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. 

Mixed Signals

Usually you can gauge the health and general attractiveness of venture capital by looking at what’s going on with fundraising, investment levels, valuations and exits. What is deemed healthy or attractive in most cases depends on whether you’re an entrepreneur, venture capitalist or limited partner, but it’s typically pretty clear if times are good or bad for you. Recently though, it seems as if the indicators are sending very mixed signals. Here’s a quick overview of what’s happening:

Fundraising: Fundraising has been brutally difficult for venture firms ever since 2008. It seemed as though the situation was improving in the first quarter when we got off to the best annual start for fundraising since 2001. However, the quarter’s improvement was really driven by three firms raising billion dollar funds – Bessemer Venture Partners, Sequoia Capital and JP Morgan (their Digital Growth Fund – not really a venture fund in the traditional sense). Non big-name firms have had real difficulties raising funds, as evidenced in the second quarter of the year which featured the lowest number of funds garnering commitments since the first half of 1995. It can be argued that this is actually a good thing (for limited partners at least) since historically, lower fundraising has been correlated with higher returns.

Investment Levels: Venture investment activity has been volatile since 2008 but generally has displayed an upward trajectory, in both, the number of deals and total dollars invested (in fact, in the second quarter investment in Internet-specific companies rose to the highest quarterly level since 2001). A couple things are troubling. For one, investment continues to outpace fundraising and at some point will have to come down as many firms currently deploying capital will be unable to raise new funds. Another issue is that the rise in overall number of deals is being driven by seed and early stage investments while the rise in overall dollars is being driven by later stage deals. This means companies in between are competing for a smaller pool of capital. It can be argued that this is good thing because only those companies with proven models are making it to later stages, but I think the dynamic is also reflective of the overly rapid institutionalization of seed investing and a huge interest that formed around specific later stage companies.

Valuations: According to the Fenwick & West Venture Capital Barometer, Silicon Valley companies funded in the second quarter of 2011 showed an average price increase of 71% - up significantly from the 52% reported for the first quarter and the highest such result since 2007. With the third quarter seemingly very unsettled it should be interesting to see where things go. Anecdotally, seed and early stage deals still seem to be commanding high valuations. This is in part due to a huge influx of capital competing for deals as so many more venture firms and individuals are jumping into seed investing.

Exits: The exit market often reflects what’s happening in the public markets and broader macro environment and so right now there seems to be a lot of uncertainty. Officially, according to NVCA statistics, we are on pace to have the best year for VC-backed exits (both via M&A and IPO) since at least 2007. However, a lot of the activity is being driven by Chinese companies and it seems as though exit activity seems to have slowed in the third quarter (we’ll know officially soon). Large companies still have lots of cash but seem to be getting more selective again. The IPO window looks to be shrinking and many companies that have recently IPO-ed have not performed so well post-IPO. Good companies are definitely “exitable” but the bar seems higher than it was just a few months ago.

So what do we have? Fundraising data indicates it might be a great time to be an investor in venture capital. Investment levels are telling us that venture capitalists are excited about young companies but valuation data tells us that deals are as pricey as ever. The exit market had been great through the first half of the year but things are starting to look shaky – in line with the public markets and the macroeconomic environment. On one hand things are great, on the other, maybe not so much. The only way I can make sense of it all is to remember that the venture industry is significantly more cyclical than most people realize. We clearly were headed up out of a trough but now I think the industry is in a holding pattern trying to figure out whether or not it should continue moving upward or if it’s already peaked. It’s important to note that venture capital returns of late have been great.

What I think will happen is that the lower fundraising levels (which are, or should be, the “new normal”) will eventually lead to a slowdown in investment activity and, in turn, a decrease in valuations. All of this can be considered good or healthy in many respects.  The exit market is hard to predict and hedges a lot on the macro environment but it’s safe to say that good companies can still be attractive acquisition or IPO candidates. On the whole though, I doubt even an amazing exit market will lead to a boost in fundraising so investment activity should really remain steady or decline. Perhaps the industry data has just been hard to make sense of because the effects of the “new normal” levels of fundraising haven’t yet trickled down to investment valuations. It should be very interesting to see how the rest of the year shakes out and where all the variables stand at year – only then do I think we’ll know if we’re moving out of this holding pattern and in which direction. 

True Crowdfunding Platforms Still a Long Way Away

I’ve always thought of crowdfunding as a key development that had the ability to dramatically change how startups are funded. While crowdfunding has evolved to the point of becoming a viable and legitimate means through which to raise capital for “projects,” there still is a long way to go before crowdfunding can be used to raise capital for companies in exchange for equity. The good news is that there seems to be some promise on the horizon.  

A while back I wrote about Profounder, a site I thought had made significant progress on the crowdfunding front.  When Profounder launched back in early 2010, it seemed to have developed a platform that allowed entrepreneurs to raise funding for their companies from the public. What I thought was impressive about Profounder was that it appeared they had found effective workarounds to SEC Regulation D. Regulation D essentially requires registration with the SEC if there is any offer to sell securities (typically the case when a company is raising capital in exchange for equity). There are a few exemptions to the rule though, and Profounder looked to have found a way to apply them to build a true crowdfunding platform. Here were a few key workarounds I had identified:

• A required password protected pitch page
• The need to have a “substantial pre-existing relationship” with potential investors
• Entrepreneurs could only raise up to $1 million
• Entrepreneurs had to provide investors with a certain percentage of revenue each year - notice you are not offering up equity in the company
• The number of investors was limited to 35, all other investors after the 35th could not receive a percentage of revenue; instead they were rewarded for their contribution by giving that same percentage of revenues to a nonprofit in their honor

While there were clearly limits, it was the most progress anyone had made. Since its launch though, Profounder has pivoted away from this crowdfunding model to simply providing the “tools for entrepreneurs to raise their investment capital,” as opposed to an actual online platform. I think reasons for why this pivot was made may have been raised on Quora back in December of 2010. Profounder looked to have found an exemption under Rule 504 which actually allowed for the raising of up to $1 million in capital from unaccredited investors (no net worth requirement). The issue with Rule 504 is that state laws come into play, which can be incredibly difficult and complex to manage, particularly when you start to deal with more than a coupe of states. I think Profounder maybe underestimated the complexity or could not figure out a way to manage it for the users of its service in a cost effective manner. Furthermore, there probably were issues around general solicitation (which is barred under Regulation D). To circumvent this, Profounder made sure that users had a “substantial pre-existing relationship” with potential investors. One issue with this is that it leaves it up to the user to determine what is “substantial.” Another is that to avoid issues with the SEC and tap only those you really have a “substantial” relationship with severely limits the “crowd” in crowdfunding.

I’m not sure if Profounder ran into issues or simply found that compliance was too burdensome to allow for a true crowdfunding platform. Regardless, the compliance issue is what has been a major hindrance to the emergence of true crowdfunding platforms. Yes, we have sites such as Kickstarter which allow for the raising of money for projects, but note that no ownership is exchanged and no investment returns are provided aside from a “reward.” Because of this Kickstarter avoids all SEC issues. It’s also why crowdfunding has been centered on the creative arts.

Once relatively new exception I have found is a site called Venture Bonsai. Venture Bonsai actually lets you raise an investment round inside the service; however it is limited to companies based in Europe where securities laws are a bit more lax as they relate to private placement. The legal framework used can be found on their site – I thought this bit was a good overview:

“This framework is built in such a way that the Share Issue can be arranged within the service as easily as possibly while still following the regulation related to private placements within the European Union. The example documents have been built in such a way that they can be modified to meet the minor differences in each national legislation.”

So there’s some progress being made across the Atlantic, but what about here in the US? Well the good news is that there has been enough interest in the space to get the attention of the SEC. In April, the SEC said it was in the very early stages of a review of securities law as it related to crowdfunding. In a letter, SEC Chairman Mary Schapirio said they have “‘been discussing crowd-funding and possible regulatory approaches" with small-business representatives and state regulators. Apparently “A petition calling for the securities rules to be eased for crowd-funding share issues of up to $100,000 has been backed by almost 150 organizations and individuals,” according to the Wall Street Journal.  While not a substantial amount, the ability to raise $100,000 through crowdfunding would at the least make it easier for entrepreneurs to raise capital and would make for a competitive alternative to angel funding for some. 

Being able to crowdfund capital for a startup means that more companies get started and more innovative ideas get the chance to be proven.  I can’t help but think that it would be good for job growth and the economy. It would also change the venture landscape, perhaps for the better, as more new startups are generally a good thing for venture firms. Hopefully a decision by the SEC comes soon and true crowdfunding platforms emerge. In the meantime I’ll be monitoring the SEC’s actions regarding crowdfunding and will share any updates.

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. 

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. 

Should Venture Funds Consider J-Curve Mitigation Strategies?

Most everyone involved with the venture industry is familiar with the J-curve. It is used to describe the nature of returns in a venture fund (based on the internal rate of return or IRR). Returns are typically negative in the early years and then turn positive in the range of three to five years after the fund starts investing. This happens as a result of a number of factors, including: management fees (which make up a larger portion of called capital early in a fund’s life), under-performing investments that are identified early and written down, and also the simple fact that investments take time to mature and grow. 

All in all, for investors with a long-term focus such as those investing in venture capital, the J-curve is is not a major concern since all good funds eventually emerge from it. Unfortunately though, in evaluating venture funds some investors irrationally eschew what are quality venture funds and firms based solely on IRR since it’s the most prominently used return measure and also the most commonly benchmarked. Funds with deeper J-curves or even funds whose early returns are viewed by investors without full understanding of the J-curve are often unfairly judged. This begs the question of whether or not venture funds would well served by taking actions that mitigate the J-curve. As the industry has come under scrutiny over returns and the competition over limited partner commitments intensifies, the idea of a venture funds using j-curve mitigation tactics isn’t so farfetched.

J-curve mitigation already happens at the portfolio level of institutional investors by mixing in funds with strategies that produce more immediate cash flows. Examples include secondary funds, direct secondary funds, venture debt funds and co-investments. Let’s say a venture firm wanted to mitigate the J-curve in a fund, what tactics could they use?

• Defer management fees to later years of the fund – management fees early in the life of a fund are a major drag on the IRR. Firms that can afford to defer them to later years of the fund could mitigate the J-curve and boost IRR.

• Be less conservative with valuations – by not writing companies off early or holding companies close to cost when they can be written up, a fund could boost NAV and IRR as a result.

• Alter the fund’s early investment strategy. Examples include:
  • PIPE deals – investing in publicly traded companies.  The liquidity associated with the public markets means an investment could be made and turned around in a short period of time.
  • Venture debt – providing debt financing to already venture-backed companies. Debt payments mean early cash flow while warrants can provide the option for future equity.
  • Early late-stage deals – If a fund has a balanced strategy in terms of investment stage, concentrating late state deals early in a fund’s life would provide early liquidity to mitigate the J-curve.
  • Direct secondaries – purchasing an investor’s (founders, employees or even venture funds) interest in a venture-backed company that is close to a liquidity event.

Below is an example of how early liquidity can not only help mitigate the J-curve but also impact a fund’s overall IRR. I’ve assumed that a fund is able to produce the same level of distributions regardless of strategy (the only difference being timing): 

As you can see, in addition to mitigating the J-curve, IRR can be boosted significantly by providing a moderate level of early distributions. Of course the difference in return is almost purely optical since the return multiple remains the same. Furthermore, by implementing these strategies, a venture fund is almost surely forcing a strategy that might not be optimal for the team, market and long-term benefit of the fund and limited partners.

Are investors concerned enough with the J-curve that they would accept lower risk-adjusted returns to mitigate it? The right answer to this question has always been no, since most sophisticated investors realize the long-term nature of the asset class (and use a broader measures of performance including return multiples). Still, the possibility of funds implementing such strategies is more real now than ever before, as managers try to keep ahead of peers and gain any edge they can in appearing better to less informed investors.

Don’t Sweat Year-End Venture Performance Figures

Last week year-end 2009 US venture capital performance figures were made available by Cambridge Associates (venture capital returns are reported on a quarter lag – even longer when it’s year-end).  Despite improving in the fourth quarter, returns over all major time periods were pretty lackluster save for the 15 and 20-year returns which still include the tech bubble. The 10-year return, the period given the most attention because it the same length as the life of most venture funds, dropped into negative territory. What’s more is that the net to LP returns for every vintage year since 1998, except for 2003, is negative. This to me stood out as the most discerning stat –it means that average investor lost money in venture pretty much every year since 1998. Yes, top quartile managers have done better, posting positive returns with IRRs in the 2-6% range – but single-digit IRRs for venture capital still cannot be justified, especially when when you factor in the illiquidity premium.

There’s no reason to be shocked by the return figures however, since they were somewhat predictable. Plus, the lag in returns makes the year-end numbers look worse than they really are because we’ve seen the public markets improve significantly since the start of the year.  You can expect the venture capital index to rise in the neighborhood of 3-5% when first quarter returns are made available– improving as a result of the public markets as well as heightened liquidity. Still, the forthcoming return increases will not go far in improving the overall picture of venture over the past decade. This means venture investments will be tough to sell to limited partners, which will invariably lead to an attrition of funds and firms and eventually lower levels of capital being deployed.

Lower levels of capital deployment, however, is almost exactly what the industry needs. Remember I mentioned 2003 being the only positive vintage year median? Well it also happened the year with one of the lowest fundraising and investment levels. Also, even though it does not make perfect sense, looking back at the returns over the last decade, imagine if only the top 50% of funds/firms were in existence – the median figures I mentioned would represent the low, and the top quartile the median. Real top quartile returns then would most likely have been in the double digits – more than acceptable. While we should always be forward-looking, we can’t ignore the fact that the past has shown a smaller group of better mangers results in a healthier industry and better returns.

And if we want to be forward looking, there are plenty of reasons for investors to keep faith in venture and continue making commitments:

• You have a contrarian play at hand;
• Innovation, the lifeblood of venture, continues unobstructed;
• There’s the diversification case -venture proved to be an extremely valuable diversifier for institutional portfolios during the recession;
• Lastly we’re finally seeing a thawing of the exit markets and the return of liquidity through IPOs and M&A activity, especially by tech giants who have huge sums of cash on hand.

These changes should result in successful vintage year 2009 and 2010 funds, but when coupled with sustained lower levels of investment, should also bode well for the future of the industry. Gaps in funding from institutional investors will be filled by novel ways for entrepreneurs to raise funding. Examples include crowdfunding site like Profounder, and more basic funding platforms such as Kickstarter. These sources of capital fill niches that traditional venture had for the large part had gotten too big for, but fewer dollars flowing into startups means VCs will (and have already started to) move back down to earlier stage deals, which also historically happen to deliver the best returns. Looking back at overall venture performance isn't pretty, but keep in mind that past performance is rarely an indication of what’s to come. The venture industry is undergoing a transformation and performance for the next few years is primed to transform as well.