to access more qualified deal flow.  No matter how it shakes out, Right Side’s new approach will be interesting to watch in action. We’ll just have to wait a while though - they plan on making their first invesments in Q2 of 2012. 

Venture Capital Overhang Continues To Shrink

Before getting to the data, I’d like to share why I’m changing how I look at the overhang statistic:

I’ve been writing about the venture capital overhang (or amount of “dry powder” available) each quarter for a while now but never felt extremely confident in the figures I’ve reported. Unfortunately the overhang figure is highly subjective and I don’t think anyone except maybe a Cambridge Associates could even come close to accurately estimating how much uncalled capital is out there - the true overhang. As a proxy, I (and other publications) use the difference in reported venture capital fundraising and investment data (as reported by the NVCA, Thomson Reuters and PwC). The trouble with this methodology starts with the fact that both the fundraising and investment data sets are continuously changed retroactively - I’m guessing as funds and deals are backfilled into their databases. Furthermore, it’s unclear to me whether or not fundraising data for a certain period is later updated for capital raised by funds in that given vintage year after that year has passed. To make matters even more complicated, things like management fees, recycled capital and investment by U.S.-based firms outside of the U.S. are unaccounted for.

I’ve always said that venture capital industry data is often highly questionable, no matter the source, and that instead of focusing on absolute numbers, the focus should be on changes in the data. Because of this, and because of the issues with the fundraising and investment data, I’ve decided to focus on the near-term trends relating to the overhang, as opposing to trying to paint a larger picture.

Here’s a look at differences in venture capital fundraising and investment data through the second quarter of 2010:

What clearly stands out is the huge disparity between venture investment and fundraising in the second quarter of this year. I can say pretty confidently that this is probably the largest such disparity since at least 2002, when fundraising screeched to a halt but venture firm coffers were still brimming from the fundraising boom of 2000. This time around though, there are different dynamics at play. For one, the preceding fundraising bubble was not nearly as large, meaning that we may be spared another decade-long hangover and that the industry should recover faster. But this also means that competition for survival among venture firms may be fierce.

Investment can’t outpace fundraising forever. Initially I had thought that after the third quarter of 2009 we might start seeing a leveling out of the differential, but clearly I was wrong. The huge disparity in the most recent quarter shows that we may have longer to go and there may be more quarters to come with investment outpacing fundraising. This phenomenon could be thought of as sort of a market correction: fringe firms that raised funds years ago will eventually run out of capital and will be unable to raise new funds. What we should see after this “correction” is fewer firms, but higher quality firms remaining, investing in better deals at better valuations and generating better returns - not necessarily a bad thing for the industry. Something else to keep in mind is that the number of funds raising capital isn’t down as sharply as the total amounts being raised, meaning firms are raising smaller funds, which should lead to a reduction in the number and/or size of deals which also brings the industry back down to a more efficient level. 

Data: The NVCA, Thomson Reuters and PwC

The Case For Lowercase

Recently, Chris Sacca, former Head of Special Initiatives at Google, announced that his new venture firm, Lowercase Capital, had raised $8.5 million. Sacca has raised $8.5 million for what is essentially an angel fund targeting web startups. While larger venture firms  often deploy more than $8.5 million in a single deal, Sacca’s fund provides start-ups with something much more valuable than just capital: “time, attention, and the empathy that catalyze winning outcomes for all involved,” as  he puts it. As I mentioned in my previous post, the cost of starting an internet company has fallen dramatically, so much so that angel investors (or “micro VCs”) may come to dominate early-stage investments in the internet sector. This is especially true since traditional firms find it difficult to deploy their funds at that level and often lack the personnel to do so in a truly meaningful way. Traditional VC isn’t dead; it just isn’t as competitive as it used to be at the earliest stages of internet investing.

Sacca does a good job of laying out some of the reasons why “venture capital is broken” when it comes to investing in internet startups:

“Today, web services can be conceived, architected, tested, and deployed to millions of users for little incremental cost beyond rent and Ramen noodles for the entrepreneurs. Yet, many traditional VC funds have been loath to admit this reality and downsize their five hundred million dollar hauls. Why? They are paid fees based upon their total amount of money managed, thus there is no incentive for them to be smaller. Yet, as they try to inject those piles of money into early stage companies, interests become misaligned and an inherent conflict between the investor and the founder often arises. Fund returns, the companies, the entrepreneurs, and the users all suffer as a result.”

It’s a rather harsh take but there is truth to his argument – there is now a huge disconnect between most venture capitalists and web entrepreneurs, and part of the solution is smaller pools of capital and dedicating more time to collaborating and working with entrepreneurs. It doesn’t necessarily have to be Lowercase’s approach (although it does address the problem directly), it can also be done through larger firms - they just need the discipline to invest smaller pools or simply set aside portions (and even staff) of larger funds for seed internet investments, otherwise they risk losing ground in the space.

Who are investors in Sacca’s fund? I’m not 100% sure but I know Kevin Rose is one. This brings about another aspect of the new angel/micro VC phenomenon – institutional investors could be left out. Instead, angels or micro VCs, are increasingly investing their own money or raising funds from other like-minded colleagues, entrepreneurs and investors. This works perfectly well because, again, the fund sizes are relatively small and when given the choice, you want like-minded, understanding, and potentially helpful limited partners.

Stepping back, as angles investment comes to dominate early stage internet investing, we may be seeing a bubble of sorts. The best are great at what they do, but those looking to mimic will probably suffer, just as “me too” venture firms have struggled. It seems as though angel funds are popping up all over the place these days. Are these angles and “micro VCs” restricting dealflow to the larger firms? In some cases yes, but you also often see them investing alongside the traditional venture firms that get this space. Plenty of traditional venture firms have recognized the shift occurring in seed internet investments and are active in this style of investing (and will probably be the most successful). Some examples are Spark Capital, Sequoia (though they kind of outsource their seed involvement through Y combinatory), and Charles River Ventures. There is undoubtedly a fascinating new venture ecosystem developing for early-stage internet companies and it will be very interesting to monitor its continued evolution – Lowercase capital is simply the latest reminder of where things are heading.

Falling Start-up Costs and Seed Investing

When you listen to and read about what is being said about the state of the venture industry you hear a lot of people throw out opinions, often misconstrued, about why venture capital is doomed. One argument that seems to be surfacing a lot recently is that venture capital is no longer needed (or not needed in the same capacity) because the costs associated with starting companies has fallen dramatically. While it’s true that the cost of starting an internet company has dropped dramatically (due to advances in areas such as development, storage and virtualization), it’s important to remember that internet-related startups only account for a fraction of venture capital investment.  It seems as though when people think of venture they immediately think of internet startups – a mindset probably resulting from the dot-com bubble era and the fact that startups in the internet sector are (and have to be) more publicized. As a result, venture investments sectors such as healthcare, media, mobile and cleantech don’t receive as much attention, even though they receive the most venture capital. To put things in context, according to PwC Moneytree data, companies fundamentally reliant on the internet for their business accounted for just 17% of all venture capital dollars invested in the first quarter of this year. So while dropping startup costs for internet companies definitely impacts venture investment, it’s hardly a development that is going to doom the venture industry.

But the role of venture investment in early stage internet startups is an interesting topic. It is absolutely true that as startup costs are in decline and because of this, the role venture capital plays is in flux. The value that a venture firm brings diminishes when capital isn’t the main concern. As a result, we’re starting to see increased angel investment activity at the seed investment level for internet startups, and it seems as though these angles either have access to, or are great at identifying, the best companies. Angles appeal to internet startups because they often have better networks and come with less bureaucracy. Plus, the smaller check sizes now required are a better fit for both parties. It’s also worth nothing that seed investments have much more flexible exit options. Interestingly, we’re seeing some angel investors, such as Ron Conway or Mike Maples (often dubbed “super angles”), building up large portfolios which essentially makes them a seed fund of sorts. This is how I think venture capital firms can still play in the early-stage internet startup space – through dedicated seed investment pools and staff.

Seed and early stage investments have historically performed very well while capturing the true essence of venture capital – early-stage risk taking. Because of this, a venture firm, even if it is raising huge funds, should consider dedicating a portion of their funds to seed investments or even raising separate side seed funds. A great example, even though it has a dual cleantech and IT focus, is Khosla Ventures. When they raised $1 billion last year, it was split between a $750 million main fund, Khosla Ventures III, which invests in early to mid-stage companies, and a $250 million seed fund, which seeks out smaller investments in very young companies. What would be even better is if such dedicated pools had a dedicated staff able to develop a good rapport with the technology community, much like angel investors. I know this essentially amounts to having an in-house angel investing platform, but if venture firms want to play in the most dynamic stage of internet investing, and capital requirements come down, it may be the only way to have access to such investments. I’m guessing we’ll see more of this as the venture model evolves.

As a side note, since I hit on the topic of leaner capital requirements for startups, I thought I would bring up a post Vivek Wadhwa made this weekend on TechCrunch. The post is titled “Startups: Poverty is Underrated. Be Glad That You’re Not Rich.” Wadhwa contends that when a company is running on a tight budget, it will usually perform far better than a company that is well capitalized because it won’t develop the bad habits that come with outside money. These “bad habits” include a shift of focus to revenue and keeping the board of directors happy instead of focusing on profitability, sustainability and keeping customers happy.

The lean vs. fat startup debate has been going on for some time, with the lean side arguing that lean is the only way to go, while the fat side believes capital is a requirement for success. I take caution picking sides on this debate because the argument should really be made on a situational, case by case basis. What is clear though is that more and more attention is being given to the idea of startups operating in a lean manner, which means we’ll probably continue to see more of them, and that the venture industry will have to adjust. 

Profounder: A Huge Step Forward For Crowdfunding

I've written about the compelling idea of crowdsourcing a venture capital fund a number of times (in fact these posts are consistently the most searched for and trafficked). The premise is that a web-based venture capital fund, with a large crowdfunded investor base and crowdsourced decision making led by knowledgeable investors can be a highly effective way to successfully indentify, invest in, and grow technology startups. By compiling a large base of tech-savvy investors who are involved in the decision making process you have a better chance of identifying the best new startups and once you do, you instantly have a large base of supporters and customers. This type of fund would have a set of leaders to guide the decision making process and also provide more hands-on support to portfolio companies, but all investors would participate through voting - a chance to invest in startups in a way like never before. All this sounds great, but the major issue preventing something like this from working is that normal people are prohibited to invest in such a fund due to SEC Regulation D which requires investors in private companies and funds to meet minimum income and net worth thresholds.

I’ve run into a few groups that have attempted workarounds (unsuccessful for the large part); however, recently launched Profounder has made impressive progress. The site, which allows entrepreneurs to raise funding for their ideas/companies from their community, was started by Dana Mauriello and Jessica Jackley, a co-foucner of Kiva.org. While not yet fully developed the site gives plenty of information on how the process will work: Entrepreneurs will first create a “Raise Page” which outlines their business plan and how much they are looking to raise. Profounder will then create a term sheet and combine it with the pitch on a custom password protected page which entrepreneurs share with friends, family and colleagues they have a substantial pre-existing relationship with. Once individuals are invited to view the business fundraising page, they will have 30 days to contribute funding. The funding must be repaid (automatically withdrawn by Profounder each month) along with a percentage of the business’ revenues each year. Profounder makes money by assessing a fee (not yet determined) on the total amount raised.

Here are potential keys to avoiding SEC issues I came away with:

• Password protected pitch page
• The need to have a “substantial pre-existing relationship” with potential investors
• Investors have 30 days to contribute funding
• Entrepreneurs can only raise up to $1 million
• Entrepreneurs must provide investors with a certain percentage of revenue each year - notice you are not offering up equity in the company
• Limited to 35 investors, all other investors after the 35th cannot receive a percentage of revenue, instead you reward them for their contribution by giving that same percentage of revenues to a nonprofit in their honor.

Clearly there are limits to Profounder’s model but it’s the most progress I’ve seen in the crowdfunding movement for entrepreneurs. Profounder does a great job of highlighting the benefits of crowdfunding:

allows you to take advantage of your biggest existing resource: your community

can be a marketing tool in addition to a financing tool, as those invested in your business will become more loyal customers and avid supporters

shares risk among many, putting less financial pressure on just a few individuals

allows for your successes to be shared among many

cuts out banks, venture capitalists and professional investors to get better terms and a friendlier process

It will be extremely interesting to watch the progress of Profounder – its success would go a long way in not only proving the crowdfunding model but more specifically the impact it can have on entrepreneurship and innovation. Look for more updates from me on Profounder’s progress and how its success can potentially make a crowdfunded venture fund a possibility.

UPDATE (06/06/2010): Looks as though Profounder has gone stealth and will not be open to the public until the fall. The information used in this post has been pulled and is probably subject to change.

Fundamental Shifts in Venture Capital Becoming Clear

I was about to do an update on the Venture Capital Overhang I’ve been tracking, but instead of the typical chart this time around I thought it’d share something interesting that stood out - for the last three quarters we’ve now seen US venture capital investment outpace fundraising (and the quarter before it was almost even):

The only other time in recent history where we’ve seen investment activity even come close to surpassing fundraising was  in 2003 following the bursting of the tech bubble. What does this mean? We have numbers clearly indicating that a fundamental shift in the industry is underway. In previous posts, I’ve mentioned how fundraising could not forever outpace investment as dramatically as it had been doing so over the past decade (creating an ever increasing “overhang” of un-invested capital, or dry powder).  Fundraising has now slowed dramatically, while venture capitalists rightfully continue to invest in what is a good environment to be doing so in.

A drop in fundraising was expected, but we may now have a “new normal” for fundraising levels. There is clearly a new standard for raising capital now, especially with so many limited partners still skeptical of the asset class. At first a fundraising slowdown was blamed on the “denominator effect,” and later it was said that many limited partners were waiting to get a clearer picture of their allocation balance before beginning to commit again. But the truth is that most limited partners will not return to commitment levels of the past and therefore we will see a natural attrition of firms in the future.

Investment may outpace fundraising for a while - until fringe firms run out of capital and are unable to raise new funds. Just as I had said fundraising could not outpace investment forever, the converse holds true as well and we surely will not see investment outpace fundraising forever either.  Think of this period (of investment outpacing fundraising) as sort of a market correction. When we had huge overhangs of capital, venture capitalists knew there were others out there with capital to deploy as well which drove up valuations and reduced returns. What we should see after this correction is fewer firms - this means higher quality firms will remain, investing in better deals at better valuations and generating better returns.

The differential in fundraising and investing should be interesting to monitor. Too large of a crossover into fundraising outpacing investment again may signal another bubble, while a leveling out should indicate a healthier venture capital industry.

Note: Data from PwC, Thompson Reuters and the NVCA.  And for clarity, the VC overhang now stands at $88 billion – down from $89 billion at the end of 2009.