News today of Tim Draper is funding a private market exchange that will allow startups and investors to sell shares in pre-public companies. There are caveats to what companies can list (e.g. they have to have yearly revenue of $20m) but this is a welcome addition to the morbid exit side.
This and other similar secondary markets are a welcome addition to business world. These markets don't address a more fundamental problem that many startups need funding but the exit reliant VC model doesn't work for them.
There are many (if not most startups) which are never going to be able to exit at a multiple that is effective for VCs. However, they are otherwise very viable companies that will generate healthy revenues and have fat margins. Providing startup capital to these companies is a problem that needs to be solved. This will then allow VCs to focus on funding companies that can exit and benefit from the VC model.
In a Let a 1000 Flowers Bloom, I've proposed income-contingent loans but that is only the start. To effectively fund these companies what is needed is a model where the investor(s) provide the capital and receive warrants or preferred equity that after 3 years requires a dividend to be paid for 5 years before converting to ordinary equity.
Later on in the life of the business the prublic model may become worthwhile in allowing the initial investor to sell off their share and allow others (founders and employees) to cash in some of their shares as well.
TechCrunch UK posted an open letter by Robin Klein of The Accelerator Group to the Chancellor of the Exchequer Alistair Darling and Lord Dryson Minster for Science and Innovation about what to do with purported stimulus funds. BVCA wants the money to go to large VC funds whereas Robin Klein wants to see the money channelled to supporting very early stage companies (amounts less than £100k). Robin’s logic and reasoning is sound and I agree with them. But it is not a good use of the money for two reasons.
Tech (web) Focused The idea is far too technology (read web) focused. There are lots of opportunities throughout theUK for entrepreneurs to create businesses; many, indeed most, outside the world of the web. Why shouldn’t someone starting a lawn-mowing business have access to early stage funding as a technology developer? Both create value. We in the technology sector tend to be myopic about start-ups, small businesses and entrepreneurs. Richard Branson can hardly be accused of creating a technology business and yet he is by most measures the UK’s most successful entrepreneur.
Yes, technology creates long term value and wealth, but the vast majority of wealth is created by companies outside of the technology sector using technology and not developing it. It is created by a lawn-moving business using twitter to alert their customers that their lawn is done and having a website where clients can go and book a visit using something like BookingBug to provide the functionality. The lawn-mowing business is creating value through better customer service and consequently generates wealth. Would a business angle or early seed stage fund invest in such a company? What about if it is located in the hinterlands of Wales?
Relying on Judgement The mechanism for distributing funding relies on someone making a judgement call as to what is potentially a good opportunity. The act of making a judgement takes time and as many commentators pointed out in response to the open letter, time is very precious at the early stages of a business. Waiting more than a month for a response is a massive drag on very early stage businesses. They need responses fast.
More problematic is that a person can only make the judgement based on their experience and expertise. Many great opportunities will be bypassed as the judges’ focus on what they know. Now however is a time to fund companies that are moving into new areas and new ways. It is a time to let 1000 flowers bloom. In the end the only real judgement that matters is that of the market. It would be better to create a situation where those companies can be judged by the market rather than a limited individual. The market is crowd-sourced investment decisions.
Proposal In place of co-investing or creating lots of seed funds, I propose that the UK government create a scheme of income-contingent loans. Under the scheme an entrepreneur can take out a loan that covers his previous salary up to a maximum of £50k to £60k. The loan is paid monthly like salary and is re-paid by the individual (not the company) through the tax system (similar to student loans). Other characteristics of the scheme are:
The scheme would provide loans for up to 3 people per business in the first year, followed by another 2 new employees in the second year
The loans are tied to the individual and are re-paid by the individual based on the individuals income
An individual can only take out a loan under this scheme once every 5 years
An income-contingent loan scheme provides funding irrespective of industry or goods and services. It addresses the funding gap that is a barrier to entry for all entrepreneurs and has a lower administrative burden. The loan scheme can be administrated through the existing Government banks and through an online loan application system which are widely geographically diverse, scalable and most importantly can return a fast decision.
One big objection is the potential for fraud. Nothing involving money is without the potential for fraud and venture funding is not immune (witness Tiger Telematics). By putting the liability to re-pay the loan onto the individual reduces the avenues for fraud using this scheme. The other limitations are also designed to reduce the attractiveness of fraudulent behaviour.
Conclusion Granted, the loan scheme is unlikely to produce the next Google but I would rather see the loan scheme generate 100,000 businesses all employing an average of 10 people. That would be far more valuable to the UK economy as a whole than 1 Google.
Ideally, you would run both an income-contingent loan scheme and co-invest in early stage investments. However, given the realities the loan scheme is more valuable. The co-investment scheme should follow. By the time the co-investment scheme is up and running many of the first lot of companies that have benefitted from the loan scheme will be ready for their first round of funding.
News broke yesterday of Sequoia Capital putting US$2m of funds into a joint project with Y-Combinator. While many commentators have focused on life in venture capital, most have ignored the strategic angle to the partnership.
Y-Combinator and similar organisations (SeedCamp in Europe) take what is a ball of mud, clean and polish it and see whether there is a diamond (however rough) in the middle. They reduce the risk of very early stage ideas. The funding provides Y-Combinator with more resources to find more diamonds.
Sequoia Capital gets a better pipeline of potential deals. These companies have been polished, cleaned and have core basis for growth that is articulated. To continue the analogy Sequoia Capital can do less polishing and focus on the cutting.
Doing this very early company nurturing is not the same as traditional venture capital and Sequoia Capital (for that matter any VC fund) is not set up to do it. The cost structure of the fund doesn't lend itself to company nurturing. Y-Combinator doesn't suffer that problem and so more money ends up for nurturing companies and Sequoia Capital builds on the experience of Y-Combinator.
The partnership points to an intereting evolution of the venture funding model. I expect we will see similar future deals between VC funds and company nurturing funds as all VCs aim to improve their pipeline and manage their risk.
Here at MarketClusters we have just launched StrategyEye. The service is still in beta and any feedback is very welcome.
What is StrategyEye I here asked? Well to quote Nick Gregg, MarketClusters CEO, it is
"a real-time intelligence platform designed to track the explosive changes in the Internet, Media and Telecoms marketplace. The dashboard gives a highly contextual view of M&A, VC and partnership deals globably, all linked to expert blog and news opinion - and our own proprietary analysis"
Its pretty cool for those trying to track deals and the commentary made by bloggers and journalists surrounding the deals. Who is it aimed at? Well anyone with an interest in digital media, telecoms or the internet. We already have a range of clients from small startups to large corporates and even one or two consultancies. Have a look at the client page. I don't feel like name dropping.
But what if you aren't interested in DM? Never fear, we will be adding further sectors with CleanTech a sector high on our list of cool.
If you want to sign up for a trial and/or the newsletter just follow the prompts on the main page.
I'm just reading Fred Wilson's recent post about Facebook. Essentially, Facebook has created a stock market-like entity for web apps. Which validates my point underlying my previous post on Facebook and micro web apps.
Extending the concept of the market and micro web apps logically leads to some interesting conclusions. A stock exchange like market could be created that allows micro web app designers another method for monetising their creation. The market would track some combination of the number of users (number of shares) and the value per user (stock price). The movement in the value of the apps would be fascinating to watch.
I wonder if you could create a Stock Exchange app using the Facebook platform?
Apart from the intellectual interest of the Facebook Stock Exchange, does it have any value? Yes. The exchange offers an interesting way of trialling new applications for possible future investment. If an application within Facebook takes off, this is a reasonable indicator that this application will a good candidate for full blown development. Facebook becomes a rapid prototyping and marketing testing platform for the internet.
Facebook Exchange also offers a Darwinian environment to develop and trial new features for existing Web companies. The features to develop out are the ones that gain widespread tracking amongst a target demographic. This will allow web companies to focus their development resources on features that will be worthwhile to their users.
The developments going on around Facebook is fascinating. Where it will end is unknown, but the ride getting there is going to be fun.
Just as eBay prompted the rise of the micro-retailers, the Facebook Platform has the potential to prompt the rise of micro-web apps. Facebook Platform provides a range of infrastructure services necessary for these micro-web apps to survive and thrive. Social networking, network distribution and hosting are all provided.
Just like the micro-retailers on eBay it is only with the environment of Facebook can these micro-web apps exist.
In the ensuring discussion fuelled by Rick Segal's original post on disrupting the VC industry many important points where raised by both sides. In particular Jeff Nolan of Venture Chronicles gives cogent arguments about the value of VCs in building and developing companies. Not the least of which is overcoming the traditional web services "hole" during scaling. Something I have commented on before.
The simple fact is that VCs are not going away. No matter how hard some people might wish. VCs bring value to the table. However, the value that VCs bring does not fit every situation. VCs are currently used as a one-size-fits-all solution to problems. This is where the VC or, more accurately, the equity financing industry will be disrupted. Disruption will come from solutions that address particular problems or situations within the equity financing industry.
In my previous post on this subject I proposed a VC marketplace as one solution. I foresee this market covering the early stages of new company/idea development. From conception to a product with a few customers and some revenue. Put in web service terms, this would be from conception to the beta with a few customers and some revenue coming in. It is from this point that VCs add value. The marketplace, while it could still be used, is not necessarily the best solution for further equity financing. VCs can help smooth the ride as the company goes through major growth spurt. The aim of VCs should be to help the companies leap the "hole".
The VC markeplace doesn't replace VCs. The VC marketplace compliments VCs. The marketplace provides equity financing to companies to get them to the point of being ready for VC funding if they so desire.
Does the investment company proposed by Dave Winer and seconded by Doc Searls have a place. Many bloggers don't think so. They point to the previous failure of publicly traded VC funds. As proposed, I agree. It really isn't a particularly good idea nor is it disruptive (no matter how you cut it) as stated. For its proposed vision it well..sucks. However, the company does have a place within the equity financing industry. Just not the one dreamt of by Dave et al.
The fund could be useful for providing cash injections into companies that either don't want to undertake a round of VC funding (remembering Guy Kawasaki's refrain "To much money is just as bad as to little") or don't wont to involve VCs in the company for some reason (they see the VCs as the devil in disguise). The fund is another way of raising equity financing when VCs or the marketplace aren't a suitable solution.
The fund would only address companyies with cashflow that have an equity requirement that is too small to be worthwhile for VC funding (which seems to be as high as US$10m at the moment and likely to go higher). The fund would focus on purchsing preferred stock as opposed to common stock. Which translates (very roughly) as purchasing a slice of future profits as opposed to a slice of the company
The discussion about disrupting the VC business hit the blogsphere late last week. Primarily driven the posts by Rick Segal and Doc Searls. A pause of a few days and Dave Winer has proposed User Internet Capital Corp to disrupt the VC business. Doc Searls has thrown support behind the idea as well. When the conversation was first begun, I thought about how the industry could be distrupted. I must admit that I am disappointed by what has been proposed. In a sense the User Internet Capital Corp is simply a VC fund open to all and sundry.
A more disruptive idea is to create a VC market. A market where people (users included) can invest in high risk/high growth businesses from an early stage. A market for Venture Capital would be far more disruptive than simply creating another form of the VC.
So how would the market work? A company would register with the market. The registration process would include the necessary due dilligence process that provides the basis for trust within the market. The company would then place a certain number of shares up for auction.
The auction process would work like this. Bidders bid not only a price but also an amount of shares they wish to buy at that price. At the close of the auction, the highest bidder pays the amount they bid and receives the corresponding number of shares that they bid for. If the highest bidder did not buy all the shares then the remain shares are offered at the final bid price to the other bidders.
An option is available where the total amount of a final bid (bid price for shares x the number of shares wanted) of losing bidders will be divided by wining bid price and they receive that number of shares. The shares that people purchase can then be traded within the market. The last traded price for a company's shares becomes the starting price if a company decides to do another round of funding.
Anyone can register to bid. The registration process for bidders is again a due dillegence process that provides the bid side trust for the market. There is no minium amount or number of shares that a registered bidder can bid for. If all they want is one share , then that is all the need to bid for.
A VC investment market opens up investment in high risk/high growth to anyone (Doc Searls and Dave Winer's users) businesses. A far greater number of businesses will be able to seek and receive VC funding than through the current method. The risk of any individual investor can be spread even further. It also brings competitive bidding to the process which will bring their own improvements to VC investment. Finally, it opens VC investment to the wisdom of the crowds which brings with it the possibility of better selection of great ideas.
I really think that a VC market will produce far greater disruption of the VC investment industry than the creation of a publicly traded VC fund as Dave Winer has proposed.
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