Pascal-Emmanuel Gobry | Nov. 2, 2011, 2:50 PM
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Image: Bloomberg BusinessWeek
There are lots of trends people have been talking about in tech financing–“superangels”; delayed IPOs; secondary market sales; and more.
But so far, few people have been putting the dots together: the entire financing landscape for companies is changing.
And, excitingly, it’s increasingly not just technology companies.
There are many new financing options for growing companies that weren’t available a decade ago.
Here’s how we break them down (we’ll visit each one in turn):
- Late-stage private equity
- The long-delayed IPO
Projects funded by Kickstarter (click to enlarge)
Image: Bloomberg BusinessWeek
Crowdfunding startups has long been a dream deferred. But it’s finally happening.
Direct crowdfunding via equity financing is still a big no-no, because SEC rules make it difficult for non-accredited investors to invest in startups. But exciting things are going on.
One of the most exciting such examples is AngelList, a “Match.com for investors and startups” that lets startups vie for capital from angels and (increasingly) VC firms. AngelList has seen torrid growth on the back of rising early-stage valuations in Silicon Valley. And it has also been expanding horizontally and geographically.
There are non-tech companies listed on AngelList, along with companies from around the world. AngelList is not technically crowdfunding–it just makes it easier for startups to get accredited investors’ attention and get funding–but it is certainly an early step in that direction. (We interviewed AngelList co-founder Naval Ravikant here.)
Another exciting example is Kickstarter. Kickstarter is a startup that helps creatives of any kind raise funding for entrepreneurial projects. Entrepreneurs on Kickstarter don’t sell equity in their companies–they basically seek donations or pre-payments for perks. So, if you want to self-publish a book, you might set a target goal of $10,000, promise an autographed special edition to those who pledge $100, a regular special edition for those who pledge $50 and a regular book for those who pledge $20. Once the number of pledges hits your goal, people’s credit cards are charged and off you go. Kickstarter helped raise $8.8 million for entrepreneurs in September and is fast-growing, with many projects exceeding their goals as the great infographic above from Bloomberg BusinessWeek shows (click to enlarge).
Image: Social Lending Network
Another model is peer-to-peer lending marketplaces like Lending Club. These marketplaces appeal to both lenders and investors.
By aggregating loans, they can at least in theory offer better terms to both sides, and manage risk better through data. Right now Lending Club doesn’t offer loans directly to businesses,. But it helps businesses get started, the way many entrepreneurs’ first business angels were Visa and MasterCard.
More importantly, it’s the future of the model that is interesting. The internet can broaden and deepen marketplaces for debt in a much more efficient way. If the SEC doesn’t quash it (it already shut down Lending Club for a while), it’s not a stretch to imagine a small business owner with several quarters of cashflows and financials logging on to a website, filling out a form, and offering bonds at an appropriate interest rate into a marketplace.
Crowdfunding can mesh with new forms of financing that offer an interesting risk/reward profile relative to equity or debt, such as revenue-based lending, where money is loaned against a percentage of a business’s revenues.
AngelList, Kickstarter, peer-to-peer lending… It’s not quite equity-based crowd-funding, but we’ve come a long way from “friends, family and fools.”
Companies graduating from each Y Combinator class
Image: Business Insider Research
These accelerators coach startups for a short period in exchange for a small slice of equity and then introduce them to investors who might invest.
The model has been criticized as being the reincarnation of the infamous “incubators” of the dot-com bubble, but this time around the model is sustainable, because of the radically new capital efficiency of web businesses.
But it’s possible that this model could be expanded to other areas or models. Various forms of incubators, after all, fill a real need for entrepreneurs, especially inexperienced ones, from office space to mentorship. And the web is making startup costs cheaper for all kinds of businesses, not just online-only businesses, especially in a Kickstarter-Lending Club world.
These accelerators have tremendous demand: they typically admit around 1% of applicants (“More selective than Harvard or Yale!”) and raise six if not seven figure amounts right out of the gate (even though Y Combinator and TechStars technically invest only 5 figure amounts, both are accompanied by funds that grant 6 figure amounts to every inductee, before the companies raise any money on their own).
To be sure, the excitement around these is driven at least in part by the broader excitement around early stage startups, which is described as everything from “frothy” to “a bubble.” But, at least in tech, the accelerator model is sustainable, and it’s not as unlikely as many people think that it could expand beyond tech, as services like AngelList have.
Super-Angels now taking place of early-stage VC
Only part of the story
Image: Business Insider Research
For a while, the conventional wisdom on venture capital was fairly straightforward: because of the dotcom bubble, VCs had grown too fat and raised too much money. This wasn’t apparent because funds are typically raised for 10 years, but now was the time of reckoning, when VCs would start dropping like flies and even the top of the industry would have to slim down.
Then, two funny things happened:
- Plenty of small funds ($20-$50 million) started popping up, in Silicon Valley and elsewhere;
- Some funds have taken to raising huge funds, sometimes in the billions of dollars.
What’s going on?
VC is not just slimming down (though it is, as the chart above shows), it is completely reconfiguring.
On the side of the small VC funds (the so-called “superangels”), they are largely happening for two reasons:
- Web businesses are incredibly capital efficient and so smaller fund sizes make sense (the demand side);
- Through sheer math, smaller funds have a better time delivering ROI to their investors (the supply side).
On the side of the mega funds, here’s what’s going on: there is a “flight to quality” for LPs (Limited Partners, the institutional investors who invest in venture firms) who have gotten battered by low VC returns over the past decade (not just in tech–biotech and cleantech have been disappointments as well). Even though they are cutting their allocation for venture firms overall, that’s still a very large pie, and more of that remaining pie is going to the very top funds.
So instead of getting a VC industry that looks much the same except a lot smaller, we’re getting a VC industry that’s smaller but also very different, with a bunch of very small funds on one hand, and a handful of very, very large funds on the other hand.
For companies, this means that there is much more of a continuum from the very early stage through to the pre-IPO stage. But even the pre-IPO stage is changing, because the IPO is much later. We call this the cash-rich adolescence.
New Late-Stage Private Equity Takes Place Of IPO
VC funds at the top of the pile aren’t just getting bigger. They’re changing the way they invest.
Several things are going on:
- Companies are putting off their IPOs, which has led to
- A new kind of late-stage venture investing, and
- The rise of secondary private markets; and meanwhile,
- Investing in more mature private companies is generally getting more efficient thanks to the internet.
First, let’s look at how late-stage investing has changed. Plenty of companies are doing what was once referred to as “DST Deals” after a spate of such investments by Digital Sky Technologies in companies like Facebook, Zynga and Groupon. The reason why they’re not referred to as “DST Deals” anymore is, tellingly, because they’ve simply because they’ve become the standard for late-stage venture deals.
These deals typically have the following characteristics:
- High valuations (so far) that make pundits howl with fury;
- Very limited control, with typically no board seats, or observer (i.e., non-voting) seats;
- Liquidity for company insiders, not just the company itself.
An under discussed feature of these deals is that the liquidity is often provided on an ongoing basis, with the investor first buying up a chunk of company stock, and then buying stock on an ongoing basis from company insiders.
These investments therefore have all the upsides of IPOs in terms of capital raising, dilution, control and liquidity, without the downsides of regulatory compliance costs and unwanted transparency.
This is a new way of doing business for VCs, who typically crave control and traditionally wanted to keep founders “hungry” and therefore cash-poor.
This means that megafunds are basically turning into hedge funds. We mean that in a totally non-pejorative way: there’s nothing wrong with being a hedge fund. But they’re not behaving like buyout firms, who use leverage and typically exercise control over companies, and not really like VCs anymore. In fact, some hedge funds like Tiger Global are very active in funding private technology companies. The lines are blurring all over the place.
This has also led to the rise of secondary markets.
Let’s get the downsides out of the way first. These markets are unregulated, with no transparency. Investors are buying stock without knowing the company’s financials or much of anything beyond press reports. There have been reports of “boiler room”-type brokers peddling stock into the hot startup du jour to non-expert “accredited” investors like dentists and lawyers. Once a hot tech company goes public at a lower valuation than its “private” valuation and regular folks get hammered (and it will surely happen), there will be a regulatory reckoning, and it won’t be pretty.
All that being said… Secondary markets are here to stay. The opportunity is real. As companies stay private longer, and some may opt to stay private forever, and as the IPO window narrows ever further, the necessity of secondary markets for private company shares is real.
What’s more, this isn’t just a tech phenomenon. Because of the huge interest in these companies, SecondMarket trades heavily in companies like Facebook and Groupon, but many other companies are listed there, from Bloomberg to Cargill to Burger King.
In fact, secondary markets are only a smaller part of a broader phenomenon: internet-based platforms making private investing more efficient.
Companies like CapLinked, AxialMarket and MergerID provide platforms for all sorts of private transactions, from middle-market M&A to real estate transactions to asset sales.
CapLinked describes itself as “LinkedIn meets Salesforce.com for private investing”; buyers and sellers can set up profiles and connect, and then use tools such as virtual deal and data rooms to facilitate transactions.
These tools are recently-launched and it remains to be seen how much of an impact they will have, but the opportunity is clear: make private financial transactions for mature companies more efficient and broader thanks to the internet.
All of this works out to the cash-rich adolescence of many businesses. They have many, many more sources of funding available between traditional VC and IPO.
A few of them have even gone public. And others will.
Today’s IPO are happening much later
Everyone who has been involved in high-growth businesses has been fretting for the past decade for the return of the “IPO window.” When will it finally become easy again for companies to go public?
Overregulation has certainly played a role. Compliance costs are high, running in the millions or tens of millions of dollars.
Markets have been very volatile over the past year. Events like the debt-ceiling fight in the US and the meltdown of Greece, like butterflies causing hurricanes, threw a spanner into companies like Groupon and Zynga.
More deeply, even if if was easy, many entrepreneurs don’t much want to go public.They complain of enforced transparency and fear being shoved around by short-term-focused Wall Street.
And yet… And yet, some day the IPO will come.
LinkedIn stock price up to and including its IPO (it’s gone down since then)
Some day the IPO will come for two simple reasons:
- The new breed of web companies are real businesses with real revenues and sustainable margins;
- Most of those companies have taken institutional money and so HAVE to go public some day to give their investors an exit; conceivably some of them could figure out other ways to stay private, and some have speculated that Facebook CEO Mark Zuckerberg would like that, but for most of them, it’s only a matter of time until they do go public.
The LinkedIn IPO was hailed as a “new Netscape”: a big IPO that opened the floodgates for many more tech IPOs and buoyant markets for tech companies. Market gyrations decided otherwise, but it was certainly a trial run. One day there will be a real “new Netscape”, followed by a wave of IPOs.
THE BOTTOM LINE
The bottom line is the way companies are getting financed is changing completely, from start to finish. Crowdfunding and accelerators are helping companies get off the ground; the new VC helps them grow up; new institutions and services provide for a cash-rich adolescence, and some day (soon, perhaps), they will get a huge IPO pay day.
We’ve summarized the new funding chain in the graphic below (click to enlarge):