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.

How A Cap and Trade Program Could Affect Venture Investment

Recently, the House passed the American Clean Energy & Security Act of 2009 which would implement a cap and trade system for carbon emissions. There has been great debate already over whether or not the cap and trade system would create jobs, decrease the nation’s dependence on foreign oil and combat global warming as proponents claim. Opponents are calling the proposed cap and trade system a tax that will actually result in job losses, high energy prices and hurt U.S. businesses. There’s no question the bill has a lot of hair on it, not to mention that it still must pass in the Senate which will be no easy feat, but for the venture capital community, a cap and trade system has huge implications.

It appears as though the recent drop in cleantech investment by venture capitalists (which I covered in a previous post) seems to have turned around in the second quarter of this year, due in part to the federal stimulus package which included hefty provisions for cleantech. The same dynamic could be at play if/when a cap and trade program is implemented, but at a much higher level. Venture capitalists have been calling for a cap and trade system (and to a lesser extent a national RPS) in the U.S. for some time now - in fact, not having clarity on a potential cap and trade program is often cited by venture capitalists as one of the major reasons for not investing more heavily in clean technology. A cap on carbon emissions will mean utilities and large industrial sources of carbon emission (by far the largest polluters) will have to employ alternative energy technologies , making them prime candidates to acquire venture-backed cleantech companies potentially ushering in a new wave of cleantech venture investment. Where will the impact be?

• Expect investment into solar technology to continue to lead all other sub-sectors. The shift from capital-intensive, utility scale solar investment to ancillary products and services such as solar services and software may slow. Venture-backed solar panel and plant makers could become attractive acquisition targets for utilities looking for a quick way to reduce carbon emissions., meaning there could be a new wave of large scale solar investment but it will still be largely dependent on the availability of project finance.
• Venture investment into wind energy solutions should not be impacted much because of the limited opportunity for technological advancement, not to mention the high costs associated with wind projects.
• Smart grid investment should continue to increase since efficiency and conservation will be part of the solution for reducing emissions. Investment flow to less capital intensive companies that develop consumer energy management systems and software that interacts with and performs analytics on new smart metering systems and should ramp up.
• Battery technology (primarily related to transportation) and next generation biofuel technology should be less directly impacted by a carbon cap and trade system but will play a role in the overall reduction of carbon as part of the move away from gasoline powered vehicles.
• Finally, we should see the growing crop of software and related services that measure, monitor and manage carbon emissions to grow much faster, but companies in this space will have to act fast as those who can gain early traction will be at a huge advantage.

Regardless of the many controversial impacts a cap and trade program may have, one thing is clear - it would for sure usher in a new wave of innovation, something the venture industry would accept with open arms.

Exploring Private Exchanges

It’s no secret that the venture industry is reeling from a liquidity crisis – we’re constantly reminded that venture-backed IPO and M&A activity is at historic lows. And while there have been recent glimmers of hope via the IPOs of OpenTable and SolarWinds, we’re far from the proverbial IPO window being open again. To address the issue, the National Venture Capital Association (NVCA) laid out a “Four Pillar Plan to Restore Liquidity” back in late April. As part of the plan (the second “pillar”), the NVCA encouraged the use of enhanced liquidity mechanisms such as private market exchanges. While yet to gain much traction, a number of these newer private exchanges have garnered attention of late. They might turn out to be great for the venture industry, but I see a few issues, including the fact that they all seem to be doing very similar things meaning the space is very fragmented right now, and volume is much too low to put a dent in the liquidity issue. Here’s a rundown of some of the major new players:

Backed by venture firm Draper Fisher Jurvetson, XChange will use a bid/ask pricing system to allow the sale of private securities to qualified institutional brokers. I’m not clear on whether or not this includes LP interest in venture funds or just shares in a start-ups employees or venture firms may hold. XChange will also offer companies the ability to do a primarily issuance of shares (they’re calling it an “XPO”). Still new, the exchange is not yet fully operational.

With the support of the NVCA, a number of venture capital firms (Oak, NEA, Venrock, Versant, DCM to name a few) and apparently 200 institutional investors, InsideVenture might be the private exchange with the most industry support right now. InsideVenture offers “Hybrid public-private offerings” in which start-ups would have to file the same way as they would for a regular IPO, but the shares would first be offered to investors that are affiliated with InsideVenture. It does not seem like there is the options to do smaller secondary sales of direct ownership stakes in companies like with XChange. InsideVenture is open to only institutional, PE and accredited investors.

SecondMarket is one of the better established private exchanges. They claim to have 3,000 market participants, with $10 billion in traded assets. In addition to shares of private companies and limited partnership interests in private equity funds, the exchange is for all types of illiquid assets including auction-rate securities, bankruptcy claims, CDOs, and MBSs. To help attract bidders for these illiquid assets, SecondMarket has developed a proprietary "ManhattanAuction" which essentially pays bidders for bidding. The exchange is open to institutional and accredited investors only.

The newest private exchange on the block is SharesPost. In fact, it just went live with its public beta release yesterday. The interface is much more open than other private exchanges - after a basic registration process, you are able to view the shares of top venture-backed companies that are for sale, what the bid and ask prices are and, for some companies, the implied valuation (more on this later). It costs $34/month to post or interact with other posts (buyers and sellers), there are no commission fees, but there is an escrow fee of $2,500. Sellers remain anonymous except to the buyers of shares (who must be institutional or accredited), but all SharesPost members can view restrictions sales are subject to and prior agreements once even one trade is made on a company. The minimum proposed transaction size is $25,000.

Of the four private exchanges I've highlighted (there are plenty more that are not as sexy, including NASDAQ's PORTAL Alliance, the NYPPEX, and TSX Venture Exchange), SharesPost stands out the most due to its openness. Both SharesPost and SecondMarket only allow for the secondary sale of private company holdings. InsideVenture seems to do just primary (semi-public) issuances and XChange looks to do both. All complete the mission of providing liquidity, particularly for employees and smaller shareholders (save for InsideVenture), but I still think the larger liquidity issues will remain. It’s unrealistic to expect many substantial full-blown venture-backed exits through any of these exchanges, at least to the point that it alleviates the industry’s liquidity issues. They’re more of stop-gaps in my opinion, and I think they know that.

The fragmentation I mentioned earlier probably hinders all of them which is why I think there eventually will have to be some consolidation in the space to allow for more efficient marketplaces. For now, they will all face competition from not just each other, but traditional IPO and M&A exit avenues (if/when they come back) and a growing crop of direct secondary and traditional secondary funds which have the upper hand when it comes to negotiating terms since they can make purchases in larger chunks while keeping the transaction private. Speaking of which...

It probably hurts companies that list on a more open exchange like SharesPost if they are looking to obtain additional rounds of funding. It’s understandable why SharesPost went the more open route (because it should attract more buyers and sellers), but a lot of private equity and venture capital firms would not be comfortable with investing in a company that has so much of its information public (sorry, but obligatory: “it’s called private equity for a reason”).

One interesting piece of information that ends up out there is a company’s valuation – and even if it’s not out there or accurate, there are implications for venture capitalists invested in the companies beyond just maybe having that information public. A layer of complexity could be added to valuating companies under FAS-157, which has established the framework for measuring fair value. Under FAS-157, investors have to mark an asset to market, which I think would mean that venture and private equity investors in companies listing on a private exchange would have to take into account transactions occurring on those exchanges when it comes to quarterly reporting to LPs. Not a fun prospect.

It will be interesting to see what impact these exchanges have. I’d like to do a follow-up examining each one in more detail if possible. I’d also like to examine the SharesPost model a bit further in a future post because of the tie-ins to my previous look into crowdsourced venture capital; the purely on-line transactions, openness of information, and allowing regular individuals to participate.

Venture Capital Overhang: $118 Billion

This past week, the Alliance of Merger and Acquisition Advisors and research firm Pitchbook Data released a report which indicates private equity firms in the U.S. are sitting on $400 billion in overhang – the difference between fundraising commitments and invested capital. The figure is essentially the “dry powder” or uninvested capital private equity firms have at their disposal. The data was covered in a number of places over the past week, but VentureBeat writer Anthony Ha pointed out that the data does not include venture capital... so I decided to do some of my own research. Below is the chart I came up with for venture capital, using the same methodology the Pitchbook Data report uses (data from PwC, Thompson Reuters and the NVCA):

Source: PwC, NVCA, Thompson Reuters

Over the past decade, venture capital firms in the U.S. have amassed $118 billion in overhang. Of course the data is not perfect; you’d have to account for management fees, recycling of capital, etc. But it does tell us that venture capitalists are sitting on plenty of uninvested capital. Only in 2003 did the ammount of venture investment come close to equaling the amount of capital raised, and the average overhang per year is $10 billion.

The $118 billion figure isn’t too surprising. It’s pretty well known in the venture industry that lack of capital is not a major issue, in fact there might be too much capital chasing too few good deals. Also this year we’ve seen venture capitalists pull back sharply on investment amid economic uncertainly, deciding that focusing their attention on better managing and growing existing investments was a better use of time. We’re also seeing deal sizes come down as the cost of starting technology companies continues to drop. These factors explain the $118 billion and perhaps it’s being reflected in the recent slowdown in fundraising.

Growing With the Real-Time Web

More and more, the way information is shared on the web is shifting to real-time. The “real-time web” is emerging (Read Write Web covers this quite well). The easiest examples to point to are the ones getting the most attention (Twitter, Facebook, FriendFeed, etc.) but the trend runs much deeper. Using Twitter as an example though; what makes its service truly valuable is the ability to aggregate, search and monitor trends within the real-time updates. If you want the latest news (and by latest I mean not just up to the minute, but up the second) on most anything imaginable, there is now instant (or at least faster) access to it, making the information much more valuable. This ability to instantly access the latest information is changing the way we experience, consume and share information. Twitter is not only place where this is happening as Read Write Web points out. Indications of the move toward the real-time web can be seen everywhere: Facebook has implemented real-time updates; the New York Times recently launched Times Wire which provides a stream of news (pictures too) that is updated every minute; Google a couple of weeks ago declared that real-time search, while still an unsolved challenge for them, will be very important; Google is also launching an application that incorporates real-time information from the web, with its just announced online communication tool Wave; through enterprise collaboration tools, companies are starting to realize the value of instant information; new recommendation engines (competing with Amazon’s or potentially Microsoft’s new Bing) are using real-time user behavior to help make purchasing decisions, the list goes on.

So what does this all mean and where are the opportunities for venture capital? The real-time web is here to stay, but it may require people coming to terms with the fact that there is simply too much information to consume. Kind of like how with television there’s always something on, the same will be true (or is already true in some cases) with the new live web – you’ll be able to “tune-in” to a site and catch what’s “on” in terms of content and information. At the same time you will be able to subscribe to, search for, or record, information that’s important to you. There’s still plenty of room for growth around these concepts as the conflux and growth of valuable real-time data is still new. Venture capital can play a role here. Here are a few areas where I think new companies might crop up and have potential to be backed by venture capitalists.

• Of course there will be companies that further develop technology and infrastructure around the real-time web – this includes companies that build tools and software to aggregate real-time data.
• There will be plenty of companies that will be able to use the increasing amount of real-time flow of information and package and present it in useful ways – there are limitless possibilities here.
• Companies that can find a way to rapidly verify the integrity of real-time data, particularly news, will find themselves in demand.
• Advertising and generating revenue around real-time data will be vital – companies that build ads using real-time data will be important, and even more important might be companies that can figure out micropayments (allowing consumers of real-time content to efficiently and effortlessly pay for content they consume – there’s definitely a huge hole here that PayPal does not come close to filling, neither does Google Checkout).
• Finally I think video presents a huge opportunity – 99% of all video is still watched over a television, and while bandwidth is often a limiting factor, video is undoubtedly going to become part of the new real-time web as the line between television and internet video starts to blur.

Crowdsourcing Venture

 

I somehow stumbled upon this book today and it got me thinking about how crowdsourcing would work if applied to the venture capital model. Crowdsourcing allows you to tap into the collective knowledge of a community to carry out a task or find a solution to a problem and is most widely used in the development of new web technology (Wikipedia has a pretty sold entry on it if you want background). But a big drawback I see is that contributors rarely get compensated adequately for their participation - the company something is crowdsourced for stands to benefit the most, all from the hard work of others. What if people could actually have "skin in the game," wouldn't the results be much better? And even more, if applied to venture capital investing, wouldn't you be able to create not only a huge brain trust, but a huge investor base as well?

I wasn't aware of anyone else out there that had made an attempt at crowdsourced venture capital or was thinking about trying it, but after doing some quick research I found the idea did have some legs:

• Steve Newcomb, co-founder of Powerset, was featured over a year ago in a Wired article which shared his plan for a crowdsourced cleantech venture fund. His idea for the fund involved investor commitments as low as $100, with a maximum of $1,000 and investments decisions made by bringing in venture professionals to vet investments and then letting the investors choose from there. I'm assuming it would have been open to as many investors as they could get, perhaps in the millions. Not sure what's happened with this idea, but it seems Newcomb's attention is now probably on his new company, Virgance.
• The closest thing, by far, to a legit crowdsourced venture idea I found was VenCorps. VenCorps was originally an offshoot of crowdsourcing site Cambrian House. The original model involved ideas being vetted by the public for an initial vote, and then moving on to a due-diligence process and a more formal vote, where an “elite group” would do the decision making (not sure of the capital structure). But since, Cambrian House sold VenCorps' assets toNew York private equity firm Spencer Trask. Now, it looks like startups will share their businesses plans, then professionals and amateurs would help select the best in periodic “showdowns.” Winners of showdowns would receive a $50,000 investment (convertible debt, but I'm not sure how participation would work for those who have voted and have interest in investing).

I have a feeling these two groups hit legal issues at some point. If you want a true crowdsourced venture fund with full participation, you immediately run into SEC issues. I'm no expert when it comes to the detailed legal aspects of private equity, but I'm pretty sure to keep an entity private you would have to stay under a certain number of investors, wouldn't be able to solicit investors openly, and the investors you do get would have to be accredited (i.e. institutional or high net worth). I'll have to do some more research, (would love feedback here) but perhaps there are ways around all this - maybe via pass through entities for groups of investors, or offshore or other forms of organization.

For fun though, let’s says there were legal loopholes or no legal issues at all - here are some elements of my ideal crowdsourced venture capital fund:

• Standard fund structure, with the GP consisting of actual venture capitalists and the LPs consisting of the "crowd."
• The LP base, or "crowd" would preferably be selective, perhaps through a vetting/application process or by targeting a specific groups. Ideally, if making tech investments, I'd want a knowledgeable set of individuals, something like the TWiT Army, behind me. I'd like to set a commitment range, let’s say between $1,000 and $10,000.
• The fund would be completely web-based. All administrative aspects, reporting, voting on investments, communication, etc. I think it would be easier to take each investor's commitment up front via fund transfer and hold the cash in an interest-bearing account. Each investor would have their own capital account page, through which they could monitor their balance, vote on whatever the GPs wanted them to vote on, see their share of the investments, etc.
• As for the investment process, I'd allow LPs to suggest potential investments, but the GPs would also source deals. Everything would have to be very transparent (GPs staying in touch via forums, messaging, blogs and podcasts). GPs could continuously poll the LPs to gauge their thoughts while evaluating companies, even putting potential investments up to vote, but in the end the ultimate investment decisions are made solely by the GPs.
• Once investments are made, the fund has the benefit of instantly having thousands of individuals with a vested interest in the companies' success. This could be huge for internet companies. And while owned by the fund, LPs could make suggestions or offer up help to aid each company's development.

...that’s it for now but I will definitely be revisiting this topic again.

Indian Private Equity: Conversation with a CEO

I recently had a conversation with the CEO of an Indian industrial forging company that specializes in automobile and oilfield related products. Here’s what I picked up on the venture and private equity opportunity in India from someone with direct experience operating a middle-market company there:

He conceded what many already know – that venture capital, particularly for high technology, really doesn’t work well in India. Aside from the lack (or enforcement) of intellectual property rights, there’s simply too much of a “copycat mentality.” Innovation happens more with processes or at the business level, because innovation in technology lacks the right risk/reward profile. For example, most young IT professionals would much rather work for an outsourcing firm and take the compensation the jobs provide rather than risk trying to innovate. For this reason, private investment in India will not be heavy in venture capital for some time.

There are many companies and industries that will be able to ride the country’s GDP growth to success. But beyond that, at the operational level, what competitive advantages does India have that make a compelling case for private equity investment? For most Indian businesses, low cost labor is the core advantage. In fact the CEO I spoke to said low cost labor might be his company’s only advantage in the global marketplace. Energy, raw materials, equipment and technology costs are pretty much level globally, but when it comes to the much more lucrative business of exporting product, labor cost savings are a huge advantage. And it’s not just the direct cost of labor, but all other related or dependent costs, such as insurance or transportation (drivers, handlers) that collectively provide a huge advantage.

In most industrial and manufacturing businesses, labor unions are still not a major issue, but they are beginning to crop up in larger Indian cities such as Mumbai, Delhi and Bangalore. Smaller, more rapidly growing cities should be able to stave off issues related to labor unions for another decade in his estimation. So, the long term potential for growth and profitability still remains even if purely based on the low cost of labor, you just have to go to the right places. In this respect, the biggest impact should be for manufacturers, particularly those who export. In fact, exporters receive incentives from the Indian Government in the form of credits which can then be sold to importers on the open market. Domestically, he identified industries such as financial services and consumer products and services that target India’s growing middle class as areas of growth. Infrastructure plays too can take advantage of the low cost of labor.

When I asked about potential detractors for private equity investment in India, the biggest drawback he saw was the trouble PE firms have in obtaining controlling ownership (or even any ownership stake at all) in companies that are family owned. It’s one thing to buy smaller stakes in large companies, but if the buyout model is to really take off in India, it’s going to take gaining the trust of families who own a large portion of the private businesses in India.

Another issue for investors is bureaucracy. Conducting business in India can be slowed extremely by bureaucratic policies and procedures. These can differ state to state and even city to city. To navigate it all efficiently takes experience and relationships, something impossible for outside investors to bring with them. This point can’t be stressed enough and is why the most successful private equity investments in India will have to involve Indians with opperating exerpience in the various regions of the country.