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. 

Real Crowdfunding Options for Startups on the Horizon?

I’ve covered the topic of crowdfunding pretty exhaustively in the past – there is huge potential that can be unlocked if startups could raise meaningful amounts of capital in exchange for equity online from a large number of small investors. As promising as the idea is, there have always been SEC regulations that have made it difficult, if not impossible for a true crowdfunding platform to exist. However, this might all change sooner rather than later. There have been a couple of very interesting movements on the regulatory front regarding crowdfunding since my last post on the topic:

• President Obama’s American Jobs Act supports establishing a “crowdfunding” exemption from SEC registration requirements for firms raising less than $1 million with individual investments limited to $10,000 or 10% of investors’ annual income. It seems as though this would eliminate the accredited investor requirement under SEC Regulation D (limiting investment opportunities to those with a net worth of over $1 million or income of over $200,000 per year).
• California Congressman Kevin McCarthy has introduced the Access to Capital for Job Creators Act. The proposed act would alleviate the “general solicitation” ban that is currently in place under SEC Regulation D. The ban prevents private companies from raising capital from individuals who they do not clearly have a pre-existing relationship with. The legislation would remove the solicitation ban and allow companies to raise capital from accredited investors nationwide, or even globally. Apparently the proposal could be packaged with another group of bills which include the expansion of the “500 shareholder rule.”

If successfully passed, these two pieces of legislation would help overcome two of the major hurdles that prevent true crowdfunding from becoming a reality for startups: the general solicitation ban and requirement that capital only be raised from accredited investors. Interestingly, the SEC had recently taken into consideration a petition for rules to be eased for crowd-funding share issues of up to $100,000, but the American Jobs Act would place the limit at $1 million – a substantial improvement that makes it more realistic for startups to raise meaningful amount of capital via crowdfunding.

In the past I’ve shared how Profounder, who I thought was a leader in crowdfunding, struggled to get traction because it was hindered by regulatory issues. Well apparently, the team has been involved in helping shape the legislation and would benefit greatly if it was passed. Further we could see sites like Kickstarter pivot and move beyond just funding for artistic endeavors.

What would these changes mean for angel and seed investing? I think ultimately there would be even more startups being funded than there are now (a great thing). Crowdfunding would be a complement to traditional angel funding, but not necessarily a replacement. Sure, some startups that would have chosen angel funding might instead use a crowdfunding platform but there is still plenty angles bring to the table – expertise, a network and the ability to provide funding with one check. If anything, crowdfunding would probably compete more directly with, or replace, friends and family rounds. Either way, true crowdfunding would be great for the startup ecosystem and the economy.

If crowdfunding does take off we will for sure see a proliferation of new crowdfunding platforms. There would also be other opportunities for businesses in the new industry, particularly in the area of trust. Examples include crowdsourcing due diligence firms for investors or company verification/certification firms. Who knows, there may even be a possibility for a crowdsourced venture fund. As always, it will be interesting to see how things shake out. I’ll share updates in this space as they become available.

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.