Venture Populist

Forbes magazine recently decried the gambling mentality of the VC industry by likening it to “a lottery system where few make unbelievable fortunes while the rest lose someone else’s fortune”.  If angel investors hope to avoid the same fate, they should strive to invest their capital (and negotiate their term sheets) in a manner that creates the opportunity for a greater range of investment outcomes than otherwise experienced by their VC counterparts.  

It is true that the VC business model accepts the notion that the majority of their investments will lose money.  The VC gamble is that a small slice of their portfolios will produce high-multiple, 20x or greater returns.  

But, most angel investors do not have the capacity to go wide enough in their personal portfolios to emulate the VC spray-and-pray model. They cannot afford to gamble. That’s a good thing because, as the VC industry has learned over the past decade, investing in pursuit of lottery-like, all-or-nothing outcomes is simply not a sustainable business model…even when the gamble is with other people’s money.

Individual investors in early-stage private ventures need to embrace unique investment terms and financing structures that increase the prospects for positive outcomes, as well as, a wider range of outcomes that include single-digit multiple returns.

In a prior post I identified an early-stage investment term sheet provision (a private investment “put option”) that provides the angel investor with the option of securing the return of the initial private investment capital and the accrued dividend if the portfolio company achieves certain pre-determined milestones. Executing such an option has a profound impact on the IRR of an angel investment and I now consider such put options to be a requisite term for most pre-revenue venture investments.

In addition to increasing the variety of exits, angels owe it to themselves to decrease the elapsed time to the exits in their investments by being creative and open to alternative financing terms and mechanisms. Recently, in addition to put options, I have been taking heed of “royalty-based financing” venture investment opportunities—the process of lending against a company’s future revenue stream, as another option to increase the optionality of positive outcomes.

A royalty-based financing (frequently referred to as a “revenue loan”) is essentially debt financing collateralized by a company’s IP, or other assets, and secured against future revenues. The investor’s note is repaid beginning at a certain date in time (often 6-12 months out) on a monthly basis at pre-negotiated percentage of the company’s gross revenues, until the investor has received somewhere in the pre-determined range of two to five times the initial investment back.

Entrepreneurs are generally favorably disposed towards royalty-based financings because they are viewed as non-dilutive to founders…relative to a more traditional equity financing round. Moreover, the financing is obtained without having to agree to a valuation, leaves management in control of the company and typically requires no personal guarantees from management.

Royalty-based financings can be an effective bridge to profitability for companies that have already brought a high-margin product to market and are seeking to expand their distribution.   Although the company incurs an additional operating expense, it is less onerous than debt because the monthly cost is variable to revenues. The company factors the negotiated variable cost into its revenue model to insure that the agreed upon monthly percentage of gross revenues payment to the note holder is at a rate that provides for sufficient operating capital.

There are also applications of the royalty-based revenue model that can be adopted by angels with respect to seed-stage venture financings. The advantage is that the angel investor enjoys a greater certainty of return of principal and a compelling return on investment, as IRRs generally run greater than 30%.

For the angel and early-stage investor these return scenarios are highly attractive. A repayment of principal that takes your risk off the table, monthly cash flows, a compelling return on investment and, additional skin-in-the-game in the form of an equity kicker

Despite the appeal, royalty-based financings (RBF) are infrequently used and represent, at best, a negligible fraction of the funding to early-stage companies. That’s partly because the survival of the VC business model is predicated upon occasional high-multiple exits. For large VC funds to have any chance of posting double-digit IRRs for their LPs they have to swing for the fences to have any chance of overcoming a 2% management fee compounded over 10 years and a 25% carry. The math just doesn’t work. It’s ironic that a financing approach that caps potential returns at 30-40% IRRs does not work for VCs, but that is indeed the case. VCs are a victim of their own business model.

The real rub here for VCs is that they have reduced their potential investment outcomes. Despite the high IRRs, 3-5X returns don’t cut it for VCs because they don’t make up for the losers. The unfortunate consequence of their LP model requires that their portfolios pursue decidedly binary outcomes composed of a vast majority of “walking-dead” and write-offs with (hopefully) a handful of home runs. It is one of the reasons we so often hear that the VC model is “broken” and VC fund returns have fallen precipitously.

Angels and their advisors should not be emulating the VC model. Rather, they should eschew VCs tired template term sheets and embrace the concept of optionality — enabling a wider variety of positive (and asymmetric) exits and investment outcomes.

Album:   The Angel and the Gambler, Iron Maiden, 1998

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In the State of the Union address earlier this year, President Obama acknowledged that “the true engine of job creation in this country will always be America’s businesses” and, that to spur the economy and job creation “we should start where most new jobs do – in small businesses” prior to declaring that we should “eliminate all capital gains taxes on small business investment”.

The result of this effervescent yet evanescent evangelism? Our lawmakers deliberated and subsequently concocted a legislative scheme to incentive private investment and job creation—that lasted all of 100 days!

That’s right. On September 27, of this year Obama signed into law the Small Business Jobs Act (H.R. 5297), which included among other provisions, a 100% exemption (subject to certain issuer limitations) of income from capital gains derived from investments in “qualified small business stock”. The 100% exclusion is an attempt to encourage investment in startups, early-stage companies and small businesses.

Blink and you would have missed it. The exemption expires on January 1, 2011, coincident with the expiration of the “Bush Tax Cuts” which raises capital gains tax rates at the highest bracket from 15% to 20%.

A critical (albeit secondary) purpose of tax policy is to encourage behavior that is deemed to be beneficial to the public interest. In this instance, our politicians pandered policy to promote employment and private investment. But, such that most private investors take at least 100 days to evaluate an opportunity, there was no way that this important revision in tax policy had the sufficient runway to effect any material changes in investor behavior. It was not actionable tax policy.

Few angel investors that I have spoken with were even aware of the exemption…and not a single offering out of a couple of dozen that I evaluated during this period pointed out the perk.  I wouldn’t be surprised if the legislative costs of negotiating and implementing this fleeting folly far exceeded any illusory benefits.

Policy penchants and partisan politics aside, politicians have extolled upon the virtues of no taxes on capital gains for the past 50 years. Prior to his tax cuts, President John Kennedy accurately asserted that “the tax on capital gains directly affects investment decisions, the mobility and the flow of risk capital…the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential for growth in the economy.”

Most of our pols know intuitively that small business is the primary and most reliable engine of job creation. Irrefutably, two-thirds of net new jobs are created by companies with fewer than 500 employees.

This past August, a research study entitled, “Who Creates Jobs? Small vs. Large vs. Young” further clarified that there is more to the equation than merely size. “Business startups contribute substantially to both gross and net job creation,” says John Haltiwanger, who co-authored the study along with the two economist from the Census Bureau, but, “it’s all age – startups are where the job creation really occurs.” Most job creation occurs in the early years of new companies.

Yet, government “stimulus” programs spend more resources attempting to promote bank lending (more of a benefit to existing business) than spurring private investment in risk-taking and entrepreneurialism.

Tactically, our tax policies need to do more today (and certainly beyond this coming January 1^st) to incentivize angels investors to fund early-stage ventures than presently contemplated by our legislative class. Strategically, our restrictive tax policies put us at distinct disadvantages to industrialized countries such as Austria, Belgium, Germany, Mexico, New Zealand and others than have no taxes on capital gains, as well as, countries that do not impose capital gains on stocks such as Israel, Spain, China, Hong Kong, Singapore and most of the other Asian countries.

To its credit, Obama’s Small Business Jobs Act provided investors considering a qualifying venture investment with a significant opportunity as the result of the full 100% capital gains tax moratorium which also excluded 100% of the capital gains from alternative minimum tax (AMT) considerations.

Alas, the three-month window was unconscionable. Moreover, the act included such archaic prescriptions as; a five-year minimum required holding period, requirements that the business be a C-corporation, a greater of 10X or $10M cap, and, unnecessarily excluded certain labor-needy business categories such as hotels and restaurants.

In short, thos disappearing Jobs Act mirrored the myriad of misinformed, ill-conceived and insincere tax policy prescriptions of prior administrations.

But it may get even worse. Last week Obama’s bipartisan deficit commission released draft recommendations on a host of third-rail political issues including entitlement, discretionary and defense spending cuts and a variety of comprehensive tax simplifications and reforms. With lack of respect to capital gains, they would be taxed as ordinary income under each of the Bowles-Simpson reform scenarios. Since the rate is currently at 15 percent, that implies a doubling depending on the plan.

I have never angst over the notion of politicians breeding due to their inability to bifurcate the baby and the bathwater.

Tax policy must be designed to promote private investment in startups, stimulate job creation and the economy in a manner that is meaningful and immutable to the estimated 225,000 angel investors. I would concur with New York Times columnist Thomas Friedman’s recent proclamation that “we need three things: start-ups, start-ups and more start-ups,” and, that tax policy should incentivize “our best minds to be able to make a killing from starting new companies rather than going to Wall Street and making a killing by betting against existing companies.”

During the economic downturn in the mid-1990s entrepreneurs created 3.8 million new jobs. If the genuine intent of tax policy is promote entrepreneurship and to encourage more risk-taking by private investors there should be a bipartisan consensus among politicians to eschew slippery slope suspicions and disingenuous diatribes that such targeted capital gains tax reform only reward the “wealthy”.

It is time to get down to small business. Venture Populist proposes specific and targeted tax reform such that;

• There would be no capital gains taxes on investments in startup or pre-revenue companies – to encourage more early-stage private investment.

• Shares of common stock issued to founders and key employees of early-stage companies should be exempt from capital gains taxation – to reward entrepreneurs for their risk-taking and create the currency (stock options) that would encourage entrepreneurial activity.

• Investors that contribute the first $5 million of equity financing to any new company should get a dollar-for-dollar tax deduction for the year the investment was made – that critical first $5 million is the hardest for any new company to raise. Risk-taking, venture-enabling job-creators should be encouraged and rewarded at the point of investment as opposed to a tax break many years down the road if the company monetizes.

• Assuming appropriate disclosure of all of the risks entailed, any investor regardless of their income should be eligible to invest in private ventures – yet our current  securities laws are about to become more restrictive as a result of former Senator Chris Dodd’s discriminatory deal. The asymmetric investment return opportunities of private venture investment and these preferential tax incentives should not be available exclusively to “accredited investors”.

And finally, it is time for both parties to refrain from further legislative lipservice. For these policies to be effective in stimulating sustainable job creation they need to be enacted permanently so that entrepreneurship is embraced by the best and the brightest and that private investment and risk-taking is rewarded without threat of uncertainty or reversal.

Album:   Lipservice, Gotthard, 2005

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