Main
Welcome To Venture Examiner

On Venture Examiner I share my thoughts on the venture capital industry, alternative ways of funding, supporting and fostering innovation, opportunities in the emerging markets and other topics relevant to my experiences....MORE.

DISCLAIMER: The content of this site reflects my thoughts only and is not affiliated with any other party...MORE.

I also share other things that are interesting or important to me on my personal site: aakarvachhani.com

 

You can also follow me on Twitter (see below)

Follow Me On Twitter
Can't display this module in this section.
Subscribe to E-mail Updates:
Can't display this module in this section.
Search Venture Examiner

Entries in Venture Capital (37)

Saturday
May082010

Profounder: A Huge Step Forward For Crowdfunding

I've written about the compelling idea of crowdsourcing a venture capital fund a number of times (in fact these posts are consistently the most searched for and trafficked). The premise is that a web-based venture capital fund, with a large crowdfunded investor base and crowdsourced decision making led by knowledgeable investors can be a highly effective way to successfully indentify, invest in, and grow technology startups. By compiling a large base of tech-savvy investors who are involved in the decision making process you have a better chance of identifying the best new startups and once you do, you instantly have a large base of supporters and customers. This type of fund would have a set of leaders to guide the decision making process and also provide more hands-on support to portfolio companies, but all investors would participate through voting - a chance to invest in startups in a way like never before. All this sounds great, but the major issue preventing something like this from working is that normal people are prohibited to invest in such a fund due to SEC Regulation D which requires investors in private companies and funds to meet minimum income and net worth thresholds.

I’ve run into a few groups that have attempted workarounds (unsuccessful for the large part); however, recently launched Profounder has made impressive progress. The site, which allows entrepreneurs to raise funding for their ideas/companies from their community, was started by Dana Mauriello and Jessica Jackley, a co-foucner of Kiva.org. While not yet fully developed the site gives plenty of information on how the process will work: Entrepreneurs will first create a “Raise Page” which outlines their business plan and how much they are looking to raise. Profounder will then create a term sheet and combine it with the pitch on a custom password protected page which entrepreneurs share with friends, family and colleagues they have a substantial pre-existing relationship with. Once individuals are invited to view the business fundraising page, they will have 30 days to contribute funding. The funding must be repaid (automatically withdrawn by Profounder each month) along with a percentage of the business’ revenues each year. Profounder makes money by assessing a fee (not yet determined) on the total amount raised.

Here are potential keys to avoiding SEC issues I came away with:

  • Password protected pitch page
  • The need to have a “substantial pre-existing relationship” with potential investors
  • Investors have 30 days to contribute funding
  • Entrepreneurs can only raise up to $1 million
  • Entrepreneurs must provide investors with a certain percentage of revenue each year - notice you are not offering up equity in the company
  • Limited to 35 investors, all other investors after the 35th cannot receive a percentage of revenue, instead you reward them for their contribution by giving that same percentage of revenues to a nonprofit in their honor.

Clearly there are limits to Profounder’s model but it’s the most progress I’ve seen in the crowdfunding movement for entrepreneurs. Profounder does a great job of highlighting the benefits of crowdfunding:

  • allows you to take advantage of your biggest existing resource: your community
  • can be a marketing tool in addition to a financing tool, as those invested in your business will become more loyal customers and avid supporters
  • shares risk among many, putting less financial pressure on just a few individuals
  • allows for your successes to be shared among many
  • cuts out banks, venture capitalists and professional investors to get better terms and a friendlier process

It will be extremely interesting to watch the progress of Profounder – its success would go a long way in not only proving the crowdfunding model but more specifically the impact it can have on entrepreneurship and innovation. Look for more updates from me on Profounder’s progress and how its success can potentially make a crowdfunded venture fund a possibility.

UPDATE (06/06/2010): Looks as though Profounder has gone stealth and will not be open to the public until the fall. The information used in this post has been pulled and is probably subject to change.

Thursday
May062010

The Rise of Funds of Funds Another Sign of The Times

The most recent release of Private Equity Analyst’s Sources of Capital Survey shows that in 2009, pension funds, historically the largest source of capital for venture firms, were overtaken by funds of funds. In 2009, funds of funds accounted over 23% of all capital raised by venture firms, while pension funds accounted for 18% of all capital raised. This is almost a reversal of 2008, when funds of funds were the ones accounting for 18% of capital raised and pension funds accounted for 25%. What’s more is that it may be the first time in a long time (maybe even ever?) that funds of funds were the leading source of commitments to venture capital funds in a given year.

 


Source: Dow Jones Private Equity Analyst

We know that all limited partners slowed their commitments last year, so why did the proportion of commitments coming from funds of funds rise? For one they were not impacted by the denominator effect. In addition, they had the freedom to act on attractive opportunities since their sole business is investing in venture (and other private equity) funds. It’s also important to note that funds of funds are not under the same political pressure public pension funds face. Nonetheless, let’s not forget that fund of funds  managers have to raise the capital they invest (just like ordinary VC firms do) and last I checked, fundraising for funds of funds was down just as it was for the rest of the private equity industry. This means that most funds of funds were probably investing capital out of pools that were raised two or three years ago and will have to raise new funds soon in order to continue investing in venture.

In a sense, funds of funds helped cushion the fundraising blow for the venture industry in 2009, but it makes you wonder what happens if funds of funds were not around, or if they are unable to raise capital for new funds in the coming years. Clearly 2009 would have been even worse for venture firms if it were not for funds of funds, which means that less capital ultimately flows to entrepreneurs and innovative new technologies. Since we can’t expect funds of funds to be leading investors in venture capital forever, you can add this funding shift phenomenon to the list of data indicating major changes in the venture industry/model (see my previous post on the VC overhang).

Funds of funds, this past year, showcased their value -for the industry, they filled funding gaps and prevented an even larger shock. For investors, funds of funds were able to provide exposure to what should be a great vintage year for venture funds (less competition for deals, lower valuations, with innovation continuing unabated) – all the while providing diversification and the administrative and monitoring expertise essential for quality venture capital portfolios. Even if the industry is shrinking and overall returns have been mediocre, there is a strong case to be made for keeping an exposure to venture capital in most institutional portfolios (less volatility, diversification, and greater return potential with continued innovation and an improving exit market). Because of this, we may see more investors choosing to go with funds of funds as a “one stop shop” for a smaller, more diversified venture exposure through the top venture capital funds.

A venture industry that relies on funds of funds for capital is not healthy, nor sustainable. While funds of funds should remain at proportionately higher commitment levels, don’t expect them to remain the driving force behind venture commitments.  In the future, commitments to venture will have to be driven by public funds (or of course single public client funds of funds). Commingled funds of funds, those fed by smaller investors realizing the importance of maintaining a venture capital exposure can only have so much of an impact, even in a leaner venture capital landscape. 

Sunday
Apr182010

Fundamental Shifts in Venture Capital Becoming Clear

I was about to do an update on the Venture Capital Overhang I’ve been tracking, but instead of the typical chart this time around I thought it’d share something interesting that stood out - for the last three quarters we’ve now seen US venture capital investment outpace fundraising (and the quarter before it was almost even):

The only other time in recent history where we’ve seen investment activity even come close to surpassing fundraising was  in 2003 following the bursting of the tech bubble. What does this mean? We have numbers clearly indicating that a fundamental shift in the industry is underway. In previous posts, I’ve mentioned how fundraising could not forever outpace investment as dramatically as it had been doing so over the past decade (creating an ever increasing “overhang” of un-invested capital, or dry powder).  Fundraising has now slowed dramatically, while venture capitalists rightfully continue to invest in what is a good environment to be doing so in.

A drop in fundraising was expected, but we may now have a “new normal” for fundraising levels. There is clearly a new standard for raising capital now, especially with so many limited partners still skeptical of the asset class. At first a fundraising slowdown was blamed on the “denominator effect,” and later it was said that many limited partners were waiting to get a clearer picture of their allocation balance before beginning to commit again. But the truth is that most limited partners will not return to commitment levels of the past and therefore we will see a natural attrition of firms in the future.

Investment may outpace fundraising for a while - until fringe firms run out of capital and are unable to raise new funds. Just as I had said fundraising could not outpace investment forever, the converse holds true as well and we surely will not see investment outpace fundraising forever either.  Think of this period (of investment outpacing fundraising) as sort of a market correction. When we had huge overhangs of capital, venture capitalists knew there were others out there with capital to deploy as well which drove up valuations and reduced returns. What we should see after this correction is fewer firms - this means higher quality firms will remain, investing in better deals at better valuations and generating better returns.

The differential in fundraising and investing should be interesting to monitor. Too large of a crossover into fundraising outpacing investment again may signal another bubble, while a leveling out should indicate a healthier venture capital industry.

Note: Data from PwC, Thompson Reuters and the NVCA.  And for clarity, the VC overhang now stands at $88 billion – down from $89 billion at the end of 2009. 

Sunday
Apr042010

A Vision For Venture Capital

 

I recently finished reading A Vision for Venture Capital: Realizing the Promise of Global Venture Capital and Private Equity. The book is an (assisted) autobiography chronicling the storied career of Peter  A. Brooke. As founder of TA Associates and Advent International, Mr. Brooke was crucial to the early development of the venture capital industry - he was truly a pioneer for the industry not only in the U.S. but in his work spreading the venture capital model internationally.

The book is split into two parts. The first half of the book takes you through his career – his development as a venture capitalist, building TA Associates, and then his shift in focus to international investments and the founding of Advent International. The second half of the book covers how to add value through venture investing and Mr. Brooke’s outlook for the future. If you don’t have time to read the whole book, I highly recommend the second part - there are some great takeaways and you still get many anecdotes from his storied career.

It was clear that Mr. Brooke is passionate about the true role of venture capital and it was a point he drove home throughout the book. Below is an excerpt that I felt exemplified Mr. Brooke’s ideology.

When discussing the industry’s early moves into international markets and the difficulty getting U.S. based investors to see potential Mr. Brooke said:

“It didn’t seem to have occurred to many venture capitalists and private equity managers that they could be a force for economic and social progress in the world. To me, however, this is the whole point of what we do. The frontier in the industry is wherever the skills of venture capital and private equity managers can be applied to address economic problems such as poverty, underdevelopment, and lack of opportunity, along with the many social ills associated with them. To put it another way, the pioneers today are those who apply their entrepreneurial spirit and problem-solving skills not only to make a profit for their investors and themselves but also to improve the lives of others.”

What’s often lost on many people in the private equity and venture capital industries is that there can be more to investing than just monetary gains.  Plenty of good can come from helping develop companies and markets, of course there is always room for rewards but that should not be the sole focus – Mr. Brooke really hammers this point home in his book.

Overall,  I think it’s a great read, especially for those starting out or considering a career in venture capital or private equity. You get a lot of history on the industry’s development and can really broaden your mindset on how to approach investing. The book is also great for those involved with venture capital and private equity investing in the emerging markets. Underdeveloped, frontier markets arguably stand to benefit the most from private equity and venture capital investment and it’s sure to be where much of the industry’s growth comes in the coming years. Approaching these markets with some of Mr. Brooke’s insights and lessons would surely be beneficial. 

Saturday
Mar202010

Investing In Emerging Managers

Limited partner interest in “emerging managers” has grown impressively over the past decade. Many pension plans have programs targeting emerging managers or have made substantial efforts to increase their exposure to funds run by emerging managers in their venture capital/private equity portfolios. The definition of an emerging usually varies slightly for everyone, but in general, it usually refers to:

  • Firms raising their first, second or third fund from a broad base of institutional investors.
  • The firm may be a spin out of one or more members of an existing venture firm.
  • It may also be the spin out of a group that was previously captive, i.e. they were the venture capital arm of a corporate parent.
  • It could also be the coming together of investors from multiple venture firms or corporations.
  • Many pension plans have mandates for emerging mangers which include a women/minority component, or a component targeting underserved markets.

In a time where funds are hard enough to raise for established venture firms with good track records, how can emerging managers compete? Why would anyone invest in them? First, here are some drawbacks associated with emerging managers:

  • They often have no track record of investments or their track record is not substantial enough to qualify them. Basically, they’re unproven.
  • Inexperience managing a venture firm. – an investor may have been great at working within an established firm with a developed structure, but when running their own firm, it’s a different dynamic and they are sure to run into situations not encountered within a larger organization.
  • Team risk. Emerging managers often have difficulty in building out their team. An individual may be a great investor, but to have a successful venture firm it takes an entire team. There is risk around having emerging managers build not only a competent team, but a team that can work well together.

That said, emerging managers do feature characteristics which make them attractive, and in some cases even more attractive than established firms:

  • They have comparable, or in some cases even deeper, domain expertise in the given sectors their strategy targets and often have relationship networks just as good as larger firms may, which means their access to deal flow is just as good too.
  • They have the desire to build their firm’s brand and respect which lends to emerging managers being more hard-working.
  • Being a smaller organization, they are more nimble when it comes to adapting to changes in the market.
  • Without the influence of a larger organization, they can thoughtfully build a team that works best for the strategies they will be pursuing.
  • Having a smaller LP base, emerging managers usually value their investors more and are able to give more attention to their needs.
  • Investors are often able to get better economics in the form of a lower management fee and/or carry with emerging managers (although the argument can be made that emerging mangers need more fee income so they can build the proper infrastructure).

Manager selection is extremely important when investing in emerging managers. Understanding team dynamics, having a sense of their infrastructure, and the principals’ ability to run a firm are all factors that have heightened importance when evaluating emerging mangers. If the right group with the right backgrounds is coming together pursuing the right strategy the results could be impressive. Take for example Spark Capital, the firm was formed by Todd Dagres, formerly of Battery Ventures, and Santo Politi formerly of Charles River Ventures to pursue investments at the intersection of media and information technology. They’ve been early investors in great companies such as Twitter, Boxee, and Tumblr. A larger more established group may not have taken the risk to invest solely in such a narrow focus, but Spark’s nimbleness allowed it to identify and pursue companies in this exploding space. Investors would be foolish not to at least give emerging managers a fair shake when considering investments in venture funds, but they must be extremely prudent in their evaluation of managers because for every Spark, there is a firm that doesn’t make it.

Sunday
Mar072010

The Venture Capital / Growth Equity Opportunity in Brazil

Apologies for the brief hiatus from posting – I was in Brazil for a good part of last month, which actually provided a great opportunity to examine first-hand the opportunity for private equity there. Why private equity and not venture capital? In almost all emerging markets, venture capitalism as it is practiced in the U.S. simply does not work for a number of reasons, including weak intellectual property laws, infrastructure and markets as well as limited innovative and entrepreneurial spirit. Private equity investment, particularly growth equity (growth capital for mature companies) is most appropriate in emerging markets. Growth equity, which involves making minority investments in mature but growing companies, trumps even buyouts in emerging markets because of issues gaining control and limited availability of leverage. I’m not close to being an expert on the Brazilian economy, but the following is some of my thoughts on the growth equity opportunity in Brazil based on a few observations.

In my travels I was able to explore second and third-tier cities and even some semi-rural areas of the country, which I think provided a better sense of the country’s potential than if I had just visited larger cities such as Rio or Sao Paulo. Compared to rural areas of fellow large emerging market (and BRIC) countries India and China, the more rural parts of Brazil seemed further developed, or more ready for development. Large infrastructure investment is not as necessary as a precursor for growth as it may be in India and China. But it is still needed, particularly in the northern part of the country which is growing faster than the south. I think the government and private investors realize this, and it was evident in the many roads and bridges under construction as I traveled through parts of the north. In many ways, investing in Brazil seemed like less risky of an endeavor than investing in India or China. There’s probably less of an upside to growth investments, but also that there’s less risk and more immediate potential, a tradeoff that is probably attractive to many investors.

Brazilian consumers seem ready for growth but I did notice that the aspiration factor was lacking, or it was at least not evident, especially when compared to Indian consumers. Examples include consumers shying away from higher quality goods even if they are priced the same, or diners shying away from nicer restaurants simply base on the aesthetics (assuming it would be too expensive). I made this observation much more in the north than in the south, which brings up another point – the country’s diverse culture. The population is not as homogenous as other emerging markets and investors will have to adjust for this, especially when it comes to investing in consumer goods and service companies.

Another thing I noticed was that there were few signs of recession or that there had even been a recession – Brazil was relatively insulated from trouble in the broader world economy. The country’s quick recovery had a lot to do with government policy (which has after many decades seems properly aligned for economic growth) but a lot of is also has to do with the fact that Brazil’s domestic growth is so resilient. It may not be as fast growing as India or China, but it’s strong and also somewhat sheltered because the country is not reliant on trade with the rest of the world, even though Brazil has been expanding international trade in recent years, particularly with the U.S., China and Europe (driven mostly by natural resource demand). Growth equity investment decoupled from the world economy provides true diversification for limited partners investing in a private equity fund - which gives Brazil a leg up on many other emerging markets.  

When it comes to private equity investment, Brazil consistently ranks behind China and India in terms of amount of capital deployed and number of deals. But in recent LP survey’s I’ve seen, interest in Brazil is growing and is often higher the level of interest in India or China. In Brazil, local pensions are a huge source of capital. They’re now allowed to invest up to 20% of assets in local private equity funds, but most only invest 1-2%, which still accounts for a little less than 20% of all commitments to brazil-focused private equity funds, according to the Emerging Markets Private Equity Association. Even though there’s currently plenty of dry private equity capital in Brazil, I’d expect to commitments to increase in the coming years. Expect investment to remain heavy in the energy/natural resources sector, but other sectors will see growth for sure.

Infrastructure investment in Brazil, both private and public, will probably see increase over the next few years, driven by the need for infrastructure improvement ahead of the 2014 World Cup and 2016 Olympic games. As I had mentioned though, the infrastructure need is not as great in Brazil as it is in other emerging countries. As such, other areas, particularly industrials, manufacturing and consumer goods and services will surpass infrastructure as a destination for private equity. What about technology and more venture-type investments? Despite what I mentioned at the onset about emerging markets not being ideal for venture investment, I actually think Brazil has promise - perhaps more near-term promise for venture capital than India and China. We’ve seen so many venture capital funds fail or pull out of India and the environment in China is too murky for venture to be attractive there. But in Brazil, the regulatory, legal (intellectual property), tax and corporate governance environment is advanced, stable and reliable enough to harbor venture investment. Furthermore, I get the sense that there is a growing entrepreneurial spirit, aided in part by government programs supporting innovation and developing technologies from universities.

There should be plenty of opportunity in the internet, and mobile sectors. Both have a lot of potential for expansion in Brazil, both from an adoption and evolution point of view. Increased broadband and mobile adoption will be a basic driver, which means me-too copies of successful internet and mobile technologies from the U.S. will do well, but also expect there to be innovation from within Brazil. Still, growth equity investment remains more attractive now (especially in the manufacturing and consumer goods/services sectors). Brazil is primed for it from many angles and it should be one of the least risky emerging markets. Investors will need to be careful they are in tune to cultural and operations nuances, which means experience is key to success, as it is in almost any emerging market. It should be interesting to monitor Brazil’s growth in the coming years and as the environment for venture capital improves, look for more innovative technologies coming out of Brazil. 

Sunday
Jan312010

Venture Capital Overhang: Shrinking

With 2009 now behind us, full final year-end venture industry data is available. There’s plenty to glean from all the fundraising, investment and exit data. Much of it tells us what we already knew or expected: fundraising and investment are down, and exits have improved, but just slightly. There’s so much you can analyze, but I’ll focus on something I’ve done in the past, which is looking at the “venture capital overhang.” This is the difference between the aggregate capital raised by venture capitalists and the amount invested. It gives us a rough idea of how much capital VCs have available for investment, sometimes referred to as “dry powder.” The chart below shows venture fundraising, investment, the difference between fundraising and investment (as the overhang) and the cumulative overhang for the last ten years.

 

The cumulative overhang for the last decade for the U.S. venture capital industry totals close to $90 billion, using my methodology and data from PwC, Thompson Reuters and the NVCA. As with so much of the data on the venture capital industry, the calculation is not perfect. Things like management fees and recycled capital are unaccounted for. There’s also the issue of investments made outside of the U.S.  which are not captured in the PwC MoneyTree data.  Rather than focusing on exact numbers, its more important to focus on trends and to look at the big picture.

For one, there’s clearly capital out there for venture capitalists to invest. It’s probably becoming more concentrated across a fewer number of firms - as I mentioned in my last post, good firms will continue to be able to raise capital. The overhang number is down from my previous calculation earlier this year, which signalz to that capital will be a bit scarcer.  Going forward, we should see more years like 2009 and 2003 where the levels of investment and fundraising have less of a gap and less of an overhang is created. Now, you don’t want things going in the other direction, where we have more capital invested than raised because that would of course be unsustainable. But then some would also argue that the huge levels of overhang amassed in years past were also unsustainable, which is probably true.

There needs to be certain level of reasonability maintained in the industry and less overhang will force venture capital firms to be more prudent in deploying capital. This doesn’t mean, however, that great new ideas won’t get funded, because VCs clearly have plenty of dry powder. If anything we’ll see more early / seed stage deals which not only require less capital, but have more potential upside and also bring the industry back closer to its roots of more risk taking. 

Thursday
Jan142010

Venture Fundraising in 2010

2009 was clearly a difficult year for venture firms – continued turmoil in the public markets and the broader economy prolonged the dearth of venture-backed IPO and M&A activity, extending the liquidity drought for venture firms. Illiquidity negatively impacted fund performance, and more importantly the confidence limited partners (investors in venture capital funds) have in the asset class. The drop in confidence is most evident in their commitments to venture funds, which in 2009 fell significantly. According to Dow Jones, “overall VC fund-raising fell 54.6% to $13 billion across 120 funds from the $28.7 billion collected by 204 funds in 2008. It was the slowest year since 2003.” Here are a few things to watch for in 2010 in terms of fundraising:

Commitments to Top Tier Funds:

Fundraising totals for 2009 would have been worse had it not been for New Enterprise Associates (NEA) closing its thirteenth fund with $2.5 billion in commitments. While the fund took longer than expected to close, the fact that it was eventually able to do at a such a large size shows that institutional investors still have an appetite for firms like NEA that have a record of consistently delivering top quartile returns. This will be a theme going forward – we will see the most sold performers (firms such as Sequoia, Kliener Perkins, Matrix, Battery, etc.) continue to be able to raise capital, but fund sizes will still come down. If for some reason we see a top firm unable to get close to its fundraising target, it would be a sign that limited partner perception of the asset class is worse than feared. The shockwaves would be felt across the venture universe.

 The Numerator Effect

Over the past couple of years, the “denominator effect” has been a central issue for most large institutional investors / limited partners. Some quick background for the unfamiliar: If you think of an institutional investor’s allocation to venture capital as a fraction, the denominator is the total value of their total investment portfolio. The numerator is what is invested in venture capital. Stocks and bonds are traded daily, whereas venture capital is only valuated quarterly. When stock prices fell during the recession, it brought down the value of the overall portfolio, or the denominator, but at the same time, the percent actually invested in venture capital went up because the value of venture portfolios 1) are reported on a lag and therefore had yet to be written down in line with the public markets, and 2) didn’t declines as much relative to marketable securities.

In 2010, what we have already seen is that the denominator has rebounded – in line with the stock market (for example, the NASDAQ was up around 40% in 2009). However, the numerator, or value of institutional investors’ venture portfolios has remained suppressed – again, because venture capital valuations are reported on a lag. The real value of the numerator won’t be known until final year-end 2009 data is taken into account, which won’t be until April. Once that happens, institutional investors will really be able to get a true sense of where their allocations stand. This means that the second half of 2010 should see more commitments than the first half.  

 Attrition:

Early in 2009, PE Hub’s Dan Primack released a list of “The VC Walking Dead.” These were venture capital firms that were officially in business but which no longer had enough cash to add new portfolio companies. Presumably that meant they will no longer try or be able to raise subsequent funds.  Expect the list of firms that fall under this category to grow in 2010. The bar for venture firms will be much higher going forward. The amount of capital committed to the asset class will probably never (or not for a really long time) return to the levels of 1999-2000, or even 2007 for that matter. It’s the general consensus that there was too much capital in the venture industry and limited partners weary of the asset class have every reason to be extra judicious with their commitments. That spells bad news for undifferentiated firms, inexperienced firms, and firms with poor track records. 

Sunday
Dec272009

Drawing From Y-Combinator - A More Perfect Crowdsourced Venture Fund

I've written a few times now about the idea of a crowdsourced venture capital fund - where there would be a large number of small investors, each playing a role in the fund's investment decisions. It’s my belief that as the venture industry evolves, the disconnect that exists between investors, venture capitalists, entrepreneurs, and the tech community can be bridged well through such a fund. If you'd like some more background on what my ideas for a crowdsourced venture fund are you find it here, and here.

 I got thinking about a crowdsourced venture fund again after reading some more about the great stuff Y Combinator does. Y Combinator provides seed funding for startups, but money is just a small part of what they bring - typical investments are less than $20,000. Instead, where Y Combinator really provides value is in their work with the startups they fund. They provide hands-on guidance to help startups become successful, including forming the company, legal issues, developing the product(s), managing the company's growth, and even finding future funding. In an age where the cost of starting an internet company has gotten pretty low, Y Combinator, which has helped spawn great companies such as Disqus, Loopt, Scribd, Xobni, and Reddit, provides something more valuable through its expertise and connections. It got me thinking that a crowdsourced venture fund would need to be able to do something similar.

A crowdsourced venture fund would be best suited for making tech investments; particularly early-stage tech investments where the backing of a crowd (in this case the LP base as well) could help propel portfolio companies. You would also be able to draw from the wisdom of the crowd to help with any problems faced by the startups invested in. Here, you have an instant network, as long as the LP base remains on the tech-savvy side, which you would expect. But what about the nuts and bolts of a company and nurturing it properly early in its life? The truth is that most traditional venture capitalists don't do much there as you would think, which makes YCombinator special. In a crowdsourced fund you would ideally want Y Combinator-type VCs armed with their own connections which, along with input and backing from the crowd, would really create an ideal situation. You would be able to help entrepreneurs effectively through a variety of issues by drawing from the crowd, only having to make sure that the crowd is sufficiently engaged to want to lend support. Part of this is achieved through their investment into the fund itself. Part of it is also making them involved in the investment process.

What would a crowdsourced fund do with a very large pool of capital? It would be able to do what Y Combinator can't do: continue to fund the companies at later stages. Instead of having other venture firms come in for a series A or B round, ownership could be maintained in the companies as they grow. Of course you could always push for a larger ownership with the seed funding as well, but you have to be careful there as you want the entrepreneurs to be motivated with significant interest in their companies.

And what about the vetting investments? Y Combinator has an application process for companies, but for a crowdsourced fund, you would probably want a combination of companies applying for backing as well as the fund's VCs going out and sourcing investments in a traditional manner. Both sources of dealflow would be pooled and, as I've mentioned before, the crowd, or LP base, would be able to vote on the most promising companies, which the VCs would then use as input in making their final decisions. The reason you wouldn't leave it up purely to a vote is that you need to protect the confidentiality of potential investment and so voters would not have complete information when making decisions. You would also use the wisdom of the crowd by voting/collaborating on solutions to problems companies face that can't easily be solved by the VCs and would benefit from having input from the crowd. While the crowd, or LPs, wouldn't be compensated for their participation, they all have their investment in the funds at stake as a motivator.

The thought of a crowdsourced venture fund is definitely idyllic, and maybe even more so if you want to try to do some of the things Y Combinator does, but as capital starts to take a back seat to the other things venture funding should provide, it’s a model that seems to make more and more sense.

Previous posts on Crowdsourcing Venture:

Crowdsourcing Venture

Another Take on Crowdsourcing Venture

Thursday
Dec172009

The Real Impact Of Overlooked Fund Return Considerations

The Private Equiteer recently brought up an aspect to private equity and venture capital returns that is often overlooked and unaccounted for: The fact that investors (limited partners) in funds have to set aside or plan around the capital they have committed to a fund. For those less familiar with private equity, investors in funds do not pay in the full amount they decide to invest in a fund right away. Instead, capital is called by the general partner as the fund makes new investments. Rarely do limited partners set aside their full commitment to a fund and hold cash to meet capital calls as they come. Most model around expectations provided by fund managers and hold only the amount of cash necessary to meet capital calls.

The Private Equiteer argues that opportunity cost of holding cash, or the risk of default associated with reserving inadequately should be factored into private equity returns. I would agree that there is some opportunity cost involved, but the simple fact is that virtually no limited partner holds the full amount of a commitment to a fund it has decided to invest in as cash – only for short periods to meet imminent capital calls, which in the grand scheme probably has a negligible effect on returns. There’s also a very limited chance that a limited partner defaults on a capital call. It’s extremely rare, and even if it does happen, there are remedies that would allow the limited partner to continue investing in the fund – rarely would all value be lost.

The reason these two issues aren’t talked about too much is probably because they’re not really major  issues to begin with. Putting aside the risk of default (which is incredibly small), let’s take a look at the effect holding committed capital as cash would have on a fund’s return. If you remember, in my model for a crowdsourced venture capital fund, I suggested that all committed capital would have to be called at the onset of the fund to make things logistically simpler – perhaps as the private equity and venture capital industries evolve, we’ll see more of this. Below I’ve modeled out a hypothetical private equity or venture capital fund’s cash flows under a normal model (which assumes that cash comes in right at the time of a capital call) and also for a model where cash is held/called at the onset of a fund (same impact on returns). I’m using 5% as an interest rate for the cash and the rest of the cash flows for both models are the same. Here’s what we get:

As you can see, there is clearly an impact on the fund’s IRR - a difference of around 1.3% in this case, but with a return multiple of 1.6x under both scenarios. Is this a significant difference?  I would say it’s definitely material, but it depends on the investor. The difference is probably significant enough to impact investment decisions and overall portfolio performance, and its why funds do not call capital upfront (negative impact on IRR, even though all other performance is the same) and why limited partners don’t hold cash. They assume they can earn even more than the 5% I modeled in on their cash. The only benefit derived from calling capital upfront or holding a commitment as cash is eliminating the risk of default, but as I mentioned before, it’s such a small risk in the first place that it does not make sense to protect against in such a way.  That said, I do stand by the idea that for different models such as a crowdsourced fund, you would still want to call all capital upfront, even if you sacrifice a bit of your IRR.