The availability of risk capital for early-stage ventures has proven itself to be remarkably resilient. It has overcome the cycles and uncertainties of our economy, as well as, the myopic tax policies perpetuated by our partisan politics. But I foresee a fresh challenge to the startup ecosystem on the horizon—and it is the direct result of bad brokers, disingenuous dealers, unprincipled promoters and iniquitous issuers.

The “bad actors” (to incite regulatory jargon) that I am referring to are the fraudsters who make confidence a career by peddling perilous product to unwitting investors of all sizes and sophistication. More often than not, they camouflage their chicanery under the cover of Regulation D.

Reg D provides for some companies to offer and sell their securities without having to register the securities with the SEC enabling access to the capital markets for small companies that could not otherwise bear the costs of SEC registration as would be otherwise mandated under the Securities Act of 1933.

Reg D is a success story that began when the SEC created the exemption in 1982 with the intent of simplifying capital-raising for small business owners to launch or expand their ventures. Subsequently, the provision has enabled literally hundreds of thousands of new ventures. Businesses ranging from neighborhood taverns in urban alleys to nascent technologies in Silicon Valley have relied upon Reg D to quickly, cheaply and efficiently secure financing.

But, private placements offered under Reg D have likewise endured a checkered history beginning with the Prudential Securites Inc. offering that devoured $1.4 billion from 100,000 investors back in the late 1980s. That was only the beginning as more recent abuses include;

• Stanford International Bank–for running a “massive Ponzi scheme” and offering phony CD’s via private placement deals totaling $2.7 billion.
• Provident Royalties, LLC—fraud and Ponzi scheme related to $485 million in oil and gas limited partnerships.
• Medical Capital Holdings Inc.—fraud accounting for an estimated $1.2 billion in investor losses from the sale of private securities in the form of notes on medical receivables.
• DBSI Inc—charged this past December with promoting a $600 million Ponzi scheme related to the sale of fraudulent tenants-in-common real estate exchange products.

Each of these private placement pilferings were conducted under the cover of Reg D in the virtual absence of gatekeeper protection or regulatory oversight. Regulators and lawmakers are rightly concerned, particularly with the private placements of limited partnerships that have been capitalized by offerings to “accredited” individual investors through independent broker-dealers that reap commissions as high 10%.

Though initially intended to enable entrepreneurship and small business financings—the legitimate users of Reg D have been eclipsed by the scamsters. The deals have become gateways to multi-million paydays for issuers, dealers and brokers.

“Fraudsters are primordial creatures who live in their own lawless existence,” says Neal H. Levin of Freeborn & Peters in Chicago, whose practice is committed exclusively to busting fraudsters and recovering assets.  “To a fraudster, it’s kill or be killed and they will use whatever tools are available to them in order to conquer.  Reg D has certainly proven to be one such tool.”

Considering the responsibility of lawmakers to protect unwary investors form unscrupulous promoters and the readiness for regulators to expand their regimes—private investments that claim to be exempt from SEC registration are a torrid topic these days.

There were 11,000 Reg D deals filed in 1996, but that number has swelled to a reported 26,485 in 2009 when estimated offerings exceeded $609 billion. Regulators are ill-equipped and lacking the proper resources to evaluate the thousands of oil and gas ventures and real estate partnerships that file under Reg D each year.

“Investors have been exposed to far more risk in private placement offerings than Congress could have imagined”, according to Denise Crawford, president of the North American Securities Administrators Association, adding “Reg D offerings receive virtually no regulatory pre-screening at any level of government.” Not surprisingly, Crawford and many others have been lobbying for a rollback of the federal statues in an effort to return the pre-empted authority back into the hands of the state regulators. In turn, they hope to close the oversight gap that Ponzi scheme operators tend to gravitate towards to engage in their duplicitous dealings.

Good luck with that. Investors certainly deserve better protection from fraudsters, but whether or not our budget, brain matter and bandwidth-strapped regulators have the resources to capably clean out the commode is a topic for another column.

The Investment News Fraud Charge Tracker presently lists 60 securities and ponzi frauds which account for $9.4 billion in bilkings, most of which were executed as private placements under Reg D. Of these 60 frauds, 20 of them (one-third) resulted in investor losses which exceed $50 million, yet these larger frauds accounted for $8.9 billion (95%) of the total losses tracked.

Clearly, more effective oversight is desperately needed to protect investors from the multi-million dollar private placement scams—so why not start at $50M?

My fear is that the sincere interest and obvious need to protect investors from these menacing mountebanks will give rise to regulatory overreach…that the earnest interest to reduce the oversight gaps that fraudsters freely operate in will inadvertently impair the ability of small businesses to finance their ventures. It almost occurred last year when former Senator and Banking Committee Chair Chris Dodd’s discriminatory dealings nearly gutted Reg D—which would have most certainly produced the unintended baby-bathwater consequence of stymieing the startups that depend upon the provision to provide efficient access to risk capital.

There is no evidence to suggest that the typical $1-10 million startup or small business financing facilitated by Reg D is a forum for fraud. In a letter to Dodd last March, the Angel Capital Association noted “The angel investment arena has been virtually complaint-free in terms of fraud. Accredited angel investors make their own decisions to invest directly into small businesses, without securities dealers or investment advisors.” That point needs to resonate with our lawmakers who tend to be notoriously nescient with respect to nuance—particularly when there are headlines to be made.

My proposal is simple. Any fund, limited partnership or series of funds that solicit investments from individual investors and subsequently collect north of $50 million from investors should be required to register as private fund advisors. Such a requirement would reduce oversight gaps and provide regulators at the state and federal level with the transparency required to identify potential pockets of individual investor’s capital at risk.

If there is a compelling case as to why limited partnerships that solicit hundreds of millions of dollars from individual investors should be exempt from oversight—I have certainly never heard it.

But, leave Reg D alone with respect to early-stage ventures. Private investment is the sine qua non of startups and small businesses. In light of current economic and employment woes, our politicians need to stop paying lipservice to the needs of small business and by avoiding unnecessary regulations that restrict capital to entrepreneurs.

Debut Album:   Them Crooked Vultures, Them Crooked Vultures, 2009

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

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

Since 2002, I have been writing a monthly column on the alternative investments for Investment Advisor magazine. A couple of years ago we renamed the column Venture Populist and focused exclusively on issues the issues confronting family offices and angel investors that make direct investments in startups and early-stage private ventures.

The column generates frequent inquiries from wealth managers as to what alternative asset classes or investment strategies may provide portfolios with risk-return characteristics that are comparable to the attractive asymmetric return profile of private venture investment (PVI). The queries acknowledge that PVI is a compelling asset class, as well as, game-changing value-proposition and differentiator for their advisory firm. Yet, despite their interest, these advisors lack the access to deal flow, due diligence skills, regulatory latitude, HNW client base, or, simply the compulsory cojones to actually allocate their client capital to private ventures.

Often these advisors have embraced the progressive precepts of Hybrid Portfolio Theory yet require more accessible investment products than direct investments in private ventures to populate Portfolio B—the 15-30% of the alpha-producing portion of the portfolio that seeks positive asymmetric investment outcomes.

So, for a number of practical reasons, some wealth managers and investors searching for a substitute asset class with the same positively skewed return characteristics of PVI, but with greater accessibility and liquidity. Many investors simply do not have the investment horizon required to successfully harvest venture investments. These investors seek liquidity—not lockups.

I have always maintained that specialized managed futures, distressed, deep-value securities and out-of-the-money option strategies have the asymmetric return profiles that are required to fulfill Portfolio B’s mandate. But for many investors and advisors, these aforementioned strategies are as arcane, elusive and illiquid as investing in PVI.

Fortunately, there appears to be more accessible alternative to PVI for investors lacking leptokurtosis in their portfolios—the universe of less liquid and smaller cap publicly-traded U.S stocks.

Recent relevant research and return data indicate that there is a seemingly significant semblance between the returns of venture capital and those of less liquid, publicly-traded, small company stocks.

In 2004, John Cochrane, finance professor at Chicago Booth School of Business published The Risk and Return of Venture Capital which examined whether individual investments in venture capital projects “behave the same way as publicly-traded securities”, and which kind of securities they may resemble.

Compiling data from the 16,613 financing rounds of 7765 private companies over a 13-year period Cochrane observed similar volatilities and alphas between venture capital returns and the smallest Nasdaq stocks and concluded that “thinly-traded Nasdaq…small stock portfolios are natural candidates for a performance attribution of venture capital investments.”

More recently, the pioneering investment industry academic Roger Ibbotson got a little more granular by re-introducing his working paper Liquidity as an Investment Style which he initially co-authored with Zhiwu Chen in 2007. The work is important to adopters of Hybrid Portfolio Theory as it more narrowly defines a potential substitute for private venture investments by articulating the phenomenon of the “Illiquidity Premium”.

From 1972 to 2009, Ibbotson studied the returns of 3500 publicly-traded U.S. stocks in the context of their relative liquidity (defined by annual trading volume divided by total shares outstanding). The surprising results were that liquidity (as an investment style) was a far more effective predictor of returns than the conventional Fama-French factors. Specifically, the equities that produced the best returns during the period were the less liquid small-caps that attract distinctively less trading interest. These companies generated a remarkable 17.87% annual return over the four decades studied.

In contrast, the most liquid (and most widely held) growth stocks performed miserably at 3.3% — below the risk-free rate. The apparent performance attribution is due to the premium that most market participants are willing to pay for the most liquid securities—which, in turn, has the unintended but discernable consequences of reducing their returns.

So, the relative liquidity of a security, according to Ibbotson’s research, actually reduces its return.

Venture investors have always acknowledged the existence of an illiquidity premium and concede that they are swapping liquidity for the potential of significantly greater upside. The historical returns of the venture capital asset class prove this out. But this quantification of the role of illiquidity as a risk factor, with a risk premium, is most illuminating.

“There is a clear pattern of decreasing returns as the liquidity of stocks increase”, cites Ibbotson. There is indeed an excess return attributable to less liquid stocks and “the less liquid stocks are not necessarily more risky. Measured by standard deviation, risk seems to increase with liquidity.”

Ibbotson himself likens liquidity as an investment style to private investment such as venture capital, commenting that private securities are most appropriate for investor’s seeking even higher returns that have the luxury of longer investment horizons.

But the illustrated fact that “the illiquidity premium is positive and substantial with publicly-traded securities” offers an “Ah-Hah” moment for advisors seeking a complimentary asset class or substitute for allocations to private venture investment.

Food for thought.

Album:   Food for Thought Substitute, Heaven’s Cry, 1997

Last month I spoke on a venture capital panel at an alternative investment conference in Chicago. As the former head of alternative strategies for a well known investment management firm, I saw many old friends and familiar faces among the family offices, wealth managers and investment firms that were attendees and exhibitors.

I also picked up on a chilling consensus that was apparent among the conference attendees…that the individual investor that has been fleeing from the public equities markets for months now, is not expected to return anytime soon. They are frozen…stunned, like the “ex-parrot” in the Monty Python sketch.

Beyond this sallow assessment, these investment pros were not particularly optimistic about the near-term. Wealth managers and investment advisors are hardly the beneficiary of todays investor’s prevailing distrust of Wall Street. Among all investor types, from retirees to HNW, money is rapidly flowing out of equities in favor of bonds and cash.

Today, the key asset management industry metric of AUM (assets under management) more aptly refers to assets under mattresses. Investors have lost faith in the integrity, as well as, the opportunity of the public equities market.

The advisors I spoke with were not prescient…merely perceptive. The evidence is hard to ignore. A recent CNBC/AP poll cited widespread investor distrust of the stock market with 61% of investors declaring that the market’s recent volatility has made them skeptical about participating in the market.

The radical shift in stock market investor confidence has resulted in a net $250 billion outflow from stock mutual funds since January 2008, according to the ICI, $48 billion in the past four months alone. Perhaps under different a different economic scenario the recent 21 consecutive weeks of persistent equity outflows would be a contrarian indicator, but Citibank’s own Robert Buckland cites these menacing metrics as support for his theses foreseeing trillions of additional dollars in outflows to follow and summarily declaring the “Equity Cult” to be DOA.

Some of these credible voices are even stronger. For example, sports mogul, billionaire investor and modesty magnate Mark Cuban initially declared that the “Stock Market is for Suckers” back in January 2006. He has frequently revisited and reiterated his meme on his Blog Maverick site since. Cuban recently called out the conventional wish-dom of Buy & Hold to be “the second most misleading marketing slogan ever, after the brilliant rinse and repeat message on every shampoo bottle”.

I guess that’s why the mutual fund company swag has been such slim pickings at investment conferences lately. There probably is not a lot of interest in those tired old laminated Ibbotson “Stocks, Bonds, Bills” charts anymore.

The stock market has become inhospitable to the individual investor. It has gone absolutely nowhere in the past ten years and investors have no returns (rather, for the most part…losses) to point to for the risk that they have assumed.

Nothing seems to work. Forget about investing in an individual company’s security based upon its specific fundamentals and outlook. The price movements of individual securities are now dictated by larger global macro themes such as the economy, interest rates, currencies, commodities and geopolitical considerations. Individual stocks are no longer priced on their own fundamentals. Hedge funds, index funds and speculators drive price action.

Adding to the investor’s frustration is the fallibility and futility of popular, traditional and even alternative approaches to extracting returns from the stock market. Buy-and-hold, day-trading, Modern Portfolio Theory, diversification, sector rotation and even the majority of alternative and absolute return strategies have come up short.

After 10 years of high volatility but no net return, two 50% bear markets and the May 6th flash crash (apparently was the result of one massive computer-triggered sell order)…they majority of investors have it figured out. Mass exodus time. They are pulling out of the equity markets in droves.

But, I did not get the sense that the majority of wealth managers and investment advisors have caught on. Most are still approaching their asset-allocations as usual.

A couple of years ago I introduced and advocated Hybrid Portfolio Theory as an alternative asset-allocation approach for the progressive advisor that held preservation of client’s capital as the primary objective while simultaneously pursuing the opportunity to achieve double-digit annual returns at the portfolio level.

Hybrid Portfolio Theory is unique as it eschews equity exposure in favor of allocating the majority (75-80%) of the assets into fixed income such as Treasurys, munis and TIPS (portfolio A). A second portfolio (B) holding the balance of the assets is mandated to pursue investing opportunities that have a positive asymmetric return profile such as investment into private early-stage private companies or small businesses, public emerging growth companies, real estate, or, specialized trading strategies that employ options or managed futures.

Of course I am biased. Venture Populist advocates that wealth managers and investors more frequently embrace allocations to direct private investment as a means of increasing portfolio returns in a manner that does not increase portfolio-level risk.

But recent numbers from Cambridge Associates underscore this conviction as the venture asset class has continued to provide compelling returns over the long term. Over the past fifteen years the U.S. Venture Capital Index has returned 38% annually against 7.4% for the Nasdaq and 7.8% for the S&P. Over the past twenty years 24% for VC against 9% for both the Nasdaq and S&P.

Exposure to private enterprise has historically been this countries greatest single wealth producer. Progressive wealth managers would be well-advised to adapt their core competencies to embrace more diverse and opportunistic investment opportunities outside of the public equities markets.

Some of their client’s certainly are…as Mark Cuban recently posted, “The stocks I own for the most part I have owned for a long, long time and I have more in gains than I want to pay taxes on. But in total, I have been a net seller of stocks for more than a year. The only investments I am making are small buys into private companies.”

Entourage fans, for the record, those “small buys” do not actually include an investment in “Turtle’s tequilla“…but considering the past decade of stock market performance, and the forward prospects, a spirits investment may not be a such a bad alternative.

 Album:   Exodus, Bob Marley and the Wailers, 1977

Angel and venture investors in startups and early-stage companies frequently have the option to determine the extent to which they intend to contribute intellectual capital, beyond their financial commitments. “Value-added” private venture investors often lend their business skills, resources and rolodex to their interests, helping the company solve tough problems, prioritize objectives, build a great team and even seek out strategic partners and potential customers.

Equally compelling to private venture investors is the ability to influence the terms of engagement of their capital in a manner that increases the opportunity for a favorable investment outcome. Unlike conventional public investment vehicles and most alternative products such as hedge funds, the investment terms for private venture investments are generally negotiable…depending on the size of the contemplated investment and stage of the company and the funding history.

Evaluate—Negotiate–Allocate

Between due diligence and the investment decision is the opportunity to influence and negotiate investment terms in a manner that increases the probability of a positive asymmetric outcome. It surprises me when angel allocators, particularly lead investors in a seed round, simply accept the offering terms of a private venture without fully leveraging their currency to negotiate the best deal for their capital. Startup capital for new ventures is scarce today relative to the halcyon days of the 1990’s. That tilts the advantage in favor of capital and provides early-stage venture investors with an opportunity to materially improve upon their position.

Angel round investors are a unique breed. They take on startups at the riskier seed stage (in pursuit of higher-multiple exits) at a point where venture capital firms will typically not engage. VCs and institutional investors are more apt to require some evidence of progress with a startup…whether with regards to financing, product development, a proven business model or market traction. Yet that does not prevent VCs from coming to the table with their own terms for a Series A financing.

On the other hand, angels too often let the entrepreneur set the terms for the seed and bridge financing rounds.

So, which provisions in an angel round’s term sheet are generally negotiable? All of them.

I am humored by entrepreneurs who describe their terms as being “market”. Because there is no market without the angel’s capital, and that means that valuation, liquidation preference, anti-dilution protection, dividends, various protective provisions, board composition and even the vesting of the founder’s stock can and often should be subject to negotiation…particularly in a smaller financing round.

Each of these terms may have a critical influence on the outcome of an early-stage investment, but valuation is arguably the most difficult for angel investors to negotiate as there is little meaningful company history to assess…rather, merely a vision around an idea, a market and a management team, and perhaps a business plan.

The “market” (of angel investors and entrepreneurs) has responded to this quandary by predominantly relying upon Convertible Notes to fund seed-stage companies. Rather than dickering endlessly about the present value of a future uncertainty, angels and entrepreneurs agree to lend their capital to the new venture in the form of a note (often secured with some form of collateral and offering a dividend) and agree to convert their debt to equity at the price set in the subsequent round of financing.

The theory is at that point in the future, much more will be known about the business, market, competition and opportunity and that it will be easier to agree on a valuation.

Consequently, Convertible Notes have become the primary template for seeding young companies and providing “bridge” financing from the concept stage to a larger, subsequent financing round.

Early-stage investors should engage the growing universe of online content that speaks to best practices, suggested deal terms and negotiation tips for investors in early-stage ventures. Most critically, tyro angels should engage a securities attorney with ample experience in private venture financings to advise them on term sheet negotiation.

In Woody Alan’s 1994 crime-comedy Bullets Over Broadway, the gangster-financier played by Chazz Palminteri exploited his angel status by casting his girlfriend in a lead role and rewriting the play’s script.

In early-stage financings artful angels should always consider opportunities to leverage their currency to rewrite the script of the bridge note and positively influence their investment’s ultimate optionality and outcome.

Album:   Script of the Bridge, The Chameleons, 1983

In short-sighted efforts to convey the accrued wisdom and tenets of their craft, venture investors occasionally declare their due diligence dogmas by way of the fallacy of false dilemma…a distorted line of reasoning where an outcome must be the result of either of two options. Often referred to as “black and white reasoning”, a false choice is offered up between two scenarios when in fact many more scenarios are probable.

Our false dilemma du jour is; which venture investment in a startup is positioned for a better outcome…the “A” idea with a “B” management team, or the A team with the B idea?

[Of course, it is never this simple, as the query ignores other critical items such as market size and maturity, competition, barriers to entry and of course, deal terms…but let’s play along…]

I opt in favor of the A team with the B idea. The B team may not be able to execute on the A idea, but I have seen many A teams successfully monetize B (and C) ideas.

I would postulate that the majority of angel and venture investors concur on the acute importance of the quality of the team engaged to execute a new venture’s business plan. But I diverge from the consensus when that same conventional wisdom subsequently surmises that the A team’s commitment is not validated unless those “founders” have contributed a material amount of their own personal financial assets to the venture.

The notion of a founder’s cash as an indication of their “skin-in the-game” ranks among the myriad of myopic and misplaced myths of venture investing. It is derivative of another false dilemma fallacy that evaluates the involved vs. the committed startup founder by pitting the pig against the chicken as the sources of a traditional bacon and eggs breakfast. (The pig has truly “committed” by providing the bacon, while the chicken is merely “involved” in providing the eggs.)

I recently attended the road show where an ambitious retail venture (redundant, eh?) was presented by a genuine A team of co-founders comprised of a young entrepreneur and a seasoned C-level executive CEO. It only took a few minutes into Q&A for an experienced institutional investor to impugn the initiative by inquiring about the absence of co-founders capital committed to the enterprise.

In this particular instance, the young entrepreneur was early in his career with a very young family and simply lacked the personal financial resources to allocate any capital to his vision. On the other hand, the seasoned 60-year old CEO walked away from a prestigious C-level position where he enjoyed a high six-figure compensation from a venerable multi-national concern at the peak of his career to take a flyer on a yet-to-be-financed retail startup…during a recession.

It is certainly appropriate to question a founder’s commitment as long as the answer is evaluated in its appropriate context. The CEO was “all-in” career-wise and the young founder had the chops, but lacked the bacon to commit to the plate.

Considering founder’s personal financial assets to be prerequisite skin-in-the-game simply ignores the lessons of ventures past. Steve Jobs was 21 when he founded Apple and his partner Steve Wozniak was 26. Gates and Allen were 20 and 21, respectively. Google founders Page and Brin were both 25. Hewett and Packard were 26 and 27 and Michael Dell was merely 19.

None of these extraordinarily successful founders had any meaningful cash to invest in their own startups. If they did, angel and professional venture capital investors would have been deprived of billions of dollars in long-term capital gains and carried interest.

Of course if a founder has a material amount of personal financial assets—it is appropriate for an investor to expect those funds to be committed to the venture. Moreover, it is prudent for the founder to use proprietary resources as it enables him to ultimately preserve more equity in his enterprise. But, career risks, opportunity costs and reputational risks can be far more consequential to a founder than losing several dollars or pounds of flesh.

In fact, our only 100% write-off in this decade was an investment in a serial internet entrepreneur who already had committed $13 million of his own funds to the startup.  He had the bacon, but not the chops or experience to execute in the specific sector. The ensuing high-profile strikeout subsequently insured that the failed venture would be the entrepreneur’s final turn at bat, as he was no longer considered bankable.

Before you judge a venture based on a founder’s capital as skin-in-the-game, make certain that you fully understand the emotional commitment, as well as, the actual impact that the demise of the startup will have on the founders. A skin tight founder is not, by itself, a reason to walk away.

Album:   Skin Tight, Ohio Players, 1974

In our previous post (Let It Be) we noted that Senator Chris Dodd’s financial reform bill that is on the way to the House floor contains new provisions that would reduce the number of individual eligible to invest in private ventures. The original draft of the bill would increase the $1 million net worth threshold that defines an “accredited investor”, which in turn determines an individual’s eligibility to invest in exempted private securities offerings under Regulation D of the 1933 Securities Act.

These Reg D offerings enable startup businesses access to “angel” capital — the critical means of finance for early-stage ventures that could not otherwise bear the prohibitive costs and regulatory burdens of SEC registration.

The angel investor and entrepreneurial community responded vociferously against the proposed legislation citing the chilling impact that an estimated 77% reduction in the ranks of accredited investors (per Bloomberg BusinessWeek’s estimate) would have on angel investment, financing startups, new job creation and reviving the reliable stalwart of economic growth—the small business sector.

Now we hear that the Angel Capital Association announced that Dodd and his Senate Banking Committee have drafted amendments to the initial proposal whereby the threshold for “accredited investor” would stay the same, although the standard for net worth of $1 million would be revised to exclude the investor’s primary residence.

The ACA has proclaimed that although “we would have preferred no adjustment to the standard for angel investors, we believe this is a good compromise” adding that the amendments “improve the bill so that it balances the importance of small business capital formation while protecting angels and other types of private investors from securities law violators.”

What bunk. The ACA should be opposing such compromising compromises. The opportunity to make a private investment in a private venture should be every investor’s right. The ability to invest in a new business should not be an exclusive privilege bestowed by politicians upon persons of a certain economic class.

Moreover, there are ample investor protections already in place. The SEC’s powerful Rule 10b-5 is all about protecting investors, and it applies to private investors just as it applies to the general public. Every state has securities laws on the books that protect private investors from fraud. Indeed, the registration requirements of the 1933 Act also serve that protection purpose.

As explained by SEC alumnus Patrick Daugherty of Foley & Lardner, “Regulation D is an exemption from those registration requirements. It’s part of our law precisely because there exists a class of investors who can ‘fend for themselves,’ in the words of the Supreme Court’s venerable Ralston Purina holding. Congress, the SEC and the Supreme Court have believed for fifty years that offerings limited to investors who are ‘rich and smart’ about finance need not be registered.” 

Although there is no doubt that the majority of frauds have occurred in highly regulated or visible investment schemes (remember Refco, Enron, Worldcom), there is ample history of unscrupulous brokers, dealers, issuers and promoters abusing Reg D and defrauding investors. The SECs recent indictment of Provident Royalties, LLC for a massive $485 million ponzi scheme is a good example of how the SEC’s limited resources could be effectively allocated away from surfing porn on the web.

But I have never heard a cogent argument that supports the notion that any individual should be restricted from the opportunity to invest in a startup or new business venture that has appropriately disclosed the risk of failure and loss of all capital that is inherent to venture investment.

Private venture investment in startup and early-stage businesses should be entirely exempt from the Reg D accredited investor provisions.

Angel investors know the risks are high and that a significant portion, if not the majority of their venture investments will fail. There is absolutely no evidence that angels investing in startups played any role whatsoever in the recent financial crisis that has prompted Dodd’s proposed reform bill. So, who does this compromise “protect”?

The notion that net worth is an effective indication of an individual investor’s sophistication or ability to bear the risk of loss is laughable. The bright-line standard used to ascertain an investor’s sophistication is ironically unsophisticated and utterly under-inclusive.

I align with Richard Rahn, chairman of the Institute for Global Economic Growth that “the rule makes little sense and strongly discriminates against knowledgeable people who are not yet wealthy but are quite capable of making good investment decisions.” Rahn refers to this as “financial fascism”.

In this connection, there is no reason to suppose that investors who are millionaires only after including home equity are unable to fend for themselves while those who are millionaires exclusive of home equity are self-reliant. Consider Sid and Nancy. Sid has $500,000 in financial assets and a $1 million home with no mortgage. Nancy has $1.4 million in financial assets and a $1 million home with a $900,000 mortgage. Both Sid and Nancy have a net worth of $1.5 million. Sid has constructed a more-conservative balance sheet for himself. But Senator Dodd says that Sid needs federal protection while Nancy doesn’t.

This makes no sense, especially since Sid can “become accredited” simply by borrowing $500,000 against his house and investing the proceeds in securities. Does Senator Dodd really want to encourage greater mortgage borrowing as a means of facilitating private capital formation?

Does anyone really believe that an IT professional making $75K is less able to evaluate a web startup than a professional athlete? Is a recent B-school grad less able to assess the merits of a new retail business venture than a trust fund baby? Is a cook any less able to evaluate a new restaurant venture than a lottery winner with an eight grade education? Wealth is simply not an effective proxy of sophistication.

But what I find most offensive is that this “compromise” only compromises personal financial freedoms and investor’s rights and liberties…a viewpoint shared by my old friend John Mauldin, acclaimed creator and curator of commentary at investorinsights.com, a blog focused on private money management.

“Why should 99% of Americans be precluded from the same (investment) choices available to the rich? If you were to tell investors that they would be discriminated against because of their gender or race or sexual preferences, there would be an outcry….It is a matter of Choice…Equal Access…Equal Opportunity…it is time to change a system where Americans are relegated to second-class status based solely on their income and wealth.”

Nice, John. I also see that one of Canada’ top angel investors also shares our opinion that any investor should be able to make angel investments (assuming the proper disclosure of risks).
 

Regulators and politicians whom plead that such provisions protect the poor and unsophisticated from unscrupulous promoters are hollow hypocrites. Presently 42 state governments run lottery programs—a regressive tax that preys on lower-income households to the tune of more than $17 billion in 2007, the most recent annual estimate. Recently, researchers have identified a correlation between economic difficulties and the popularity of lotteries….so we are likely seeing greater lottery ticket sales today.

Single state lotteries usually have odds of about 18 million to 1, while multiple state lotteries have odds as high as 120 million to one. The state lottery and government officials know that it is a sucker’s bet that is disproportionately supported by low-income households and marketing programs make sure to advertise in lower income areas and increase television advertising when welfare and social security checks are distributed. The poor and unsophisticated are left to their own defenses when government acts as the issuer and the promoter.

Government should be encouraging private investment in new businesses which historically account for the majority of the innovation and job creation in the American economy. The Kauffman Foundation, tells us that “between 1980 and 2005, virtually all net new jobs created in the U.S. were created by firms that were 5 years old or less…That is about 40 million jobs. That means the established firms created no new net jobs during that period.”

Startups continue to be a robust and critical engine of job creation as according to Bloomberg, despite the sluggish economy some 259,480 angels invested $17.6 billion in 57,225 entrepreneurial ventures in 2009.

As the average startup employs approximately eight people, increasing the bracket for accredited investors in any manner will only make it more difficult than it already is for startup businesses to raise money and create new jobs.

To the contrary, nothing would be gained by reducing the pool of accredited investors—no additional protections to investors and no benefits to the national financial system or the economy. Private venture investment in startup and early-stage businesses should be entirely exempt from the Reg D accredited investor provisions.
 

Album: Up The Bracket, The Libertines, 2002

Senator Chris Dodd looks determined to leave his last term in office with a dubious legacy – his sponsorship of the Restoring American Financial Stability Act of 2010  which passed the Senate Banking Committee on a party-line vote  on its way to the House floor.

Dodd’s 1,336-page reform bill seeks to address the timely and substantive need to police abusive and unfair terms for mortgages and other financial products, the “systemic risks” inherent in derivatives such as credit default swaps, as well as, the use of leverage by tackling the “too big to fail” issue. Of course this comes after the barn door has been open and all the horses have fled, and many will argue that The Street will inevitably develop new instruments to challenge the new regulations and oversight…but that’s another problem.

In the over-reaching spirit of not letting a good crisis go to waste, Dodd’s bill also seeks to fix what’s not broken with provisions that asphyxiate investment in startup ventures and subsequently stifles what has historically been the most sustainable source of new job creation during a period of hopelessly high unemployment.

Dodd proposes adjusting for inflation the income and net worth requirements for a person to be considered an “accredited investor” by the SEC under the 1933 Act. If this were to occur it will materially decrease the pool of private capital that is available to finance new companies, and in turn, innovation, job creation and economic growth.

Presently, an individual must have a minimum net worth of $1 million or an annual income of $200K to be an accredited investor. Although the reform bill does not identify the proposed multiplier to adjust these numbers, it is fair to assume that an inflation adjustment approach (based on CPI) is likely which would raise the 1982 mandated $1 million dollar net worth threshold to approximately $2.25 million and the individual annual income threshold to approximately $450,000.

Applying a $450K income threshold to the latest IRS tax return data, the number of accredited investors would drop approximately 77%, from 4.5 million individuals who earned $200K or more to a little over 1 million. That’s a material decrease in the pool of available “angel” capital.

A 2008 study of accredited investors based upon data reported in the 2008 Statistical Abstract of the United States by business demographer Paul Reynolds found that only 10.5% of accredited investors had made a private venture or angel investment in the prior three years. Adjusting that data for the increased thresholds implied under the Dodd bill reduces the number of likely angel investors to between 121,000 and 174,000 individuals…devastating.

We can debate forever the wisdom behind an over-inclusive system that uses personal wealth as a proxy for investment sophistication. Yet, many others (myself included) would maintain that the accredited investor standard prevents those with adequate access to information, or experience, or due diligence skill, or sector expertise, or entrepreneurial spirit or emotional tolerance for risk to embrace the potential asymmetrical upside of private venture investment. (What would you expect from a Venture Populist?)

I agree with the recent opinion expressed on this subject by digital strategist Alex Alben in the Seattle Times…”more investors today have access to financial information and filings through electronic databases than ever before. The old notion that only wealth buys access to financial information is increasingly quaint in our digital age. The financial crisis of 2008-09 was not precipitated by millionaires losing money in private placements…the monetary amount should not be a moving target, changeable at the whim of the SEC… Both houses of Congress should pass a bill with meaningful consumer protection and bank oversight, but not harm privately funded startups in the process.”

I would also add that if the current administration is so intent on identifying the $200,000 income level as “the rich”…as those capable of taking on a greater financial burden in the form of higher taxes, shouldn’t those same individuals continue to have the right of access to private equity and venture capital transactions, the asset class that has historically delivered investors the highest returns?

Rich enough to tax should at the very least mean rich enough to invest.

Personally, I believe the accredited investor thresholds as they are applied to investments in early-stage businesses are arbitrary, under-inclusive, undemocratic, discriminatory, and unnecessarily restrict innovation, economic growth and new job creation. All individuals should be allowed to invest in new businesses. The current rules should exempt venture capital.

But the most that you can ask of a regulatory regime is too simply leave the current law alone. It’s may not be ideal, but it certainly is not broke. Dont’ fix it. Let it be.

Album:   Let It Be, The Beatles, 1970

Private venture investors consciously embrace the notion of swapping liquidity and safety of principal in the pursuit of positive asymmetrical outcomes and the higher risk premium associated with venture capital. Against the certainty of uncertain outcomes, the venture investor accepts liquidity and principal risks as the apropos quid pro quo towards achieving high double-digit and triple-digit IRRs on investment.

But, venture investors too willingly accept the notion that their investments outcomes will be the result of a binary set of events—characterized either by loss of capital or an attractive multiple on exit as the result of an IPO, sale, merger or other change of control transaction.

These investors can become more effective fiduciaries of their capital by demanding investment terms that broaden the variety of each investment’s potential returns. I refer to this as increasing an investment’s “optionality” beyond a binary set of boom or bust outcomes.

Among the most frustrating venture investment experience is the non-outcome outcome. In an earlier post (Hits & Exit Wounds) we described this sort of venture purgatory as “My Grandkids Company”—a private company that is successful but there is no exit in sight. (Perhaps your grandchildren’s inheritance?). You were prescient enough to back an early-stage venture that is now successful yet all you have to show for it is an annual K-1. This is where investment term sheet mechanisms that enhance the investor’s optionality really come in handy.

I have become a strong proponent of requiring that venture investors demand a “put right” (or, put option) as a contingency to committing venture capital to an angel round or early-stage equity financing. A well-conceived put option may reduce unintended gifting to your grandchildren by giving you one way out of a private investment without an exit in near sight.

Typically, a venture investor’s exercise of a “put” would require the company to repurchase their equity securities at fair market value. Investor put rights have been around venture transactions for years for the express purpose of providing a way out of an investment with no liquidity event in near site. But, because of the terms by which they have generally been structured, they have been rarely exercised.

That’s because if the company appears to be on the right track, investor’s are more likely to let their fortunes play out. On the other hand, if the company is not performing to plan it is not likely to be able to afford to honor the investor’s put—rendering the option worthless.

With investors rarely exercising these puts and with companies generally apprehensive of the uncertain implications of any non-budgeted hit to their balance sheet, issuers are less willing to draft investor put rights into their offerings…but you should insist.

It works like this…upon completing due diligence and deeming a venture to be worthy of a capital commitment the investor reviews the company’s anticipated revenue projections to identify a period in the future (beginning at 30 or 36 months out) at which the company’s cash flow model and pro forma balance sheet suggests that it would be able to return the investor’s initial capital contribution along with any accrued dividend. As a contingency to financing the venture, the investor requires the company to grant a put option for that future point in the company’s growth trajectory.

If the investor exercises the put, the investor is entitled to redeem all or a portion of their equity interests in exchange for the initial capital contribution value plus a nominal return above the risk-free rate. In addition to the return of investment, the put right allows the investor to maintain a reduced equity position in the company…perhaps, somewhere between 50% to 75%. (This would imply an increase two to four times higher than the company’s initial valuation)

Essentially, the exercise of the put allows the investor the ability to take “risk off the table” (the initial contribution) while still maintaining a material amount of “skin in the game”.

To prevent the investor from exercising the put at a moment when the company’s financial stability or expansion plans could be jeopardized, the company can require that in addition to a prescribed time period restriction, certain revenue and/or R&D milestones must be achieved and set as “triggers” before the put may be exercised.

The put option must be constructed in a manner that enhances the investor’s optionality, without putting the company at balance sheet risk. It is possible to achieve that balance. The company that achieves the predetermined revenue milestones would likely savor the opportunity to buy back its stock to the pro-rata benefit of the remaining stakeholders, and of course the investor benefits from the possibility of a wider variety of liquidity events and exit outcomes…which, in turn, enhances the ultimate appeal of venture capital as an asset class.

Album:    One Way Out, The Allman Brothers Band, 2004