Financial Capital Is Not Just About Money
In my early years as a business person, I worked for Enron Corporation. While many see the company as a punchline today, at the time it was on the cutting edge of innovation (and not just innovative accounting). The company helped push through changes in the regulatory environment of natural gas (FERC Order 666) and Electricity (FERC Order 888, 889). These changes created a variety of market opportunities, including the advent of EnronOnline which massively shifted the wholesale market for those commodities.
The federal regulatory changes also created a ripple effect of structural changes to markets at the state and regional levels – creating or strengthening regional ISOs, such as the Midwest ISO and the PJM Interconnect. My point is not that this was good or bad for the context of this blog post – simply that it created a laboratory environment where states and regions were creating market rules that were tested in real-time. There were many learning opportunities for a young person like myself that impacted the way I view early-stage capital markets. After all, market structure conversations are not exactly common, but as someone who sat and developed rules and markets across multiple geographies and commodities, it informed the way that I think about markets in early-stage capital.
One common mistake that many policymakers and ecosystem builders make is to put all of their eggs into the “more money is good” basket. This is not necessarily true. In fact, too much money too soon has caused significant harm to ecosystems around the country. Certified Capital Companies (CAPCOs) are a good example of the type of investment vehicle that has some structural strengths but in practice were disasters. Moreover, in many instances, nascent capital market nudgers think that the answer is simply to build a really big “fund”.
So, in the interest of providing general, macro guidance, I will provide four elements that should be considered when thinking about policy changes in a state that may affect a capital market. [If you love this blog post, please retweet…then go buy Josh Lerner’s excellent book called – “Boulevard of Broken Dreams”.]
Distributed Capital Sources
Distributed capital sources can be defined as both a multitude of individual check writers and a variety of different types of investment vehicles. Many Midwestern cities struggle because they only have a handful of active angels or a single fund that dominates the landscape. Often this leads to a single investor driving many people’s investment decisions. This also leads to good companies being unable to raise capital because they are outside of a single individual’s investment thesis. For example, we worked with a community that had a single gatekeeper who was responsible for providing insight to many of the active angel investors. This gatekeeper was not writing the check but was hidden from the entrepreneur. Only after interviews with the investors did we discover that virtually every angel was seeking the guidance of a single person. This caused that person’s view of the markets and world to perpetuate across the ecosystem. This created a significant market failure.
Instead, communities should seek to cultivate skills needed by individual investors. This decentralization of expertise creates an environment where good-faith disagreement on a company is possible. Moreover, by creating good-faith disagreement individual angels seeking advice can use past experience and views of the market to review their own expectations with their chosen advisor or fund manager. When there is only a single voice, markets do not develop. Instead, they lack transparency and they fail to develop transparency that helps both sides understand value and price. This leads to bad deals for investors. However, occasionally you will witness an investor that buys something way above the market price.
We recommend that communities attempt to build a decentralized, early-stage capital market. This means that funds are staggered across multiple capital teams – building a portfolio of potential venture capital managers for larger funds. It also ensures that various viewpoints are constantly examining the market for opportunities, and does create a more urgent market when an entrepreneur is seeking funds. In other words, when there is more than one game in town, the fund managers may worry that they will miss out on a deal, and thus, they are more prone to jump in more quickly.
Liquid Markets
Liquid markets are those where investors can get into and out of positions more quickly. One of the major issues that affect early-stage capital markets is that they are relatively illiquid for investors. if an angel makes an investment of $100k today, they are unlikely to be able to use that money again for a minimum of seven years. The reason is that they will not get paid back in a successful venture exit for a long-time. Good market structures account for this by creating mechanisms that slow the investment of dollars at a single time by not overweighting an individual fund versus the total investment capital of a region. For example, I had a conversation with a group from a large Midwestern city. They described a fund that was significant for their region. This fund fully deployed in about 18 months, and then, they saw the problem that there was no one left to add on follow-on capital. Moreover, they did not have the means to fund deals happening after the deployment of the first fund because the fund created a vacuum that sucked in a large majority of the investible dollars in the region – leaving the region relatively cash-poor to make follow-on and future investments. This meant that new entrepreneurs simply had no access to capital because the funders were all illiquid. This is the “big fund” challenge that we see on occasion where a community raises a big fund but sucks in all the capital and loses access to those funders for a duration of time.
So, as a rule, we try to understand the importance of liquidity for small investors as an informing principle. Make sure that there are multiple vehicles that are cross-investing and have mechanisms in place for all funds to retain dry powder for follow-on investments. Moreover, we recommend working to establish a path that leverages early funds to prove concepts so that institutional dollars will take on the funding requirements of future funds. Most will not enter until there are at least two funds worth of investment results from the same capital team (five years minimum).
Transparency of Terms
Transparency is, in practice, the ability for all parties involved in the ecosystem and in individual transactions to understand the terms of the deal and rules by which the deal is governed. For example, in times of scarcity, an investor may be able to push a harsher liquidation preference at a time when there are many more investors. For example, we worked with a community where an individual investor was relatively high profile, and thus had access to a variety of deals. However, experienced entrepreneurs knew to avoid this investor because the deal terms were extremely unfavorable on valuation, liquidation preference, and governance. As we interviewed entrepreneurs, we discovered that most of the entrepreneurs – not just those that did deals with the specific investment group – did not understand the terms of the deal. This lack of understanding caused a ripple effect across the ecosystem that prevented the correction that should have occurred when entrepreneurs realized that they were getting taken advantage of by this investment group. Instead, the investment group was able to use its high standing to perpetuate their “key” role in the market. Ultimately, this has a chilling effect on the market because it makes capital too expensive for entrepreneurs. When the supply of capital is limited, the investor will get favorable terms. But, when the demand is unaware or acting irrationally, the ample supply situation still creates unfavorable terms for the entrepreneur.
Many times, communities decry the lack of capital as the problem, and investors decry the lack of good deals. This sometimes is because the market, itself, is broken. Instead of blaming the other side, the transparency of deals AND DEAL TERMS may be at the heart of the issue. When there is more transparency, both sides are more likely to find deals that are in their “Goldilocks zone”.
We recommend a couple of key transparency guidelines. First, it is useful to know what is actually happening in the early stage funding markets. Surprisingly, many communities have limited ideas because there is no real news source that is easy to get to and understand. Thus, communities should update Crunchbase. Second, we recommend that communities provide some basic training tools to their entrepreneurs from trusted intermediaries. Having the wolf (the funder) teach the class on funding, often leads to holes in individual sheep (the entrepreneur) knowledge. Thus, ensure that there is a standing place for entrepreneurs to understand the basic NVCA term sheet. Ultimately, transparency of deals and deal terms creates both better understanding and more transactions – benefitting the entire ecosystem.
Governance
Formal and informal governance are both important. Governance can best be described as the rules of engagement. So, formal governance is, in practice, the rules by which a local city, state, or region regulates the deployment of capital. Informal governance is how the entrepreneurial and investor communities self-regulate.
There are a number of formal governance rule structures in early-stage capital. One relatively common example of a rule is an angel tax credit policy. This rule generally provides a tax credit to an individual investor that they can use to offset tax liability in a state. So, for example, if I live in a state that has a 10% income tax, and I make $300,000, I will owe $30,000 in income tax (assuming that I have no account and this is a simple model). If I make a $50,000 investment in an early-stage company, many states will allow me to take a credit against my investment. In our fictional example, let’s say it was a 10% credit – or $5000. This means that instead of owing $30,000, I will only owe $25,000. According to the Angel Capital Association, twenty-nine U.S. states have this type of policy.
Every one of these laws is gamed. Some are gamed by professional angels. Some are gamed by large corporations that create spin-out entities. Some are gamed by individual investors or founders. The point is not whether or not they are gamed – but understanding how they are being gamed and whether or not it is okay. Following Enron’s demise, there was a significant amount of energy put into the bad trading practices of the firm in California. And, they were bad. This is an example of a bad gaming situation. This happens regularly with formal governance rules in early-stage capital, and the problem is that most communities do not have the transparency on activity to understand 1) that this is happening and 2) that this is good or bad.
Informal governance is similar in that it helps hold people accountable by enforcing standards on the investment or entrepreneurial community. For example, I am aware of multiple bad acting investors. One sad story involved an investor that I know who was holding themselves out as a rich and powerful “big dog” investor with hundreds of thousands of liquid cash to invest – while working a side job at night to make ends meet. To be clear, many investors are making their way in the world and need side jobs to make money to afford their regular life, they also are subject to the liquidity principles mentioned above. It is holding oneself out as something that one is not that can lead to challenges.
On the entrepreneur side, I know of multiple entrepreneurs that tell investors that they are all-in on their company – working 100 hours a week, etc. When in fact, they did not quit their prior job and are working full-time to keep their income in place. Again, the problem is the lie – not the action. Informal governance structures are built around this type of information. Investors know who they would not do a deal with – and they should communicate that to trusted intermediaries of the entrepreneur. This is not a means to bad mouth another firm or investor, but a way to share information so that the market becomes more evenly governed. This is how trust is built. Trust is one of the key elements of a strong entrepreneurial ecosystem. Places that have strong capital markets have trust in both the formal and informal governance of the system.
Conclusion
In conclusion, if you are thinking about how to reset, rebuild, or build for the first time your local ecosystem’s capital markets, keep in find the four principles from above: Decentralized, Transparency, Liquidity, and Governance.