How to Plant Seed Capital With Today’s Idea Farmers
If there’s been one bright spot amid the financial volatility and excesses of the past decade, it’s that this country is terrific at spawning innovative enterprises. Almost uniquely, Americans can take a technology, a few bucks, a lot of ambition--and even more persistence--and grow a company that creates a new market. Sure, there are lots of failures, but these ventures give our economy a flexibility and resilience that other nations envy.
But is the capital there to seed new companies with bright ideas?
In the early 1980s, there was too much of it. An awful lot of lousy deals were funded. Today, investment observers convincingly argue, too many venture capital firms--traditionally the source of seed capital--are more interested in managing “megafunds” and doing leveraged buyouts than going through the risk, angst and agony of a pure start-up. “It’s just as difficult doing a $500,000 deal as a $5-million deal,” they argue, so many firms prefer the bigger deal over the smaller one.
Reality dictates that it takes at least a sprinkling of capital to bring a breakthrough to the market. It’s equally true that our securities laws and our private markets for seed capital are grossly inefficient. It’s both legally and logistically awkward for potential entrepreneurs and private investors to meet. An entrepreneur seeking backing for a venture may run afoul of laws requiring SEC registration.
“The securities laws, which were drafted over 40 years ago, weren’t drafted with this world of entrepreneurship in mind,” asserts Securities and Exchange Commissioner Edward H. Fleischman. “I think the laws and rules need to be revisited, reviewed and reformed for that purpose.”
What’s one way of making an inefficient private market more efficient? Make it more public. “There are terrific deals out there,” insists lawyer Joseph Bartlett of Gaston & Snow, who’s actively involved in venture capital finance. “It’s time to open up new sources of capital and give people more rational access to this market. Everybody’s running around saying we have to change the tax code to encourage these investments; there are securities act changes that can also attract a new breed of investor.”
Bartlett proposes what he calls an “Emerging Growth Stock Exchange”--which really would be less of a stock exchange than a computer-driven registry for high net worth individuals and their capital-seeking counterparts. Think of it as an entrepreneurial/investment “dating service,” Bartlett suggests.
Both entrepreneurs and investors would have to be sponsored by members of this exchange--presumably members of already recognized stock exchanges--and appropriate disclosures would have to be made, i.e., business plans, key management personnel, etc. Potential investors would have to be able to put in a minimum of, say, $150,000 into an enterprise. Someone who’s always wanted to help godfather a medical technology company would talk to his or her private banker or financial adviser and be steered toward the appropriate registrants in the neighborhood.
Obviously, this registry would have to be policed to minimize the possibility of fraud. Bartlett likes the idea of encouraging universities, teaching hospitals and research institutes to become special members of this exchange for the purpose of introducing entrepreneurs.
This registry wouldn’t foreclose the more traditional venture capital option and, if nothing else, might smooth some of the more notorious inefficiencies of this private market. More information means more efficient markets. Not incidentally, more efficient markets mean more liquid markets--it ultimately becomes easier for investors to value and sell their shares.
Now there’s nothing extraordinarily novel or profound about this proposal--indeed, there are a variety of semiformal “angels networks” around the country which try to match up investors and entrepreneurs. “This is strictly a regional phenomenon,” says William E. Wetzel, the director of the Center for Venture Research at the University of New Hampshire and president of the Venture Capital Network, a New England-based seed capital registry.
Wetzel argues that “the notion of a national exchange is inconsistent with how those (investors) behave. . . . A passive listing is doomed to failure.” More often than not, he says, these investors are self-made, high net worth individuals who want to take an active interest in a start-up that’s close by. “They offer the value of their street smarts as well as their capital,” Wetzel says, and “they are value-added investors as much as the professional venture capitalists purport to be.”
Wetzel estimates that for every active angel trying to nurture a start-up, there are 10 “virgin angels” who could be but, for a variety of non-financial reasons, are not. “The ones that are really active are a gnat on the rump of an elephant,” he says.
Much of the problem, both Wetzel and Bartlett agree, is that this is a “virtually invisible market” that attracts little formal media or investment establishment attention. However, it’s an extraordinarily important investment subculture because the most successful of these seeded companies are the ones that ultimately move into the mainstream of investment finance. “It’s the farm system that is spawning the deal flow for venture capital,” asserts Wetzel.
While Wetzel is intrigued by Bartlett’s idea, he likes it mainly because it would focus more attention on the swirl of ideas and innovations that can be found at the seed capital level. As you might guess, the more established venture community is very leery.
“Any time I see something happening that would make for a more perfect market, I’m hard pressed to resist that,” says B. Kipling Hagopian, a founding partner of Brentwood Associates, a top venture capital firm. “But I think it would result in a lot of high net worth individuals losing a lot of money and souring on the whole thing. The start-up process is extraordinarily difficult and even the professionals aren’t doing it with exemplary returns.”
“I endorse the concept of funneling more capital into start-up ventures,” says Eff Martin, a Goldman, Sachs & Co. partner in San Francisco who helps run the firm’s high-tech practice, “but I’m a little skeptical of individual investors making wholesale investments--start-up companies are extraordinarily risky and subject to wide variations.”
Well, yes. But then again, so is the stock market these days. Obviously, start-up investments should be part of a diversified portfolio--not the focal point of investment.
Whether or not a formal Emerging Growth Stock Exchange materializes isn’t the critical issue. What matters is that the SEC, Congress, state governments, universities and other institutions with a stake in capital formation and economic development more explicitly recognize that seed capital from “informal” investors is already a significant part of the U.S. economy. My bet is that this investment subculture will become even more significant. We should have policies that reflect that.
