Exit Early

Recently I have come across two websites proposing to facilitate the raising of angel/VC funds directly from smaller investors. This is not a new idea, but perhaps with the current poor fund-raising climate, it may have some legs. The implicit assumption is that the value from finding a funding partner is more about getting the money than it is augmenting the board or getting help with strategy (as these sites are just about the money).

VentureBeat ran a short burb today on a company named Sprowtt:

On the Sprowtt site, companies enter requested information and upload their businesses plans, and Sprowtt handles the legal details. Users can then log onto the site and buy shares in the company, which they can then sell. In a way, the company is pitching itself as an alternate NASDAQ, though Sprowtt hasn’t created an exchange for selling those shares yet.

To be clear, these aren’t your traditional IPOs. Since companies are selling shares earlier on, they’ll probably make less money. This is more like an alternative or complement to traditional venture funding. There are other companies trying to offer startups additional ways to achieve liquidity (i.e., sell their shares), such as SecondMarket.

NYT’s Bits Blog also covered a similar idea from a company named Kickstarter:

Kickstarter is a Web site that helps connect aspiring artists with patrons who finance their projects and often receive some tangible memento in return.

But it’s not just artists who are using the platform. Some small businesses and entrepreneurs see it as a way to raise money to supplement and support their business in new ways.

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Great opinion piece in the WSJ today criticizing the Obama administrations proposed changes to securities law and the effect these changes will have on VC and Angels:

As part of their regulatory redesign, Team Obama and Congress still don’t have a plan for reforming the giant taxpayer-backed institutions like Fannie that caused the credit crisis. Yet they’re moving to rewrite the rules for investing in tiny technology companies that had nothing to do with the meltdown. Under the proposed rules, venture firms will be declared systemic risks until they can prove themselves innocent. The typical venture capital (VC) firm has nine principals plus five support staff and doesn’t use leverage. Yet Treasury Secretary Timothy Geithner wants VCs to be regulated as investment advisers by the Securities and Exchange Commission.

This means the firms will be required to send heaps of data to the SEC and be subject to unannounced examinations that can last days, weeks or months. The firms will also have to appoint a chief compliance officer, create written procedures to comply with the various securities laws, and follow new regulations on record-keeping, privacy of client information, marketing, and so on. Information gathered by the SEC will then be analyzed by the Federal Reserve or some other systemic-risk regulator to decide if there is a hidden danger buried deep inside these companies. Never mind that VCs don’t trade derivatives, or much else for that matter.

The article goes on to propose a sensible alternative….

Treasury’s position is that if it doesn’t drag VC firms into the bureaucratic swamp, then high-rolling hedge funds playing with borrowed money will present themselves as venture funds to avoid regulation. Yet any firm calling itself a VC is already subject to the antifraud provisions of federal securities laws. VCs also have to describe the funds they raise in annual Form D filings with the SEC. Washington could let the SEC address any concerns simply by adding three questions to the form: Do you use leverage? Do you trade equities or debt? Do you trade derivatives? Anyone answering “no” to all three would be free to go find the next Microsoft.

The National Venture Capital Association comissioned a review of the impact of the proposed legislative changes on VC fims and their report is available here.

Aside from the compliance costs, which will be significant, their is also a provision that doesn’t allow performance fees (carried interest included) to be charged on funds from investors with < $750k invested in the fund. The lawyer’s memo linked above details this. That implies that a minimum investment in the fund from any LP needs to be $750k or greater to comply (or else the performance fees have to be restructured in some way to be compliant). This obviously will make angel funds (many investors and smaller dollar amounts) much more difficult to structure.

Like many, I am firmly in the camp that a detailed hundred-page word document business plan is not helpful in raising capital. What is needed, however, is a succinct power point presentation that covers the basics of the people involved, the business opportunity, the macro industry, and deal terms. I came across the blog posting below and the associated power point that does a nice job of simply outlining what key questions need to be answered in such a presentation. For the sake of brevity, some of his points may be overkill, but as an outline, it is a great start.

From http://www.centernetworks.com/template-for-venture-capital-presentations

The idea behind the presentation is to help you create the most ideal pitch to secure the funding your startup is seeking. There is a discussion about font sizing, market, what’s the problem your startup is solving, customer base, go-to market strategy, team (what makes the team special), along with information on financials and competition.

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Open source technologies, APIs/Mashups, and Off-shoring have dramatically reduced startup costs. Could cloud computing and scalable public systems lower barriers to entry enough to delay or even forgo VC investment and usher in a new wave of innovation? Answer would largely depend on how VC funds are primarily being used by the startup (development, marketing, or really scaling).

From http://due-diligence.typepad.com/blog/2009/07/behind-the-cloud.html

The combined reductions created by off-shoring and open source had already led to what I’ve called two-stage ventures, where engineering to the point of market test could be accomplished with minimal startup funds. Now public cloud offers the would-be net entrepreneur a way to avoid both the upfront costs of putting service infrastructure in place for a launch, and the ’success failure’ risk of not being able to obtain capital or equipment fast enough if the offering turns out to be a hit. In an extremely tough fundraising environment, staying capital-light as long as possible is just the ticket. The upshot will be even more ‘below the radar’ ventures launched on personal or angel funds, and only turning to venture when and if they prove demand and require external capital to scale their marketing.

From http://blogs.wsj.com/venturecapital/2009/07/23/angels-more-in-tune-with-ipo-companies-than-vcs-study-says/

An academic study published in 2004 said initial public offerings are more often underpriced when a company is venture-backed than when it is not. This means the company pockets less from the IPO than it might have had the offering been priced closer to what the market would bear…

Now, researchers at the University of New Hampshire’s Center for Venture Research have refined the thesis to suggest that underpricing is less likely if a company is backed by wealthy individuals, called angels. This is because the angels are more likely than VCs to sell shares as part of the IPO. Venture investors generally claim any market gains when they sell or distribute their stakes after the six-month lockup.

“While venture investors are prone to underprice IPO firms, reducing the proceeds from the offering, angel investors have incentives more aligned with non-venture capital pre-IPO shareholders,” says the working paper, authored by UNH Professors William Johnson and Jeffrey Sohl, the venture center’s director.

The full UNH working paper is available here

Assuming founders, voluntarily or involuntarily, are subject to the same lockup as VCs, then this doesn’t ultimately affect their proceeds. It does beg the question of what VCs stand to gain by a post IPO pop. More bragging rights, less effort needed to subscribe the offering, better relationships with investment bankers, etc.