August 27, 2014

“We will be judged by only one thing — the result.” Vince Lombardi

Opportunities in Early-Stage Investing

I have been in the process of launching a new company in the financial services space the past few months and my efforts at fund raising for the company have confirmed some interesting developments within venture capital. Of course, not all venture capital firms, and venture capitalists, are created equally, so I am making broad-based assumptions in this post which apply to most but certainly not all of the players.

The purpose of venture capital is to invest in (and develop) early-stage companies, and by doing so successfully, produce a profit for shareholders, namely the limited partners who invest in venture funds as well as the general partners of the venture capital firm. Venture capital is inherently risky with 20% or less of all investments producing a return. Venture capital investments are historically in companies which are pre-revenue and often in pursuit of markets which haven’t even formed. The role of venture capital—and this source of funding for entrepreneurs–is one of the reasons this country is the greatest place in the world to innovate and be an entrepreneur. Unfortunately, though, there is a troubling trend in venture capital to shift away from early-stage (at least as a percentage of fund size) and put more capital to work in growth or later-stage companies. The loser in this trend is entrepreneurship and, frankly, America.

The reason for this shift in venture capital investing is two fold: (1) the size of venture funds has become so large that in order to produce a suitable ROI for shareholders the venture firms have to find the next Facebook or the like or make big bets with large amounts of capital in later-stage companies. Finding the next Facebook is like catching lighting in a bottle and don’t let any other entrepreneur or VC tell you otherwise. Sure, certain entrepreneurs and VC are better than most in being visionary and picking markets, and blue-chip management is always important to success, but in the end it’s a lot of luck and impeccable timing in creating Facebook. I think Mark Zuckerberg would say as much. Further, investing in and finding the next Facebook simply doesn’t scale relative to the size of today’s venture capital funds. In other words, there aren’t enough Facebook’s in waiting to allocate the capital of the large VC funds and produce the expected ROI for the asset class. Therefore, venture firms are allocating large amounts of capital to later–stage companies in order to fully deploy the capital for which they are handsomely paid to invest and mange.

The decrease in early-stage investing by venture capital companies has created a market void and opportunity for a new form of early-stage investor. Super Angels and high net worth individuals are increasingly the funding source for many entrepreneurs. It’s opportunistic and smart for these new early-stage investors to play in this market. Valuations are typically attractive at less than $4MM pre-money and if you have enough capital to make multiple investments then your anticipated return for this asset class is probably better than what you can get with other asset classes over a ten year period. Further, the web has made it easier, faster, and cheaper to launch a company so the capital requirements to test a new concept or prove a market are substantially less than the past, expanding the market (and need) for angel investors.

However, angel money is often “dumb” money, meaning it provides no value beyond the capital itself (which, by the way, is pretty damn useful). Of course, I’m not suggesting the angels themselves are dumb. They have the money so they are probably smarter than the rest of us. However, most angels lack the motivation, drive, and most importantly, focus, to really be value-add to an early-stage company. Again, there are exceptions to this rule. For the most part, though, angels are in passive mode. They invest to stay connected. They invest out of boredom. They want to be helpful strategically and sometimes they are but typically they aren’t. They just don’t have the motivation to go the extra mile and do the dirty work to help develop early-stage companies.

This is why I strongly believe there is an opportunity to create a new kind of early-stage investment firm. Small in fund size, laser focused on specific markets, and run by operational experts who are hungry for success and willing to help early-stage companies succeed. It’s some place on the competitive landscape between an incubator, an angel group, and a traditional VC. In the end, what makes America great is the role of free markets and the drive of entrepreneurship to innovate. Angels are a great example of that today. The point of this post is not to criticize angels or traditional venture capital for that matter. I applaud all angels and VCs who have the stomach and risk profile to invest in early-stage companies. As is always the case, markets have shifted, and business models have evolved, and there is an opportunity for a new investment company to form and serve the needs of early-stage businesses. Stay tuned for more on this subject!

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