Observing Larger Trends in Healthcare VC

This year, venture investment into the healthcare sector surpassed investment in the traditionally heavyweight information technology sector for the first time in over a decade. This trend has been well covered and there are plenty of reasons as to why venture capitalists have shifted focus to healthcare (less cyclical, lower valuations, less fundamental change, etc).  What’s interesting about the trend is that there’s been a historical correlation between difficult economic environments and the relative level of healthcare venture capital investing.

Here’s a look at healthcare investment as a percentage of all venture capital investment over the past 10 years: 

 

What you notice, besides the clear increase in relative healthcare investment over the past decade, is two dramatic spikes: The first in the years following the tech bubble – which is partly the result of VCs shying away from the tech sector while those investing in healthcare maintained their investment pace. Plus, many tech VCs looked for safety in the relative less volatile healthcare sector. The second spike is more recent - starting last year as the recession took hold and what can be considered a small venture bubble burst.  The reasons for this spike are similar as the previous, and as with the previous spike, the absolute dollars invested in the sector have still declined.

What’s also interesting about the two spikes is that they are predicated by a short decline in relative healthcare investment, which makes you wonder - is the relative level of healthcare investment perhaps a leading indicator for venture capital bubbles? It appears so. During bubbles, VCs are more apt to pour cash into what can be more lucrative, but also more risky technology investments.

This recent spike, where healthcare investment has reached almost 40% of all venture investment, is probably just that - a spike. Unlike earlier this decade, the levels of healthcare investment should come back down again as clean technology and IT investment pick up. But the case for healthcare investment remains and we’ll probably see it remain around 30% of venture investment going forward. Demand will continue to be driven by an aging population, continued technological progress, declined pharma productivity and government programs such as those pushing healthcare IT and increased access to healthcare.

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

VC’s: How To Benchmark Yourselves Properly

Plenty of VCs are guilty of deceitfully presenting fund performance – especially when it comes to benchmarking themselves against their peers in marketing materials. There’s a reason why so many LPs complain about almost every VC claiming to be “top quartile.” When raising new funds or providing updates, you too frequently find venture capitalists benchmark their performance improperly, often in an attempt to make themselves look better. Instead of these attempts, existing and prospective LPs would probably find it much more amicable if VCs candidly presented their relative performance - in fact, being candid in presenting performance and benchmarking goes a lot further than you would think with most LPs.  Here’s a guide on how to go about benchmarking properly and in a way that LPs will surely appreciate:

Selecting a Benchmark:

Use the Cambridge Associates Benchmark Statistics - don’t even consider any alternatives. Their benchmarks are far and away the most comprehensive. A common alternative you see is the ThomsonReuters (Venture Economics) benchmarks but they fall so short of Cambridge in terms of sample size that their statistical validity is questionable - sophisticated LPs are aware of this issue. The Cambridge benchmarks exhibit slightly higher returns because of their selection bias (all funds that Cambridge clients are in get pulled in so some consider it more of an “institutional quality benchmark”), but they are the industry standard and using anything else immediately raises doubts for LPs.

Don’t have access to their quarterly benchmark statistics? Simply contact them and participate in their quarterly survey and you’re receive the benchmark statistics free of charge. You’ll have to provide your quarterly financials to them but don’t worry, all data is kept confidential and your performance remains anonymous. They’ll even sign an NDA if you ask them to.

What to Present:

Determining the Proper Vintage Year: Cambridge Associates determines a fund’s vintage year based on the partnership’s date of legal formation - not by when a fund holds its final close and not by when a fund started investing. This means that under most circumstances you should do the same, unless there’s a special case where a fund took over a year to raise or if the fund was legally formed so late in a year and didn’t start investing until late in the next year that its most logical to use the next vintage year. If either case applies, make sure you footnote the situation properly.

 Determining the Proper Asset Class: Usually it’s not difficult deciding whether the venture capital or private equity benchmark is most appropriate. But in some cases where a fund has a later stage or growth equity strategy, LPs like to see it benchmarked using private equity benchmarks. If you have a strategy that straddles venture and private equity, consider using both benchmarks.

 Performance: You must of course show IRR, but make sure it is the IRR NET TO LPs (net of fees and carry) not the gross fund IRR. Nothing is worse than a VC that either purposely or inadvertently shows just gross IRR and then even worse, benchmarks it against the net to LP benchmark. It’s ok to show a fund’s gross IRR but if you decide to do so, you must also show the net IRR as the next line item. Generally, when benchmarking you want to show just the Net IRR because if there’s a large discrepancy between the net and gross, it draws attention to the effect management fees and carry is having on the return to LPs.

 In addition to the IRR also show and benchmark the distributed/paid-in and total value/paid-in multiples. Showing fund level cash flows is a plus too. The reason for showing the multiple is to help iron out some of the effects timing has on the IRR and give a truer sense of the fund’s performance. This goes back to being candid – you don’t want to omit multiples if IRR has been boosted by a quick exit, and conversely, for older funds you might actually be doing yourself a disservice by not including the multiples if IRR has been dragged down because of timing.

 Not Meaningful Performance: A general rule you can follow is that a fund’s performance is not meaningful and thus okay not reporting on and benchmarking if there has been less than three years of activity. Just make sure you footnote why you have decided that a fund’s performance is not meaningful and why it hasn’t been benchmarked. But also be sure to have the performance handy and expect to provide it if an LP asks for it.

Here’s an example of how fund benchmarking should look (note: figures are fictional):

 

Note that these guidelines apply to sharing fund level performance only and that the guidelines for sharing company level returns are much different – something I’ll eventually post about later. In the meantime, feel free to provide feedback or ask questions about these guidelines.

The 10-Year Venture Capital Return Doesn’t Mean Anything

Over the past year there’s been a lot of talk about how venture capital returns over a ten-year time horizon will no longer look so hot once this year is out. This is because after this year the ten-year timeframe will no longer include returns from 1999 – a year featuring huge exits through quick IPOs in what was the last year before the bursting of the tech bubble.  The 10-year venture capital return currently stands at 14.3% (as of 6/30/09 – VC returns are always on a quarter or quarter and a half lag), but has been in a steady decline. There’s been some speculation that the decline in this return will have a negative impact on the venture industry’s attractiveness to investors, but I don't think that is necessarily the case.

Over the last four quarters, the 10-year return has tumbled from over 40% to 14%. For a visual, here’s what the recent drop in the 10-year return looks like:

Before going further, here’s some background on how the return is calculated:

The 10-year return is an end-to-end venture capital fund-level return, meaning it looks at the fund-level (read: not company level) cash flows – to LPs only, meaning it is net of fees and carried interest ( a good thing because this is the true level of return an investor in venture capital funds would have received). The return is a standard IRR calculation except that it in the period in which it starts, in this case the second quarter of 1999, the cash flow pulls in the negative starting net asset value of all the funds comprising the index. Going forward, all contributions and distributions are netted to get the cash flows for each quarter (for timing purposes, the figure is assumed at the midpoint of each quarter). For the final quarter of the calculation the current net asset value of all the funds in the index is added in as a positive cash flow.

What’s the recipe for this drop in the 10-year return? For one, huge IPOs started tapering off after 1999 while at the same time, inflated valuations made the beginning negative cash flow much larger and tougher to overcome, dragging down returns.  Then add in the fact that there hasn’t been another period of fantastic exits since, and that the past year has been absolutely dismal for venture-backed exits and you get a free-falling 10-year venture capital return.

But how important is the 10-year return really? The whole notion that the 10-year return’s fall will have a negative impact on the venture industry is actually hugely flawed. The pure numerical drop in the 10-year return should not be what deters investors. Why? Because sophisticated investors (limited partners) are smart enough to not have been looking at the 10-year return anyway. If anyone looked at the 10-year return as their reason to invest in venture, they clearly do not understand the asset class enough to be making decisions on investing in it. 10-years, despite being a round number, is just as arbitrary as any other number. Nothing makes it different than looking at 9 or 11 years. Even if you are comparing to public markets. The only thing that makes this current case unique is that we are on the brink of excluding a great period for venture. But by now, most investors have come to accept the tech bubble as an aberration, and new expectations for venture returns are much more tempered, albeit still relatively high because of the illiquidity and risk.

Plus., if you want to get technical, the 10-year return isn’t realistic for investors because to have gotten those 10-year returns they would have had to have gotten into funds in the prior one to four vintage years – the ones which were actively investing prior to the bubble and able to exit during the bubble.

Finally, no legit VC I can think of is selling their fund based on 10-year industry returns. In fact they probably look to avoid having to talk about the bubble years because the business is so different now. What happened 10 years ago is pretty much irrelevant. VCs are judged on their performance over the last five years, how their strategies can take advantage of the current environment, and their ability to exit deals over the past year and going forward.

What the drop in 10-year return does more than anything is highlight a major shift in the venture industry - a shift that investors and VCs were aware of years ago and probably ever since the bubble burst. This drop in the 10-year return is not new information and could have esily been predicited a few years ago. We’ve gone from some 250 venture-backed IPOs in 1999 to just 10 so far this year. We know there will be attrition in the industry, but investors that stick with venture capital should be better off because of it. Innovation continues unabated and top mangers continue to provide quality returns through building and growing companies - the way it should be.

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.

Venture's Role in Innovation

A big debate was spurred by Vivek Wadhwa last week when he lashed out at the venture community through a post on TechCruch.  Wadhwa contends venture capitalists do little, if anything, for innovation and even detract from innovation. His post comes on the heels of the National Venture Capital Association (NVCA)’s most recent “Venture Impact” report which highlights the importance and impact of venture-backed companies in the macro U.S. economy.  The report does make some outlandish claims, such as 12 million jobs, and 21% of GDP can be attributed to venture-backed companies. Clearly venture capitalists cannot realistically lay claim to those statistics. The report, meant to be a lobbying tool more than anything, includes any company that has received any type of venture funding at any point in its life under its definition of “venture-backed,” which is pretty misleading. Not to say that venture capital does not have a positive impact on the economy - it does - but it is definitely not responsible for the numbers the NVCA presents.

Wadhwa took things a bit further in his post though, and cites research (itself a bit questionable) that shows not only do the vast majority of successful entrepreneurs not need venture capital, but that those who do take it see their companies become less innovative. This leads Wadhwa to conclude that “gold digger” venture capitalists with MBAs have increasingly been simply funding “me-too” companies resulting in high failure rates and declining returns. Looking past the VC-bashing, his main argument really is that venture capital does not facilitate innovation and therefore does not play a meaningful role.

The argument that venture capital does not facilitate innovation is really not much of an argument at all; aside from the rare cases when VCs start their own companies, entrepreneurs are clearly the innovators - no VC would argue with that. So then the next question is around the role venture capital plays. VCs are not simply “middlemen” as Wadhwa states. It would be ignorant to group VCs into one bucket - some are better than others, but almost all VCs play a role in their portfolio companies’ management and strategy. Wadhwa points to research that shows a company’s innovation decreases after it receives venture capital. This is actually a product of maturation. Most companies far enough along to receive venture capital funding would see a decline in innovation regardless of whether or not they received that venture funding.  Venture investment is meant more to take an innovation to the next level, raising its impact and growing its reach, not to prompt innovation.

The role venture capital plays varies by industry as well. In the more visible internet sector, there is limited need for venture capital investment, particularly because the cost associated with starting and scaling web startups has become so low. Venture capitalists won’t always admit it, but it’s a space most do not understand well, and because of its high visibility they catch the more flack for failures. Other sectors such as biotech and cleantech need venture investment to scale. Innovation can be halted if not for investment by venture capitalist. Wadhwa does not account for this at all.

Looking at the big picture, there’s not necessarily causality between venture investment and innovation, rather the two go hand in hand. Innovation can only have limited impact without scaling which is often made possible by venture investment. At the macro level, as the US is faced with increase competition from abroad from countries like India and China, innovation will be paramount in our global competitiveness. The only way the US can continue to compete and maintain its current standard of living is by creating new jobs through innovation. Entrepreneurs will be at the forefront and VCs will continue to be there to back them. The innovation ecosystem is fragile and the last thing it needs is people like Wadhwa causing an unnecessary break in trust.

As an aside, Wadhwa in his piece also mentions that “VCs are looking for bailout money and tax-breaks.” I’m not sure what the basis for this claim is. Surely anecdotal evidence is not what bears the proof. There’s not a single VC I know of that would want to touch bailout money, given the caveats it would come with. Nor are VCs aggressively looking for tax breaks. The only major activity on that front is resistance against a change in capital gains tax, which is reasonable. The one exception where tax breaks have been asked for by VCs is in the cleantech industry where government subsidies have led to increased investment by not only venture capitalists, but by a wide range of investors. And finally, I’ve written about this earlier, but venture capitalists are sitting on approximately $120 billion of “dry powder,” not a figure that indicates the VC community is looking for handouts.

The Venture Capital Industry in 2009: Over/Under

With this week marking the start of the NFL season, and the calendar marching toward the fourth quarter, there’s no better time to do a bit of speculation around how this year may end up for the venture industry. Especially when you can have it take the form of the over/under wagers commonly associated with the sport (which are only made for fun of course). Half the fun was in deciding what the over/under should be the rest is in the takes. Here we go:

Category: Venture capital index return for 2009 (one year/end-to-end)

Over/Under: 6.5%

The Take: UNDER

This was a tough line to formulate without the second quarter venture capital index return which is not yet available. The Cambridge Associates US Venture Capital Index return for the first quarter was at -2.9% and the preliminary second quarter end-to-end return currently stands at 0.16%. With the NASDAQ up well over 10% in the third quarter so far, it’s fair to say the venture index will track further upward in Q3 and probably Q4. The venture index has been less volatile than the public markets despite FAS 157 mark-to-market rules, but the trend down the line should still be upward. There should be some bump in valuations before the year is out, but since exit activity will remain weak, the index should have a tough time breaking 6% for the year.

Category: Venture capital fundraising totals for 2009

Over/Under: Funds: 125, Dollar Amount: $12 Billion

The Take: UNDER – both number of funds and dollar amount

At the end of the second quarter, 70 venture capital funds had raised a total of $6.3 billion. Fundraising activity declined significantly in the second quarter, when only $1.7 billion was raised by 25 funds. As we find ourselves amidst the toughest fundraising environment in some time, limited partners have shown no signs of increasing their rate/level of commitment in the near future. Allocations within private equity for most institutional investors have either remained unchanged or dropped for venture, while increasing for more opportunistic strategies. Well established firms and proven general partners should be able to raise funds, but newer firms and those with less than stellar track records will have trouble.

Category: Venture capital deal-making totals for 2009

Over/Under: Deals: 2,750, Dollar Amount: $15.5 Billion

The Take: OVER – both number of deals and dollar amount

At the end of the second quarter, venture capitalists had invested in 1,215 deals totaling $6.9 billion. Investment activity was quite consistent between the first and second quarters. There’s the sense that investment activity has dropped a bit in the third quarter but that deal sizes seem to be larger, perhaps reflective of a shift to investment in the healthcare and cleantech sectors. Look for venture capitalists to continue to invest in innovative new companies, particularly as they should still have the upper hand on deal terms and valuations. Follow-on investments in later-stage companies will continue as well since the exit market will not open up significantly at least till next year.

Category: Total number of venture-backed IPOs in 2009

Over/Under: 9

The Take: PUSH

 At the end of the second quarter there were just 5 venture-backed IPOs for the year, I’m counting just the LogMeIn and Cumberland Pharmaceuticals IPOs since, and projecting just two more. You have to have faith that two more venture-backed companies can hold an IPO in the next four months buoyed by the solid performance of those that have managed to go public so far this year. The good news is that 2010 looks to be a much better year.

Category: Total number of venture-backed M&A exits in 2009

Over/Under: 230

The Take: OVER

Through the end of the second quarter there were 121 M&A deals in which venture-backed companies were acquired. At the start of September we were at around 165. While the third quarter will probably end in line with first and second quarter totals, I’m expecting the fourth quarter to be relatively more active. The over/under is adjusted for this expectation, but I’m still taking the over. Strategic buyers, particularly those with abundant cash reserves will probably look to take advantage of depressed valuations while they last. 2010 could see a rise in valuations, especially if the IPO market opens up a bit more. It’s still worth it to note though that even if we manage to reach 300, the year will go into the books with the lowest venture-backed M&A tally since 2003.

Note: NVCA data was used for all the statistics in this post

Is Mobile Venture Capital Investment Really Dying?

It seems as though there has been some consensus building around the idea that venture capital investment into the otherwise booming mobile sector has been trending downward. The latest comes from PEHub last week – apparently only just over $2 billion was invested in 204 mobile companies last year, down from $2.5 billion invested in 237 companies in 2007 and $3.3 billion invested in 252 mobile companies in 2006. The data is admittedly imperfect and seems to primarily include mobile infrastructure and mobile-exclusive companies. Given that context, I can’t really question the data, but I do question anecdotal evidence pointing towards less venture investment into the mobile space in general and less attention given to the mobile space by venture capitalists, as the PEHub piece suggests (I'm speaking on a relative basis to other sectors – we know overall venture investment is down).

The reality is that the mobile market is gigantic, growing rapidly and undergoing a major transformation – a perfect storm of driving forces for venture capital investment. Interestingly, it’s the transformation that is skewing mobile investment data and perception. As smartphone adoption continues to grow and the mobile experience continues to evolve- mobile devices are more and more becoming an extension of the internet. At the same time, venture-backed internet companies (and really all internet businesses in general) have increasingly been adapting content/services to be delivered through multiple channels, including mobile (other examples include the use of desktop applications, widgets, social media sites, etc.). Investment going into extending channels of distribution for internet and tech start-ups to mobile users - including developing and maintaining downloadable apps and mobile sites- doesn't get pulled into any mobile venture capital investment tally, giving the perception that venture capitalists are perhaps bearish on the mobile sector. Furthermore, as the web browsing experience on mobile devices continues to improve and the line between apps, mobile sites and regular sites blurs, looking purely at investment data/figures on mobile investment will not tell you the real story.

As mobile becomes another distribution channel for internet content, what you are going to see is mobile-specific services, such as advertising or payments become less relevant. Existing companies will eventually become consolidated into larger advertising or payment networks. This will either happen through the acquisition of mobile-only companies by larger service providers or expansion of mobile-only companies into other areas. For example, let’s say you are a mobile ad company such as admob. As the traditional internet experience starts to meld with the mobile experience, advertisers will be looking for cross-channel ad distribution, and you will be forced to cease being a mobile-only company and have to either expand your offerings or be acquired (meaning you will not longer be considered a “mobile company”). These same principles will probably apply to television and game consoles as the lines between them and the traditional computer and internet experience begin to meld.

So yes, investment into traditional mobile-only companies is declining, but it’s a natural progression. In no way is the mobile space being ignored or underappreciated by venture capitalists. The use of mobile as a channel of distribution and a source of growth will continue, but as the mobile experience evolves, fewer and fewer investments will fall strictly under the category of “mobile.” In fact, its existence as a category for venture investment may cease to exist all together, whether it’s 10, 20 or 30 years from now.

One final note – From meeting with a lot of VCs you find that those with international presence (particularly in Asia) are actually investing more heavily in mobile-specific services such as games right now. In the US, operators get in the way of the distribution channel too much. Although they are starting to work with developers a little bit more as they search for new revenue during the recession, operators in Asia and Europe are much more open and have allowed for much more innovation to take place, resulting in more venture investment into the mobile sector in those regions.

SharesPost Gains Traction - Issues Remain With Private Exchanges

A few days ago I received the first member update e-mail from SharesPost, one of the newest online private exchanges providing liquidity to holders of private company shares. I covered how the exchange works in a previous post – essentially, holders of qualifying private company stock can post to sell a block of stock to accredited investors who are allowed to purchase these shares through a bid/ask system. Participants pay a $34 month fee for the right to post (buyers and sellers) and transactions incur a $2,500 escrow fee (to both buyers and sellers).

Sharepost is one of the most open answers to the liquidity problem faced by holders of pre-public private tech company shares (including founders, employees and investors such as venture capital firms) in the face of a narrow IPO window. According to the e-mail I received, the service has signed up over 4,000 members and is adding hundreds more each week (registration is free). There have already been transactions involving LinkedIN, eHarmony, Linden Lab, XDX, Tesla Motors, and SugarCRM, with postings out there for the sale of stock in at least seven other companies, led by Facebook. In fact, there are 250,000 shares of Facebook up for sale and bids out for over 900,000 shares, though a transaction has yet to close.

One feature of SharesPost I did not touch on in my last post is the free research reports offered on select companies. These reports provide insight into the valuations of private companies - information that is usually kept a bit more private, although generally attainable if you dig around. The figures always have to be taken with a grain (or handful) of salt since it’s so difficult to accurately ascertain the true value of private companies. This is where I think SharesPost, or most any other private exchange falls short. There is a lack of controls and transparency typically associated with public exchanges – a buyer can easily be taken advantage of because the seller has so much more information on the true value of the shares. There’s not enough volume to determine fair value for a company’s shares either and I’m not sure private exchanges will ever get there.

A potential source of volume, particularly on the sell side, could be venture capital firms (which most private exchanges are trying to attract), who, just like the founders and employees of many pre-public tech companies are facing liquidity issues with their portfolio companies. But the problem I see there is, why would companies/VCs looking to reward their employees by providing some early liquidity simply post, or allow employees to post, shares on a private exchange like SharesPost? The term “private exchange” then becomes an oxymoron. Instead, there are other options available to less publicly provide liquidity, such as direct secondary funds. These funds are private equity funds formed for the sole purpose of providing liquidity to the shareholders of pre-public companies. Think of them as large buyers on SharesPost, except with more capital, the ability to “buy in bulk” and access to more information since they maintain privacy of the transaction. These types of funds have been growing in number and size of late, meaning sellers still maintain the ability to get bids on the shares they want to sell.

The CEO of SharesPost has also suggested the exchange could be used by venture firms looking to wind down funds. One of my earlier posts on this blog was about the huge issue looming over vintage year 1999 and 2000 venture capital funds. These funds will soon be desperate to unload investments - so, yes, they will be hungry for liquidity, but will a private exchange like SharesPost be the solution? I’m not so sure. The question is who will buy the companies’ shares? And why? If after 10 years the companies are still not “exitable” then VCs will be forced to sell at huge discounts. Not only that but selling on SharesPost provides no guarantees in terms of a complete sale or timing.

While SharesPost and other similar private exchanges might be good for individual sellers of private company shares, they are still very much targeting a small niche. They have their place and could even thrive, but I don’t think they are the solution to any of the venture industry’s liquidity issues.

Another Take on Crowdsourcing Venture

The venture capital model is not dead. Its time to end the back and forth already and move on with it (at this point, I might even be beating a dead horse just mentioning how it’s talked about too much). To recap: the major issue is that there's too much capital (for many reasons) chasing too few good deals. As a result, many firms will flounder due to poor performance, and those that have raised large funds will probably face difficulties. The amount committed to venture capital as an asset class by institutional investors will drop and so will the number of and amount invested into startups. But all this does not mean the venture capital model is dead. Instead, think of it as creative destruction as the venture capital model continues to evolve. Yes - not death, not maintaining the status quo (for sure), but good old evolution. The evolution will of course involve attrition and a shift back to basics, but it also means that there will be openings for new and interesting investment models to come forward.

A while back, I explored the possibility of crowdsourcing venture capital. I still think this idea has some legs; in fact some form of crowdsourcing will almost certainly be part of the evolution of the venture capital model. Since my last post on the topic, I've discovered many other attempts at similar models, but none that have truly succeeded. A good way to think about crowdsourcing venture is to frame it as a wiki - VentureDig does a great job of explaining this model (worth a read, good comments too). In this sense, any number of individuals could directly invest in startups they choose, allowing the collective wisdom of the crowd to ultimately choose the best companies and provide them with the capital they need to grow. While there are legal issues around this model (the SEC, but let’s assume that there are ways around them), it makes sense intuitively and probably would work well for web startups, particularly those that were previously bootstrapped.

The issue I see with wiki model though is that I think it tries to make the leap to giving power to the crowd too aggressively. Remember, the venture model just needs to evolve, not change completely. With that in mind, I think it’s important to stick to some form of how venture capital funds are currently structured, but change the way investments are sourced, diligenced, made and managed. That last part is key, because one of the key components of venture investing is managing companies post investment. This is why we still need venture capitalists and why any crowd sourced venture capital entity needs to be structured as a fund - so that the collective wisdom of the crowds can actually influence a company's growth. Here are a few more reasons why I think capital still needs to be pooled in order to be effective in making venture type investments:

• Pooling capital eliminates the need to attract enough individuals to make an impactful level of investment - its much tougher to get, say, a thousand one, two or three thousand dollar investments than it is to get a single investment of one, two or three million dollars.
• Pooling capital allows for the accountability of entrepreneurs - a set of individual investors do not have the power to hold entrepreneurs accountable once they have invested, but if you pool capital and act as one, you can.
• Confidentiality issues are avoided - no need for startups to send out agreements and diligence documents to thousands of investors.

With these points in mind, how would I ideally go about crowd sourced venture investing? I would not have any type of competition or structure it as a private exchange or even list an entity publicly – all ideas that have been tried before. Instead, I would have a general partner consisting of actual venture capitalists and a limited partner base of thousands of individuals, each contributing somewhere between one and 10 thousand dollars. But these would be no ordinary limited partners. They would be active in the investment decisions made by the fund through voting and collaboration through a messaging system. The fund would be totally web-based and investors would be encouraged to offer suggestions and the venture capitalists would maintain an open dialogue with investors.

Admittedly, this idea of what a crowd sourced venture fund should be is quite idyllic, but if we are to bridge the disconnect that exists between venture capitalists, entrepreneurs, and the tech community the venture model needs to evolve such a way. As the world moves towards more openness and collaboration, it’s inevitable that some of it will creep into the venture model, it’s just a question of how.