The VC industry is broken. So now what?

By Stacey Higginbotham   This was originally posted here.

OMG!  These returns!

The investment team at the Kauffman Foundation believes the venture capital industry is broken and they — or rather investors in VC funds — are partially to blame. The report condemns venture firms for being too big, not delivering returns, and not adjusting to the times. But then it blames the situation on a misalignment of incentives: Namely, limited partners that invest in venture firms have done so in a way that encouraged VCs to raise huge funds at a time when huge funds weren’t really warranted. And now, for the Kauffman Foundation at least, the chickens have come home to roost. From the report:

The most significant misalignment occurs because LPs don’t pay VCs to do what they say they will — generate returns that exceed the public market. Instead, VCs typically are paid a 2 percent management fee on committed capital and a 20 percent profit-sharing structure (known as “2 and 20”). This pays VCs more for raising bigger funds, and in many cases allows them to lock in high levels of fee-based personal income even when the general partner fails to return investor capital.

A smaller VC industry is needed

The solutions to the problem — changing the compensation structure, investing in smaller funds where the partners have also committed at least 5 percent of their own capital, investing directly in startups or alongside funds at later stages, and taking more money out of the over-saturated VC market — are already happening. Look at the widespread trend of angels or smaller funds created by a few investors. Or look at the rise of hedge funds orDigital Sky Technologies’ investing directly in hot companies like Twitter or Facebook at crazy valuations.

It’s unclear if other LPs will take the advice issued in this report, but the trends around VC investment these days are fairly clear. There are plenty of firms willing to put small amounts in at an early stage, so they have the option to keep playing if the deal gets hot. And they are just as likely to drop firms quickly around the second (Series B) fundraiser if they aren’t shaping up into a Pinterest or a Spotify. This hit-driven style of investment is a symptom of too much money chasing a new type of startup, and it’s likely that venture investors will compete until much of the return is squeezed out of a hot deal. And that’s no good for limited partners either.

The Kauffman report lists the ways it has decided to solve the mismatch between LPs and venture firms, and it goes into a lot of depth on how to improve the industry overall. But if one agrees with the assessment and solutions offered in the report, it also will result in some serious questions about the startup economy. The venture industry invested $28.4 billion into 3,673 deals in 2011, according to the NVCA and the PWC MoneyTree report. About 50 percent of their total investments were in seed and early-stage companies.

Does less venture money mean fewer startups?

Following the Kauffman Foundation’s suggestions means the pool will shrink. In many waysthis is a good thing, as there will be less money chasing the few standout deals, but it also opens the door to thinking about building companies in a connected era. Angels are already picking up some of the VC slack and will likely continue to do so. Once Facebook goes public, I expect we will see a host of newly minted millionaires playing at being an angel or perhaps taking their riches and using it to build something new.

For those without soon-to-be-liquid options, Kickstarter and the gold rush promised by the JOBS Act are also likely to fill the gap. So it’s entirely possible the pool of venture capital will shrink while the pool of startups will remain about the same. In such a scenario, VCs, angels and then the rest of us play the role of investor. It’s a role millions already undertake, withKickstarter’s seeing $200 million pledged and 22,000 projects funded since its founding.

And the passage of the JOBS Act means startups can now beg for money among the ranks of friends and family who aren’t accredited investors. I for one am leery of this development, believing it ripe for scams. The law also has the side effect of cloaking information about companies until right before they hit the public markets, which I think is the exact opposite of what a bill that encourages consumer investment ought to do. But still, there will belegitimate companies that will be able to start businesses thanks to the bill.

And as lawyers and entrepreneurs get comfortable with the law, new funding platforms should arise. So perhaps the Kauffman Foundation will find itself on the cusp of a trend, from the old-school style of fundraising where an entrepreneur has few choices and has to play by the VC industry’s rules to a crowdsourced and connected era of raising capital that mimics how the Web is changing a variety of businesses. Maybe the VC industry is like Motown. And it’s going to have to adjust to the new reality.

The Promise of Crowdfunding for Social Enterprise

This blog originally appeared here. 

By Doug Rand, Senior Policy Advisor, White House Office of Science and Technology Policy.

Earlier this month, the White House hosted a briefing for the American Sustainable Business Council, a national network serving social enterprises from early-stage startups to established success stories, like Patagonia and Ben & Jerry’s. Senior White House staff took time to meet with chief executives and thought leaders, such as Seventh Generation founder Jeffrey Hollender and Stonyfield Farms pioneer Gary Hirshberg, to discuss many aspects of the President’s agenda to support overall economic growth, including the Impact Economy.

As part of the conversation, the discussion focused on the Jumpstart Our Business Startups (JOBS) Act. The JOBS Act is a bipartisan bill signed by the President into law in April that will allow small businesses and startups to raise capital from investors more efficiently, leading to faster growth and hiring.

One of the key features of the JOBS Act is to enable “crowdfunding” – letting companies raise up to $1 million in small increments from many investors. As the President said, this is “a potential game changer”:

Right now, you can only turn to a limited group of investors -- including banks and wealthy individuals -- to get funding. Laws that are nearly eight decades old make it impossible for others to invest. But a lot has changed in 80 years, and it’s time our laws did as well. Because of this bill, start-ups and small business will now have access to a big, new pool of potential investors -- namely, the American people. For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in.

In many ways, nonprofits and social enterprises are already adept at raising money through crowdfunding – think of donation-based tools like Network for Good or zero-interest microfinance platforms like Kiva. What the JOBS Act will do is allow micro-investors to purchase a stake in the venture.

Many social enterprises already have benefited from donation-based crowdfunding platforms, and they are looking forward this new opportunity to attract impact-minded investors. Two such companies guest-posted on the White House blog, and their founders attended the JOBS Act signing ceremony: Stockbox Grocersbuilds tiny grocery stores in urban “food deserts,” while LuminAID Lab manufactures solar-powered lights for disaster relief. Both companies stress the power of crowdfunding to connect social enterprises with their communities and customers.

At a time when nonprofits are struggling for revenue, as charitable donations have slowed and government budgets are tight, the social sector needs to find new strategies to attract resources. The Obama Administration has taken some important steps toward this end, developing policies and programs to unlock capital and to increase investment. For example, the Administration launched the Social Innovation Fund to provide growth capital to high impact nonprofits. In two years, it has catalyzed nearly $400 million toward communities’ solutions. The Treasury Department recently updated the example Program Related Investments, providing guidance that should facilitate the flow of impact investing from foundations and philanthropists to support businesses and nonprofits pursuing charitable purposes.

Building on this momentum, crowdfunding offers tremendous promise. Some believe that it has the potential to revitalize underserved communities by improving access to capital for small businesses. As the leader of a major group representing Main Street microenterprises recently wrote, “Given the tremendous demand for credit among microbusinesses and entrepreneurs, crowdfunding offers real promise for underserved business entrepreneurs and may allow the organizations that serve them the ability to reach even deeper into the entrepreneurial community.”

To be clear, investment-based crowdfunding is not legal just yet. Congress required the Securities and Exchange Commission (SEC) to write new rules of the road for crowdfunding, which will be finalized in 2013. Some open questions include the following:

• Any company raising money through crowdfunding must use an SEC-regulated intermediary. How should these intermediaries be required to educate investors, safeguard investor privacy, reduce the risk of fraud, and ensure other investor protections?
• In any given year, investors are limited in the total amount they can invest across all crowdfunding investments (5% of annual income or net worth if less than $100,000, or 10% of annual income or net worth if greater than $100,000). How should intermediaries be required to verify that investors stay within these limits?
• What disclosures should be required of the companies raising money through crowdfunding, above and beyond those spelled out by Congress?

The SEC has invited members of the public to submit comments to inform their rulemaking. These comments could include considerations unique to social enterprises, along with those investors willing to trade some financial return for greater social or environmental benefits.

To provide comments on crowdfunding, read the JOBS Act and visit the SEC comment page. 

Tenacious D

The SEC has announced that it will hold an open meeting to consider rules to eliminate the prohibition on general solicitation in offerings made under Regulation D under the Securities Act of 1933. http://www.sec.gov/news/openmeetings/2012/ssamtg082212.htm

Since this is the first of the real deadlines under the JOBS Act – the SEC was required to “revise its rules” in this area within 90 days from April 5 -- some have asked whether the delay in taking action has negative implications for the timing of crowdfunding rules.  The answer is “not necessarily.”  Regulation D sits within a web of inter-related rules, and its provisions cannot be changed without affecting many of those other rules. 

For example, the SEC is also directed to permit general solicitation in Rule 144A offerings. Most Rule 144A offerings include a Regulation S component.  Regulation S prohibits “directed selling efforts.”  Directed selling efforts are very similar to but not exactly like general solicitation (and present their own policy issues).  If general solicitation is permitted but directed selling efforts are still prohibited, the resulting confusion could adversely affect international markets.  And there are similar issues with respect to a number of other rules.

Crowdfunding rules do not pose the same bundle of challenges that changes to long-established rules like Regulation D do.  Writing rules from scratch can sometimes be easier than revising rules that have been in place for decades.  So we would not necessarily read any significance into this delay.  Especially since Chairman Schapiro said in Congressional testimony last week that she didn’t anticipate failing to meet the crowdfunding rule deadline.

Notes From Capital Hill

The NLCFA's SEC Committee had a representative in this week’s JOBS Act hearings on Capitol Hill when crowdfunding was mentioned.  These are his notes:

Notes from 6/26/12 House subcommittee hearing on The JOBS Act in Action: Overseeing Effective Implementation That Can Grow Jobs

Brian Cartwright (testimony)

Scholar-in-Residence, Marshall School of Business, University of Southern California

Former General Counsel, U.S. Securities & Exchange Commissioner

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C. Steven Bradford (testimony)

Earl Dunlap Distinguished Professor of Law

University of Nebraska College of Law

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Alon Hillel-Tuch (testimony)

Co-Founder and CFO of RocketHub

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Professor John Coffee Jr. (testimony)

Adolf A. Berle Professor of Law

Columbia University Law School

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-       Much talk about high costs for small businesses to enter the crowdfunding industry if the regulations are too strict. Hard for small business and startup to have to pay for legal and financial advice and regulatory fees when they are attempting to crowdfund in order to get the capital they already are short of. Professor Bradford believed there cannot be an expensive mandatory disclosure option because of the extra costs to entrepreneurs.

-       Alon Hillel-Tuch felt that these fees and the need for entrepreneurs to pay extra costs before they crowdfund has potential to kill crowdfunding. Also some adamant talk about the endline profits these companies could raise in order to make crowdfunding more attractive and more worthwhile for business to equity crowdfund. His suggestion is raise the crowdfund exemption from $1 million to $5 million.  Another note from Alon Hillel-Tuch is that if the SEC regulations are too strict Rockethub may not look to become an equity portal and this could be a similar theme with other donation-based portals not wanting to expand to equity crowdfunding.

-       On the issue of crowdfunding leading to fraud, Alon Hillel-Tuch and Professor Bradford both felt that the transparency that is inherent in crowdfunding will allow most of the crowd to root out fraudsters and that portals will be able to regulate and perform their own due diligence, meaning there should be less overall regulation through the SEC and more through the portals. Professor Bradford felt similarly but at the same time emphasized the need for investor education in order for the crowd to effectively help in preventing fraud. Investor education, he believes, is something the portals could provide but overall “lack of clarity and inability of entrepreneurs to understand what they can/cannot do could kill crowdfunding”. Mr. Cartwright was the staunchest believer in the growth of fraud following the start of equity-based crowdfunding noting the amount of low level “street level” securities fraud that takes place and the portals, SEC or whomever the regulations to protect investors against fraud falls upon are going to need to have extensive anti-fraud measures. Mr. Cartwright proposed an expanded SEC force to deal with this type of fraud.

-       Another main theme of the hearing was the stress put on the fact that these regulations are going to need to be written to be easily understood by the entrepreneurs, many of whom will be uneducated in the field of securities law. Not only will many errors be made by small businesses who do not understand the act but additional fees needed to pay for legal and financial advice could compound the inability of these companies to enter the crowdfunding market and grow. John Coffee noted that Rule 508 in Regulation D -- “innocent and immaterial exemption” could be applied in equity based crowdfunding in order to preserve the offering. As he noted the rules are ambiguous so far as to what happens if a business is raising funds within a portal and then found they had made a mistake under the guidelines; this exemption could help protect business.

Notes from 6/28/12 House subcommittee hearing on The JOBS Act in Action: Overseeing Effective Implementation That Can Grow Jobs

The Honorable Mary Schapiro (testimony)

Chairman U.S. Securities and Exchange Commission

-       After initial comments Chairman McHenry asked about the ways in which the SEC has been reaching out to the public community for comments. Chairman Schapiro mentioned the comment board on the SEC website along with FAQ pages and the availability to send remarks through email.

-       The July 4^th deadline for rules relating to general solicitation cannot be met as it does not allow enough time for drafting a new rule and the SEC is working towards the drafting but the deadline will not be met. From the testimony: “time limits imposed by the JOBS Act are not achievable”.

-       McHenry noted that the Senate changes to the jobs act causes concerns because of the added regulations could limit the growth of crowd funding and the ability for startup companies to benefit. Schapiro notes the SEC is very sensitive to the issues of cost and that the use of intermediaries will be major factor so that small business’s due not have to deal with extra fees through legal and financial council that could “stillbirth” equity crowdfunding and startups entrance into the market. There still needs to be oversight and regulation outside of the intermediaries to ensure there is a standard level of protection for investors. Schapiro quote on the need for regulation, “if the exemption is fraught with fraud it won’t be useful for anyone”

-       Schapiro quote on meeting the December 31^st  deadline for crowdfunding rules: “I don’t foresee not meeting the deadline”.

-       The need for deeper “economic analysis guidance” throughout the regulations creating process has added extra time to the process. Schapiro notes the commission is working hard to implement strong economic analysis to coincide with rule creation. McHenry is skeptical about the fact that the large majority of recent hires for the drafting of regulations are lawyers by trade and not economists downplaying that the greater stress on stringent economic analysis isn’t supported by this fact. Schapiro backs the commissions continued effort to implement the economic analysis guidance throughout the job act regulations.

-       Rep. McHenry asks about regulation for SROs. Chairman Schapiro agrees for some regulation but believes it would be a mistake to have blanket requirements across all SROs. Rep. McHenry notes that since SROs can react faster than government bodies and regulate themselves there should be more regulation of SROs. Schapiro replies Commission will strive to do more but burdened by timeline.

Time With Clinton, Our Crowdfunding Advocate

Great to be with President Bill Clinton at the Clinton Global Initiative - America in Chicago two weeks ago.   He had just said something about the National Crowdfunding Association, and I was responding as the camera 'clicked'.  Terrific guy.  Very enthusiastic about crowdfunding, and was surprisingly (and flatteringly) aware of the NLCFA and our work.  Now for us to launch our commitments and kick this into the next gear.  Who's with us!?!

PS:  There is no better eat-well champion than Pres. Clinton, and being around him for two days was highly motivating.  So consider this picture my 'before'!

Hope you Jump Aboard our Moving Train

Ok, so that didn't work....my pledge to blog more often.   It's the best I can do.

Just back from Clinton Global Conference.  Terrific.   Pres. Clinton is a fascinating man.  Terrific.  Very enthused by and supportive of crowdfunding.  I will try to find some of his plenary talks and post them.  Good news:  we have new blog-master coming on board at the NLCFA and he will hopefully keep this thing hopping.  I am off and running.   Talk soon.  David

PS:  if you want to get more than these glancing snapshots of our fast moving organization, please join and get involved.  www.NLCFA.org   Great group of people.  We want YOU too!

PSS:  Feel free to email me directly at david.marlett@NLCFA.org

David