New Opportunities for Seed and Early Stage Venture Funds (One Man's Opinion) - 1

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New Opportunities for Seed and Early Stage Venture Funds (One Man's Opinion) - 1
In a December post, I discussed the impact of the changes to Reg D 506c on regional funds, investors and startups, and the rise of online fundraising sites like AngelList, FundersClub, Gust, Wefunder, Fundable, Seedrs, Dealroom, and hyperfund. In this post, I will examine new opportunities for seed and early stage venture fund managers and angel investors as a result of these changes, and then briefly look at what the changes might mean for entrepreneurs.

For Fund Managers:

If you can't beat 'em, join 'em: AngelList and other sites are still getting to critical mass, and that creates an opportunity for first mover advantage. Fund managers who decide to allocate some of their existing capital to investing through an online platform can form a syndicate and be one of only a dozen or so large and credible lead investors. The large size and investor-friendly terms of the syndicate (as well as the dearth of current competition) create an opportunity to become entrenched as one of the big, early players on an online platform, enabling the fund to attract third party angel investors as syndicate members (yielding additional carried interest for the fund managers). Over time, and provided the platform continues to grow, this status could be increasingly significant.

A variation on join 'em: If current or would-be fund managers don't have an active fund, they can raise capital from investors for the express purpose of creating an online platform investment syndicate. A fund of say $5 million with a strategy of investing in deals alongside high-profile online investors like Foundry Group, Kevin Rose, Naval Ravikant or Jason Calacanis can be a fairly attractive opportunity for prospective fund investors. Though a lower management fee (maybe 0-1% instead of 2%) and carried interest (maybe 5-10% rather than 20%) is expected, the fund manager also receives an additional 5% to 20% carried interest from any third party investors who decide to join the online investment syndicate. That makes it a pretty compelling alternative to option 1.

If a fund manager elects to continue to operate a fund exclusively offline, I suspect that it will eventually need to go either downstream (to later stage deals) or upstream (to even earlier stage deals). Next let's examine those two options.

Go downstream: I believe the best strategy for this approach is for a fund manager to build relationships and align with some of the stronger online investment syndicates. Then, when a syndicate's most promising portfolio companies are in need of follow-on funding in excess of what they can provide or more than can be raised through online platforms, the fund manager performs diligence on the companies and invests in the ones it finds most attractive. Put another way, the approach here would be for a traditional fund to position itself to see the best online investment platform 'graduates' and have the opportunity to invest in them.

Go upstream: The final opportunity is a bit harder to detail because there are likely multiple approaches. The strategy I lean toward is sort of a hybrid between a seed fund and an incubator, where a fund invests in smart individuals or small teams (rather than established companies) and provides them with resources (developers, designers, marketing staff, legal, pre-sales staff, etc.) to help them rapidly iterate a handful of ideas and determine if any are viable. It seems plausible that a fund could finance several individuals or teams at a time and provide them with a shared pool of resources to test ideas and determine if it makes sense to launch businesses. After some appropriate period of time, the teams either graduate from the incubator and start a company or simply leave the program if they are unable to get traction on a concept.

In exchange for the office space, resources and potentially some sort of financial stipend, the seed fund/incubator receives equity in any businesses that emanate from the vehicle, as well as (possibly) an option to participate in a subsequent round of financing.

This approach is attractive because it serves a low cost and extremely early stage market niche—helping founders build a business from just an idea up to the point where it has established sufficient proof of concept and market traction to raise a traditional seed round. This benefits investors because they get into companies founded by top-notch entrepreneurs at very low valuations, and benefits founders because they can quickly and inexpensively test ideas and leverage a shared resource pool to accelerate development.

For Startups & Founders:

I think the long-term impact of these changes on entrepreneurs raising funds will be to level the playing field geographically and to increase transparency.

Companies founded outside Silicon Valley, NYC or Boston will be able to raise capital on the platforms listed above on the basis of their ideas, teams, metrics, progress and other relevant factors rather than their proximity to investors. Furthermore, they will receive fair market value relative to the industry as a whole rather than their geographic market. Online syndicate lead investors are also likely to be more experienced and sophisticated, since attracting follow-on investors typically requires a demonstrable track record. The downsides will be increased competition for capital and (potentially) less hands-on involvement and mentorship from investors outside the area.

Another area where online fundraising may impact founders is the growing use of algorithms to evaluate and screen investment opportunities for investors based on data related to the team's background, customer acquisition and web traffic metrics, market size and more.. Highly regarded funds like early stage investor Correlation Ventures and later stage firm OpenView Venture Partners already use algorithms to help make investment decisions. And a young San Francisco company called MatterMark uses algorithms to stack rank and benchmark startups as a tool for investors. Increased online investing may result in expanded adoption of algorithms to screen (if not select outright) investment opportunities, which would reinforce the importance of metrics for early stage companies.

Whether removing some of the emotional and human aspect of investing will ultimately be a positive remains to be seen, but it stands to reason that doing so should reduce selection bias and perhaps result in increased opportunities for companies and founders that don't fit the traditional mold but are still performing well.

Finally, it will be interesting to see if incubators similar to the description above emerge and breed specialist communities of companies over the long term (i.e. spin out niche clusters of mobile, fin-tech, hardware, cleantech, consumer, B2B, etc. companies). This could help regions become known for certain niches and attract top industry talent to start these types of businesses.

As with my prior post, I recognize not everyone will agree with these ideas, but I hope to foster a worthwhile discussion about the opportunities new funding mechanisms provide. I welcome any feedback or thoughts.