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. 

Seed Investment Sizes Rise But Stay In Check

I recently shared that seed investment relative to total venture investment neared an all-time high in the second quarter of 20011. One-third of all new venture deals were made at the seed stage according to data from the National Venture Capital Association and PwC. I thought it might also be useful to share what was going on with the average investment size for new seed deals. Is more of a focus on seed stage deals driving up valuations? Well, yes and no. The average seed investment more than doubled over the first quarter of the year – up from $1.5 million to $3.1 million. So yes, clearly there’s a significant increase from the quarter prior (but I have some issues with that data which I’ll discuss later). On the other hand, the average seed stage investment has averaged $3.3 million since 2006. So we’re actually still below the average in recent history.

Data Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree™ Report, Data:  Thomson Reuters

I think there are a few factors at play that have prevented seed valuations on the whole from rising too much:

• For all the attention some of high profile deals get, they seem to be the exception, not the rule. Huge early stage rounds like the one for Color garner a lot of attention, but I think on the whole, investors have all the talk about us being in a bubble in the back of their heads and are being prudent with deals.
• We also need to remember that most seed deals are in the IT sector, and specifically for internet companies. This means the amount of funding they need in a seed round, on average, is getting smaller because it’s so much cheaper to build a company out to at least to proof of concept. What this does leave room for though is the potential that the amount of investment going into seed deals is getting high relative to the amount they actually need. It’s hard to extract this from just basic investment data.
• There are also alternatives to funding – instead of higher profile companies and entrepreneurs seeking seed funding outright, many are increasingly going to incubators. These programs, such as YCombinator, TechStars and a whole slew of others, are growing in number and size.
• Finally we can question the data source – the NVCA and PwC gets their data from ThomsonReuters which captures data through surveys and only includes institutional investment. So, individual angel investment, for example, is generally excluded.

Back to that issue with the Q1 data - as with the data on the number of new investments, there’s a strange anomaly in Q1 of 2011 with the average deal size as well. It’s as if investors took a dramatic pause in the first quarter – did fewer seed deals, and invested less in each deal. Again, the reason is not quite clear to me because the general impression I got from observing the market was that seed and early stage investment was hot, driven not only by a rise in super angel/micro VC funds, but also more seed investment activity on the part of traditional venture firms. One reason why the data might not match up with anecdotal evidence is that maybe investors were really taking a wait and see approach on how the venture-backed companies that held IPOs in the first quarter did before actually closing on new deals. Clearly a record-setting second quarter in terms of venture-backed IPOs in the IT sector helped boost confidence and probably led to the spike in the relative number of seed stage deals and dollar amounts in Q2. I’m still open to hearing if anyone has any alternate theories. 

UPDATE: On his blog Reaction Wheel, Jerry Neumann shared that he has a nagging suspicion about early-stage venture capitalists: "About six months ago it seemed like they were slowing down their pace of investing while the corporates and newer super-angels were doing a lot more deals." If this is true, it surley can help explain the anomoly in Q1 the data. Since only institutional venture firms are included, the suspicion that they slowed up on seed stage deals can actually be confirmed. On the whole though, seed stage investment seemed like it was going strong because in reality, it was - just led by super angels whose deals do not make it into this data. As for if this is a warning sign, I think its too early to tell - but it is intersting that in the next quarter, relative seed stage investment by VCs hit levels last seen right before the bursting of the tech bubble. 

Relative Seed Stage VC Investment Nears All-Time High

Last week, US venture capital investment data through the second quarter of the year was made available by the National Venture Capital Association and PwC. What stood out to me most was that seed stage deals rose to account for one-third (33%) of all new venture capital investments in the second quarter. This was the highest such level since the first quarter of 1999 (yes, over 12 years ago!). Only three other quarters (all in 1998) come close to reaching the one-third mark (the data goes back to 1995). Essentially, we are just about at an all-time high in seed investing relative to all other venture investment. In absolute terms, $317 million was invested across 101 new seed deals. Both these figures have been eclipsed in recent history, however, looking at the relative level of investment gives us better insight as to what is happening in the venture industry at any time, regardless of its size. Also, as I have mentioned before, because most venture industry data is not consistent in terms of quality, it’s better to look at trends rather than focus on specific numbers.

Data Source: PricewaterhouseCoopers/National Venture Capital Association MoneyTree™ Report, Data:  Thomson Reuters

The reasons for a rise in seed stage funding are seemingly pretty clear - the data helps perhaps confirm the growth and institutionalization of Super Angel/Micro VC funds as well as the recognition of the importance and benefits of seed investment by larger venture firms with more diversified strategies.  The interesting thing about the last time seed investment hit these levels was that it was right before the bursting of the internet bubble. Perhaps a high relative level of seed investment is a leading indicator for a tech/vc bubble. I think this is a controversial topic and I won’t stray into my thoughts too much but I think it’s very hard to tell if we are in a tech bubble. You probably can never know for sure if there has been a bubble until it pops.  In general, I do believe higher level of seed investment is healthy for the venture ecosystem, as long as valuations are reasonable.

One other thing that stands out when looking at the data is the temporary, but sharp, drop in the relative level of seed investment in the first quarter of 2011. I can’t help but think this was just a random anomaly, because no other stage of venture investment experienced the same volatility. I can’t think of any convincing reason why the drop would have been so large for just the first quarter. Feel free to comment if you have any suggestions. It should be interesting to see what the data shows us for the coming quarters. I’ll be sure to provide an update when new data is released.

UPDATE: On his blog Reaction Wheel, Jerry Neumann shared that he has a nagging suspicion about early-stage venture capitalists: "About six months ago it seemed like they were slowing down their pace of investing while the corporates and newer super-angels were doing a lot more deals." If this is true, it surley can help explain the anomoly in Q1 the data. Since only institutional venture firms are included, the suspicion that they slowed up on seed stage deals can actually be confirmed. On the whole though, seed stage investment seemed like it was going strong because in reality, it was - just led by super angels whose deals do not make it into this data. As for if this is a warning sign, I think its too early to tell - but it is intersting that in the next quarter, relative seed stage investment by VCs hit levels last seen right before the bursting of the tech bubble. 

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. 

VC Shift To Seed Stage Investing Is For Real

Third quarter venture capital investment data was made available last week which prompted me to re-examine the data I looked at in my previous post on the recent spike in seed stage investing by venture capitalists. More specifically, I wanted to see if the data trend held true to what seems to be going on anecdotally - are venture capitalists really dramatically shifting their focus to early and seed stage deals? The answer still seems to be a resounding yes. The chart below is a more detailed look at the percentage of all initial investments allocated to seed stage deals by venture capitalists by quarter since the post-bubble period (2001-2003).

You’ll notice the spike in the second quarter of this year, but the third quarter still represents the highest level of relative seed investment since the second quarter of 2005. Furthermore the data trend still clearly shows that venture capitalists have indeed continued to shift more of their focus to seed stage investing. Why? Well, as I’ve covered before, it’s a reflection of a few factors:

• Lack of syndicate partners for later stage deals
• Lack of capital or adequate reserves for later stage deals
• Skepticism around the medium term prospect for exit (IPO and M&A markets)
• The realization that more risk needs to be taken to achieve desired returns
• A rise in the number of quality “venture-backable” start-ups and entrepreneurs (partially a product of the state of the US economy)

Data Source: NVCA PricewaterhouseCoopers/National Venture Capital Association.

Why Have Venture Capitalists Shifted To Seed Stage Investing?

On the heels of my last post on venture capital’s role in innovation, I decided to take a look at how active venture capitalists were in funding companies that are early in their innovation lifecycle. The proxy for this is the earliest stage at which venture capital can come in – seed capital or start-up investment. What I found was surprising. The chart below shows the percentage of new venture capital investment (in terms of dollar value) that went to seed /start-up stage companies each year over the last 15 years. This is the best way to look at this type of data - absolute figures tell you more about what the venture market is doing overall - to understand real deal trends you have to examine changes in proportions of investment over time.

What’s clearly surprising about this data is the recent spike in seed investment (relative to other stages) by venture capitalists. 32% of all new venture investment this year has gone to seed stage deals. What’s driving this?

I know for a fact that pure seed-stage venture funds have had trouble raising funds over the past few years (relative to balanced and later stage funds), which means that traditional venture funds are now leaning more towards seed stage deals. I can think of a few reasons why:

• Venture capital firms are being forced to engage in cheaper, earlier stage deals because syndicate partners are increasingly tougher to find for later stage deals.

• Venture capitalists are still worried about the future of the exit markets (the IPO market and M&A activity) and therefore are hesitant to engage in later stage deals. These are deals in which they would have to reserve adequate capital for if subsequent venture rounds are needed to sustain the companies. We've seen a lot of firms face reserve shortfalls over the past year as the exit markets have essentially been closed. Venture capitalists with the expectation that exit markets will remain tight would clearly be detered from making later stage investments and would perfer less capital intensive earlier stage deals.

• Perhaps venture capitalists are simply going back to their roots and finally taking more risk again. There’s probably the realization that outsized returns can only be attained by generating higher return multiples off of earlier stage deals. Some of this might be pressure from limited partners - low multiple later stage deals just are not attractive, particularly when you consider the fees and illiquidity that come with commitments to venture funds.

Regardless of the reason, this shift to earlier stage investing can only be a good thing for the venture industry. The firms that are truly good at building companies and working with entrepreneurs will stand out and perhaps help repair the image of the venture industry.

Data Source: NVCA PricewaterhouseCoopers/National Venture Capital Association.

PricewaterhouseCoopers/National Venture Capital Association. MoneyTree™ Report, Data: Thomson Reuters.