Friday, April 15, 2011

Angels and friends. When it rains, it pours.

Hopefully it isn’t salt on a wound

As has been mentioned in previous discussions of angel investing, formalizing angel investing hasn’t served the US well. It serves the government well, but it is a disservice to the public because: (1) it limits an investor’s option to diversify into these businesses unless he or she falls into the chosen class of accredited individuals, (2) it reduces the flow of capital to startups, and (3) it forces the entrepreneur to take greater financial risk as well as the business risk associated with a startup. (These themes are discussed in the series starting with “Angels, entrepreneurs, and diversification: PART 1.” It runs through the three-part series that started with “The discussion Congress should be having: PART 1 Angels, entrepreneurs, and diversification,” and it surfaces as a theme in the last two postings). Seems the government notices since we are witnessing more trial balloons than a county fair.

The problem may have arisen out of a change in Americans’ ability to manage loss, but it seems to also have institutional roots. Don’t get me wrong; Americans have honed their skill at blaming someone else for their mistakes thus avoiding the necessity of learning from them. However, that’s not the topic of this note. Rather, the point of departure is the quote in “Investing PART 12: Angel Investing.” The quote is, “Many of the financial and social institutions that supported new ventures in the past have weakened or vanished in Western societies. Angel networks may be the substitute.”

The growth, or refinement, of angel networks is just one example of a new institution that is developing. Secondary markets seem to be another response to capital markets that are overly- rigid for the confusion that characterizes startups. This posting will discuss other institutional responses including possible government responses.

As stated previously, part of the counterproductive rigidity has its origin in the government’s need to regulate. It’s a natural government response to the public’s inability to accept responsibility for losses that originate from their own actions. However, there are at least three other reasons for the development of new institutions. Each seems worth highlighting. They will be used as a framework in which to discuss various institutions.

The three reasons new institutions are developing are scale, community, and intermediaries. Each is important at different points in a successful startups’ life. Understanding each is particularly important currently because the government has belatedly recognized that there is a problem. As they consider letting other “substitutes” develop, it will open opportunities. How and whether those opportunities matter to you will depend on two things. First is which of the three problems listed above (i.e., constrained investment options, the flow of capital to startups, or the risks that market distortions create for startups) the government emphasizes. Second is your personal circumstance (e.g., investor, entrepreneur, neither, or both).

Let’s start with scale. Why, you ask, should this be important? Ignore angel investing for a second and think about how startups become startups. Many stories abound of businesses started in a garage, a college dorm room, or, in a few cases I’m familiar with, a founder’s bedroom or a shared loft. Small incremental investments were characteristic, often in the form of the founder(s)’s forgone earnings or their salaries from other jobs. However, these personal sources have definite limits. For many startups that limit is reached when a very small group of individuals, usually the founders, exhaust their capital and personal ability to borrow.

Taking it a step further, early employees may be compensated partially in stock or options. Since compensation is generally paid in small increments, it is another way around the scale issue. Companies that are employee-owned through what is known as ESOPs are another example of small, incremental investment, but in this case the companies aren’t as restricted in size or age of the company.

All of these workarounds preclude the development of a broad base of ownership. Looked at from the other side, they restrict ownership to a select group. They don’t scale up when, as, or if, the capital required increases.

One potential response to this lack of access to a broad set of potential investors is called crowd-funding. A quote from WALL STREET JOURNAL, April 9, 2011 “SEC Boots Up for Internet Age” By Jean Eaglesham and Jessica Holzer summarizes the current status of crowd-funding: “The Securities and Exchange Commission is looking at adapting its rules to encourage Internet-age techniques for small companies raising capital. The issue is part of a wider review by the agency into whether to ease decades-old constraints on share issues by closely held companies…The use of ‘crowd-funding’ techniques has spread in recent years from artists looking to fund creative works to entrepreneurs trying to expand their firms. In a typical example, a company looking to raise $100,000 would use an Internet site to invite investors to buy as much as $100 of shares each.”

Leave aside for the moment the absurdity of having the government write rules for $100 investments. (Perhaps they should write rules for people “investing” $100 in lottery tickets). So, who will crowd funding benefit (investors, the economy in general, entrepreneurs)?

(1) It would allow investors more options to diversify into these businesses. But, viewed seriously it is pretty lame from that perspective. Let’s say a $100 investment turns out to be successful, what’s the result? In startup terms that might be a 10 or 20 bagger. So, we’re talking say $1,000 or $2,000 and recall the quote in “Investing PART 12: Angel Investing:” “Angel investors should be prepared to have their money tied up for seven to 10 years.” On the other hand, it might let a small investor diversify within the asset class.

(2) It would increase the flow of capital to startups, but only if it really takes off as a funding method and doesn’t become a method for the crowd to chase a few high profile companies. The very small level ($100,000) might be a saving grace in both respects.

(3) It could reduce the need for the entrepreneurs to take greater financial risk as well as the business risk associated with a startup. A bank loan (be it a personal loan or a business loan is leverage. With leverage comes financial risk.

Going beyond the initial startup stage, this scaling problem/characteristic is aggravated by the changes in the venture capital industry and the IPO market discussed in “Why ten million dollar IPOs matter.” I’m not going to rehash the discussion, but the article points out that for various reasons there is a gap between the capital requirements angel investors can efficiently meet and the threshold at which VCs become interested. There’s a pothole in the scalability continuum.

One shot at a substitute is the secondary markets. But, the hoopla surrounding Twitter, Facebook etc. doesn’t bode well. The SEC is considering raising the limit of 499 on the number of shareholders that closely-held companies can have before having to open their books to the public. These offerings are almost exclusively covered by Regulation D. Thus, they are limited to “accredited investors” or about the richest 7% of the investing public.

There’s also a danger the secondary markets will simply become a way to compete for large capital investments rather than a response to the point where the gap exists. The same WALL STREET JOURNAL article notes: “Former SEC Chief Accountant Lynn Turner said he feared lifting the cap would allow companies that are "more hoopla than they are substance" to raise capital based on limited disclosures.”

Even if the secondary market became “healthy” (i.e., liquid, broad, tight spreads, more symmetrical information availability), it still doesn’t address most of the problem. (1) It’s restricted to accredited investors. Thus, it doesn’t offer access to new investment options to most investors. (2) In aggregate it adds no new capital. It doesn’t access a different investor pool; it accesses the same pool in a different way. (3) But, here’s the payoff. Secondary markets could significantly reduce the risks for entrepreneurs. The secondary market could allow entrepreneurs to access capital at lower cost.

To illustrate how important this last point could be, here’s a lengthy quote discussing the roll of Reg D investing from another article in the WALL STREET JOURNAL, April 9, 2011, “The Next Google—Or The Next Debacle?” by Jason Zweig. “This provision enables firms to raise capital without all the disclosures that are required in a public deal. So-called Reg D offerings are ‘the most prevalent form of capital-raising in the U.S.,’ says Robert Robbins, head of the corporate-securities practice at Pillsbury Winthrop Shaw Pittman.

In fact, ‘I can't think of any public company that got to the public spot without first issuing [shares] under Reg D,’ says Martin Dunn, a former SEC official who is now an attorney at O'Melveny & Myers. Once in a while, such a company turns into the next Google; if Facebook or Groupon offered its shares more broadly, a Reg D deal could be a next step.”

Just for balance the article goes on to say, “So investors can miss out when companies are constrained from offering shares this way, and the SEC appears to be responding to concerns on Capitol Hill that U.S. companies face too many regulatory hurdles in selling securities to the public. On the other hand, FINRA is reacting to widespread evidence that investors have also been ripped off by sharp operators in the market for private offerings.”

Then it goes on with a quote that is patiently absurd: “Above all, ‘the average person should do these things only when advised properly by a credible and honest investment adviser,’ says John Borer, head of investment banking at Rodman & Renshaw, a leading originator of private deals.” Put bluntly, if an investor needs an investment advisor, he or she shouldn’t be making that investment. All the quote does is reveal that current accreditation standards are a total failure at identifying who should or shouldn’t be investing in entrepreneurial startups.

One can hope the exclusion of US investors from the recent Facebook capital raising focused enough attention on the problem to generate a real response. However, all outward indications are that the government is going to stick to the absurd notion that only rich people are smart enough to deserve a chance to take risks.

With this background information, the discussion of the other two factors giving rise to new institutions can be abbreviated. So, let’s examine the second reason that we need to develop new institutions. It is changes in what many sociologists call community. It’s worth noting that most of the ways of raising capital mentioned about involve a community of sorts (an angel NETWORK, roommates, close friends, employees). It’s only at the secondary market level that the impersonal market takes over. There it’s competing with the impersonal VC market (to the consternation of some VCs).

In this respect it is important to realize that Facebook isn’t the first example of entrepreneurs having to avoid US capital markets in order to raise capital. As discussed in “Innovation will stay, but Silicon Valley IPOs will go to Hong Kong, Singapore, Shanghai or Bombay” entrepreneurs can raise capital anywhere, and will abandon the US if need be.

Entrepreneurs are being forced to take a global approach to defining a community. In a sense, this is the flip side of the use of an international investor community for the recent capital-raising activity of Facebook. (1) This doesn’t benefit US investors in terms of options. (2) At the global level it could lead to a more efficient use of capital, but it would make more capital available to US entrepreneurs only if they are the world’s best entrepreneurs. (3) It could reduce the financial risk that entrepreneurs face, but introduce political risk.

The SEC’s review recognizes and attempts to come to grips with the existence of communities in cyberspace rather than geographic space. That is probably the most encouraging aspect of the development of new institutions. (1) It could provide investors with easier ways to diversify into these businesses. (2) It won’t increase the flow of capital to startups unless it calls into question the idea of a chosen class of accredited individuals. There is reason for hope on the accreditation issue. Cyber communities will make it hard for the government to continue using accreditation as a way to defend the upper class of the US. (3) It will be easier to spread the financial risk associated with entrepreneurial ventures beyond the entrepreneur.

The final reason for the development of new institutions is the role and influence of intermediaries in capital markets. Contrary to a lot of populous bunk, intermediaries aren’t villainous vampires. There are legitimate efficiencies associated with creating an environment where one lends to one party, and that party then lends to another party. At the societal level, the benefits are tremendous. Intermediaries deserve a return for providing that service.

However, as the role of the intermediaries expands, and especially as the number of different types of intermediaries increases, the institutional infrastructure supporting the intermediaries becomes more specialized. Capital markets have become very efficient at serving investors with a certain range of funds to invest and a certain range of risk preference. However, startups and many people who might want to invest in startups aren’t well served.

If you need evidence, think about how few institutions used to raise capital for entrepreneurial startups involve intermediaries. They are far more likely to involve a specialized community. The secondary markets are the most significant case of a potential development of an intermediary. Closely watch the reactions of those who have benefited from the lack of effective intermediaries. The level of hostility displayed by VCs and regulators will be fairly directly related to the effectiveness of the secondary markets at mitigating all three inefficiencies mentioned at the beginning of this posting. Currently, they aren’t there.

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