On the opportunity (and dying, crushing need) to revamp organizational structures:

• John Hagel, Attracting Talent in Spikes and Firms (via Ethan Bauley):

  Attract and retain vs. access and motivate. Talent strategies of companies often focus too narrowly on the talent that resides within the enterprise. … Few companies make a systematic effort to map the relevant talent that exists outside the company. Even fewer companies develop effective strategies to access and motivate that talent through networks of relationships, including positioning in relevant spikes around the world.

  … At the most fundamental level, the rationale for the firm is shifting. As JSB and I have written, the rationale for the firm articulated by Ronald Coase back in the 1930s – that firms exist to economize on transaction costs – is diminishing in importance as continued innovation in IT systematically drives down transaction costs. In its place, we are seeing a new rationale for the firm emerge – firms exist to accelerate talent development. This is increasingly the reason why people choose to affiliate with firms. They believe they can get better faster by working with others within the firm, as well as with others across firms, through the privileged relationships built by the firm. If firms can’t find ways to deliver on this promise, talent will exit and Tom Malone’s e-lance economy will flourish.

  And a more recent refresh:

• John Hagel, John Seely Brown and Lang Davison, Tomorrow’s Talent Networks:
  

  Operations, organization, and strategy must all be reconceived through the talent lens. They must be re-thought as part of pull platforms that treat all workers as capable creators who are continuously improvising in response to unanticipated situations. In this view, talent isn’t just the highly trained and deeply skilled knowledge workers one typically thinks of as talent: they’re just about everybody.

  Push programs have enabled scalable, cost-effective operations. But they’ve come at a steep price: the rigid standardization and specification of activities and tasks they require. What if instead companies were to create more flexible pull platforms to help employees access resources whenever and wherever they are needed? What if, rather than treating exception handling as a nuisance to be eliminated, companies welcomed these problems as opportunities for participants to tinker and experiment?

  Pull platforms are essential to fostering learning on the job since they can make it easier to access unexpected resources in unexpected ways and thereby encourage participants to try new approaches that simply would not be feasible in more rigid push programs.

  Structures compete for talent; as much as I talk about the frames creating the opportunities for a larger scale of entrepreneurship based on the structures for personal, distributed, collaborative value creation, the issue is truly about economic organization and the rationale for the firm. In essence, firms will adapt to create better structures for organizing and utilizing talent to compete for talent being lost to better organizing firms and to new ventures.

  How?

• John Hagel, John Seely Brown and Lang Davison, The Strategic Advantage of Global Process and Practice Networks:
  

  … No matter how much talent a company might have, there are many more talented people working outside its boundaries. Yet all too many companies focus solely on acquiring talent, on bringing talent inside the firm. Why not access talent wherever it resides?

  … Companies must also participate in (and sometimes orchestrate) new organizational forms and structures called global process and practice networks.

  … Both kinds of global networks — process and practice — create opportunities for talent to come together and generate “productive friction”: a powerful force that shapes learning, as people with different backgrounds and skills work together on real problems.

  While many executives pursue the nirvana of a frictionless economy, aggressive talent development inevitably and necessarily generates friction. It forces people out of their comfort zone and often involves resolving differences among people with divergent views and experiences.

  How? Organize the right environments to generate productive friction and innovate talent management within the firm. Read the rest of the post for details.

  What are firms doing to create better structures for organizing value creation?

  (Note: organizing value creation is not the same as organizing people.)

• Morten T. Hansen, Harvard Business Review April 2009, When Internal Collaboration is Bad for Your Company:
  

  Internal collaboration is almost universally viewed as good for an organization… But the conventional wisdom rests on the false assumption that the more employees collaborate, the better off the company will be. .. Our research [into 100 experienced sales teams at a large IT consulting firm] yielded a surprising conclusion about this seemingly sensible practice: The greater the collaboration (measured by hours of help a team received), the worse the results (measured by success in winning contracts).

  Wait, that’s a surprise? Since when was collaboration merely about the HOURS of knowledge sharing? Since when was collaboration merely about sharing information?

  The rest of the article spends its entire time creating a decision framework based on calculating the “collaboration premium” using the benefits and costs from collaboration. Yet no time or thought is spent on the strategies or tactics behind collaboration; the entire article is based on the premise that internal collaboration is equal to time, when in fact many of the real opportunities behind current technologies are to create better structures for collaboration, making time a much less important driver behind collaboration. Collaboration is much more than just sharing information. A waste.

  How about a better example?

• Aaron Chua, A crisis in human resources. My comment:
  

  The biggest opportunity is to change the structure of management, the hierarchical systems we created in order to pass down structures and tie people to processes. As our ability to communicate processes and needs improves through better, cheaper, transparent and archivable communication tools management will be less needed, leadership will be more important, and “linear progression” career paths will be less necessary and lucrative.

  People follow value creation, and people will follow the value creation to the edges. Now if the edges could just make money

  Maybe they can…

• Via Ed Cotton, The Open Company – Running your business as if it were an Open Source Project..

  Based on the idea that “self-organizing groups in many cases can outperform traditional organizations”, E-Text Editor is working to create structures to give people “the freedom to decide for yourself what you want to work on”.

  Imagine you had a company like this. Totally open. No concept of bosses or employees. Anyone could join in at any time, doing whatever task they found interesting, for whatever time they found appropriate. How could you possibly find a way to compensate them fairly?

  The key is in a technology called Trust Metrics. In essence this is a technique for rating each other, but with the key distinction that the way ratings are calculated makes cheating ineffective. This is a new technology, which has not been applied for this purpose before, but it has already proven itself as the underlying principle behind such well known technologies as Googles pagerank and the certifications on Advogato.

  By basing the compensation on continuous rating by your peers, it becomes possible to start out by just participating a bit in your free time, and then gradually, as your ratings increase, spend more and more time on the project. It may eventually come to fully supplanting your day job, becoming your primary source of income, or you may choose to just keep it as something you do on the side. And not only can nobody stop you from participating, there is nobody who can fire you either. This makes it a far more secure way to make a living, where your status is solely dependent on your own ability and effort, rather than on arbitrary decisions from some superior.

Can we “pagerank” an organization?


• Developing open, flexible and transparent platforms to power a new breed of organizations has been a recurring topic of mine: how can we develop the funding and organizational models…
  … to incubate and “scale our lives” by creating personal ecosystems…
  … using systems such as peer-production and the social venture commons…
  … to power our personal “freemium” life models…
  … by enabling us to create and “exchange” social capital…
  … and lower our inter-personal transaction costs…
  … and create cheaper context behind our value-creating actions…
  … to create our own hubs on the edges of value creation?

  Much more on this later…

“Venture Capital for Long Tail Entrepreneurs” describes the need for a fundamentally different, economically viable model for creating and funding micro-businesses. Venture capital needs a new model to adapt to declining costs to start businesses, the impact of Generation Y and increased personal and corporate transparency and sharing.

• THIS IS NOT: “How to raise venture capital”, “How to fund your startup,” or “What is the right funding and operational model for a venture capital firm today.”
• INSTEAD: The future will be different than today; knowing that, what cultural, business, technological and political trends are “framing” our future?

Presentation and Talking Points
These slides won’t be shown at the SXSW Core Conversation itself, but will be available for anyone to view on their own devices in the room and at home.

Ten Frames (+1)

• A. Value is created at the edges, but captured at the hubs.
  B. The Long Tail has many edges ”and it better have a hub”.
• Broken or not, venture capital is ripe for creative destruction and reconstruction.
• Incubate people, not companies.

  “Lifestyle business” shouldn’t be a dirty word.

• Collaboration is a core competence.
• Companies are people.

  “Transparent lives” will create “transparent companies”.

• “Scaling people” is the untapped promise of the Internet.
• Creating context is more valuable than creating content.
• Social capital isn’t new, but everything about it is.
• Value (flow) is king.

  Value > Cash
  Flow > Stock

• “Passion allocation” is more important than asset allocation.

  Time, passion and attention are the most important costs of tomorrow’s economy.

• Generation Y isn’t waiting around.

  Conflicts create companies.

• Everyone is a futurist.

  Yet we’ll almost always be wrong.

Participate in the Backchannel
We all know the conversation is the most important part, but only a small part of the potential discussion will actually reach everyone in the room. Participate in the broader discussion in the comments below from SXSW and from home; I will answer all questions and dig into the backchannel after the “official” discussion ends.

Details

• “Venture Capital for Long Tail Entrepreneurs” Core Conversation on Sunday, March 15th at 3:30 PM in Hilton Room E.
• Short URL to this post: http://bit.ly/xxhRA
• Hashtag #SX09-682 to participate in the discussion on Twitter; admittedly, most people will simply use the #SXSW tag.
• Click here to read past writings and comments about the subject.

About Me

• I’m currently driving cross-country from Virginia to California (and back) meeting interesting entrepreneurs, investors, photographers and change agents. Check out the full details on the trip so far. And yes, I took all the pictures in the presentation.
• I write two blogs, Unstructured Thoughts (about business, entrepreneurship and innovation) and Taylor Davidson | Photography, Travel & Culture (about photography, photography business models, travel and more), and I love to interact and comment across the web.
• I’m easy to reach by email, phone or @tdavidson, and I’m easy to find on the web on my photography and business websites, LinkedIn, Facebook, Backtype and many more profiles across the web.

Influences & Thanks
Umair Haque, John Hagel, Kevin Kelly, Chris Anderson, Ethan Bauley (@ethanbauley), Alan Patrick (@freecloud), Michael Lewkowitz (@igniter), Chris Schultz (@cschultz), Mike Bonifer, Aaron Chua, Sean Tario and many, many more that have commented, provided their thoughts and added to the conversation.

Details: Sunday, March 15, 3:30 PM, Hilton Room E (tag #SX09-682)

A bit about meet me…

• I’m at SXSW in Austin, Texas this weekend (Friday 13th through Tuesday 17th). Drop me a line to meet me at the event or come to the “Venture Capital for Long Tail Entrepreneurs” Core Conversation on Sunday, March 15th at 3:30 PM in Hilton Room E (tag #SX09-682) to participate in the discussion. Check out the basic details on the core conversation on the public SXSW and my.SXSW sites.
• I’m currently driving cross-country from Virginia to California (and back) meeting interesting entrepreneurs, investors, photographers and change agents. Check out the full details on the trip so far.
• I’ve got a variety of interests and “frames”; business strategy, photography, innovation, entrepreneurship, financial modeling, nomad, perspective and hope.
• I write two blogs, Unstructured Thoughts (about business, entrepreneurship and innovation) and Taylor Davidson | Photography, Travel & Culture (about photography, photography business models, travel and more), and I love to interact and comment across the web.
• I’m easy to reach by email, phone or @tdavidson, and I’m easy to find on the web on my photography and business websites, LinkedIn, Facebook, Backtype and many more profiles across the web.

But more importantly, I’m looking forward to meeting everyone else, listening and learning.

Also
Want to enjoy SXSW? Chris Schultz (@cschultz) of Voodoo Ventures created a list of practical details on How to Rock SXSW.

Have fun…

Updated
The original title of this post was “Hello, I’m Taylor. (Meet me at SXSW)”

And then I realized it’s really not about me, and that I’m more interested in meeting you; and thus I changed the title to “Hello, I’m Taylor. (And I’d like to meet you at SXSW)”

I feel much better about that…

A Forgotten Past, Dying Present and (No) Future | Orla, Texas | Feb 2009

Tom Friedman raised a few feathers with his article Start Up the Risk-Takers and the ideas about redirecting part of the US financial stimulus package to venture capital investors to invest in startups.

The basic idea about creating jobs and economic activity through supporting startups and new businesses is a concept that many in the venture industry have voiced previously. But this article stirred up a little debate as Fred Wilson, Roger Ehrenberg, Alan Patrick, Don Dodge, Brad Feld, Tom Evslin and others (including many, many insightful commenters) entered the scene with a range of opinions.

I’ll summarize and throw in a couple points along the way…

In a perfect world, “more money for entrepreneurs” would mean more businesses would get created. But it doesn’t work that way.

The title of Friedman’s article might be the most insightful part: “Start Up the Risk-Takers”.

That does not mean “start up the venture capitalists”: entrepreneurs are the true risk-takers in the venture industry.

Helping entrepreneurs create businesses in order to jump start the USA’s economy is a good idea: but simply giving money to existing venture capitalists is not the way to execute it.

Hopefully we’ve learned what happens when we give money to companies: they spend it how they see fit, not how we want them to.

The history of the government directly investing in startups is spotty at best, with In-Q-Tel as one of the possible success stories. But it’s unlikely that the USA government bureaucracy would be the most effective organization to invest in startups, and not surprisingly, few commentators advocate that approach.

That said, I would be curious to hear more about the examples of government-supported entrepreneurship in other countries. Examples? Thoughts?

But even more telling, more money doesn’t necessarily mean more (or better) businesses even if venture capitalists are the ones placing the bets.

Why?

The fundamental math behind venture capital works against:

• Early-stage investing. Roger has written about the subject of early-stage investing before, and Matt explained it particularly well in Roger’s post about the debate.
• Service-based businesses. As Don explained, “Service based companies create lots of jobs, but don’t get VC funding.”

  Fred also pointed out a role for government programs (using the example of current programs like SBA and SBIC as examples) to fund businesses that don’t fit the traditional VC economic model.

Incentives guide behavior; and the current venture capital models simply don’t create the incentive structures to invest in the early stages of new ventures, especially service-based businesses.

If you’ve read some of my past posts, none of this should be a surprise.

If “more money” is the path, where should it be directed?

Where are the needs?

• Traditional seed-stage, $200K to $1 M. We’ve developed effective ways to test ideas, but we’ve created a funding gap between “testing ideas” and “building businesses”

  Given Marc Andresson’s plans to start a venture fund and his thoughts on the industry from a recent interview with Charlie Rose, Marc might agree.

• Government programs or new private funds to “incubate lives”, focusing on service-based and “lifestyle” businesses. These companies won’t create big-hit investment returns, but they can generate cash flow and create jobs. The SBA and its programs are a start, but without other structural changes they are not the ultimate answer.

Should we focus or direct money towards specific industries, technologies or geographical regions? I’m open to thoughts, but I still believe the market, not the government, should decide which deals to fund. The big win is to focus on strategies instead of tactics, the system instead of the specifics.

The current needs will not always be needs; instead of plugging the gaps, let’s address what created the gaps.

Everyone is focused on pumping more money into the venture ecosystem. But why don’t we think more about removing costs?

My comment on Fred’s post:

Thank you. Dumping more money into the same structures, the same incentive systems, the same uses, is not the answer.

Instead, how about streamlining the legal processes behind creating businesses? Or reducing other transaction costs to starting new ventures?

Why don’t we invest in the underlying venture ecosystem by removing transaction costs and streamlining the processes in starting, funding and growing business?

A number of commentators touched on the issue:

• Fred explicitly noted the opportunity in investing in education; others added in thoughts about funding basic and applied research and development.
• Dan pointed out the opportunity to use existing structures like the SBA to increase the funding of the SBIC and SBIR programs.
• Brad pointed out the Seed Capital Tax Credit, a way for the government to incent seed stage investments. Chris Schultz mentioned similar programs in Louisiana specifically aimed at igniting post-Katrina economic growth when I met him in December.

But it’s not enough.

How can we invest in streamlining the system?

• Create easier and quicker processes for researching, applying for and accessing government funding (SBA, SBIC, SBIR, research grants, etc.)
• Reduce transaction costs, including legal requirements, taxation policies, accounting rules and government regulation. How can we make it cheaper, quicker and easier for companies to start?

Let’s be clear: this is not about “propping up startups”. I’m not advocating creating more structures to help entrepreneurs, but instead removing the need for those support structures in the first place. Investing in creating better structures would mean less distractions, less costs and more productivity, right?

Entrepreneurs face the problem of navigating government bureaucracies all around the world: take Singapore as an example in the difficulty (and opportunity) in figuring out government funding programs.

At the end of the day, this is just the latest round of a debate over the future of the venture capital industry.

It’s all about money: who, what, when, where, why and how, and the traditional answers to those questions may not be the right ones for the current situation.

More money does not mean more businesses, better businesses or more jobs.

Blindly pumping more money into the existing system will exacerbate, not fix, the venture industry’s structural issues.

All industries go through cycles of creative destruction and resurrection: why would venture capital be any different?

Not a replacement, but an alternative for some situations. Instead of accepting what is, let’s think about what could be.

Feedback Requested: A Flexible Structure for Partnering with Entrepreneurs

Conversations around the best structures for pre-venture capital Series A investments often focus on convertible debt and preferred equity. It’s not a simple question: the “best” structure really depends on the specific situation and often comes down to a value judgment over which structure is more “fair” or “easy”.

Structures create incentives; perhaps what the venture industry needs is an alternate model to align incentives and economic models.

In response to a couple business opportunities I’ve been evaluating, I’ve been playing around with some ideas for an investment and compensation structure that could work for the type of fluid investor, consultant and entrepreneurs partnering relationships that new organizational and economic models are making more possible and more common.

Goals

• The fundamental problem: how can investors and consultants help entrepreneurs start businesses and get fairly compensated for the value they create?
• Establish the rules and create more interactions: what’s the hardest problem in starting a new venture? What decisions need to be made in the beginning?
• Create structures that enable flexibility, create more intermediate decisions and tie payments to actions, not to negotiations.
• Allow consultants and investors to contribute as needed to help entrepreneurs.

Structure
The structure has two key parts to create compensation and investment agreements for investors / consultants and entrepreneurs:

1) Compensation: Convertible Preferred Shares granted under a Kudos Model.

• Convertible Non-Participating Preferred Shares.
• Granted by the entrepreneur to the consultant / investor under a version of a Kudos Model: the entrepreneur selects the number of shares to grant every three months based on their estimate of the value created over the past three months. The entrepreneur cannot retract granted shares.
• Shares are priced at $X per share (price TBD: set at same for all shares).
• Share holder holds the decision to convert (portion or all) of shares to 1) Equity at next qualified investment round or 2) Convertible Debt at any time under the terms in the instrument detailed below.
• Shares are convertible at 1:1 ratio for shares bought by the next investor at the next round (common, preferred or whatever form of equity negotiated).
• “Next round” traditional VC sets the pricing and terms of the shares.
• The shares vest immediately.
• Cash compensation: the holder of the shares holds the option to be paid cash compensation whenever the company reports a cash flow positive month (or whenever the entrepreneur draws cash from the business), commensurate with the share holder’s % equity ownership of the company. Repayment will reduce the amount of Preferred Stock held by the Consultant / Investor. E.g. if the preferred stock holder owns 10% of the granted shares in the overall company, whenever the entrepreneur draws cash compensation from the business the preferred stock holder will be paid 10% of the cash compensation.

2) Investment: Convertible Debt

• Consultant / investor invests capital into the business through a convertible note.
• Note carries an interest rate of 10%. Interest is not paid as cash but is added to the contributed capital in the note.
• Multiple closings: the note is “open” for continued investment for one year from date of issue. This is so that the investor can continue to gauge progress and invest money into the business depending on capital needs and continued interest and commitment to the business.
• The note converts at a discount to the conversion price on the next round. The discount will be a maximum of 25% (five percent per month, depending on how long it takes to close the financing, up to the maximum) off of the per share price.
• Debt repayment: the holder of the convertible debt holds the option to be repaid portions of the debt whenever the company reports a cash flow positive month (or whenever the entrepreneur draws cash from the business). Repayment will be X% of the positive cash flow or X% of the cash flow drawn by the entrepreneur (% TBD, to be negotiated).
• No personal guarantee of the note by the entrepreneur.
• Weighted average anti-dilution protection.
• Investor holds the right to participate equally (pro-rata) in further investment rounds under the same terms as the next investors.
• Basic protective provisions: no pre-payment of the note by the Entrepreneur, pre-specified payment if there is a change of control prior to a venture round, and a cap on the amount of additional debt a company can take.

Other Terms:

• Financial statements: entrepreneur is required to send a monthly CEO update; unaudited financial statements available upon request.

Starting the conversation…

• A little confusing? Perhaps.

  As you think through the terms and the necessary improvements, consider one of my basic thoughts: How can we let continuous interactions and decisions, rather than scheduled commitments, determine the flow of attention, talent, time and capital? How can we introduce elements of game theory into our investment and operating structures?

• Valuation: Why aren’t the convertible shares or the convertible debt properly priced to a % ownership of the company at the time of grant or issuance?

  Establishing valuation at this stage really isn’t worth it. The intention is to push the valuation decision to when all parties have more information.

• Can’t the entrepreneur choose to “underpay” the consultant / investor by not granting enough shares?

  Yes, but that will make the working relationship pretty short, and that’s probably not in anyone’s interest.

• What if the entrepreneur will never be able to sell the business or achieve a qualified investment?

  The consultant / investor has the continuing option to take cash or hold shares; if the business turns out to be a cash-flow based business, then the consultant / investor will want to convert their ownership into whichever instrument maximizes their return.

  Yes, that means the investment may turn out to just be a loan.

• Keeping an accurate share register is very, very important to track the conversion options and current shares / debt structure.

  No question. And while this is a bit more complex, is it anything more than a couple extra lines in our Excel models?

• Why are the grant timelines set for every three months? Why don’t the grants only occur at investment rounds?

  Because for some “lifestyle” startups there may never be qualified investment rounds; the economic models simply won’t fit. Why three months? No particular reason, open for ideas.

• This is way more complex than the typical convertible debt or preferred equity structure; investors, entrepreneurs and lawyers understand those agreements and this type of agreement will create large legal costs for investors and entrepreneurs. Legal agreements are already too large of a transaction cost (time, money and focus) in starting businesses.

  Really? Seriously? We are nowhere close to a set of industry standard documents. A huge variety of structural decisions, terms and clauses are negotiated on a case-by-case basis. Legal fees are a pretty hefty transaction cost in raising capital and and creating option / equity structures. Is this really that much harder to structure?

  The goal of this idea is to create a standard structure and a set of interactions and less-standard decisions after the agreements are signed and the business starts, instead of focusing on the decisions before the business starts. Legal agreements are important; let’s help figure out ways to get them done sooner and quicker to let people start creating businesses.

  In addition, this structure effectively “punts” on many decisions and pushes the negotiations over pricing and other terms to the next investors, the next round or the later stages of the company, at which point the entrepreneurs and investors will be in better position to pay the necessary transaction costs and additional investors will be involved to help set terms.

• We (investor and entrepreneur) know exactly how we’re going to work together, how we’re going to balance our time and capital contributions and how the business will make money for both of us.

  If you know all of that, awesome.

  But there’s a good chance you don’t, and a better chance you’ll be wrong.

  Why create a structure that won’t allow you to adapt and change your relationship, time commitments and capital contributions over time?

Disclaimers

• It’s not meant to work for all situations. It probably won’t work for traditional angels or venture capital investors: in my mind it is best suited for the $0 to $100K “friends and family” pre-seed stages. But more importantly, it might work for consultants / investors and entrepreneurs that need a flexible, multi-facted, non-priced investment and compensation model to fit their fluid organizational model and “the great unknowns” of the future for their businesses.
• I’m not an expert. I’m not a VC. I’m not even an entrepreneur, really. But by sitting in the middle I see a both sides to similar arguments. I’m trying to imagine something different. Maybe I’m wrong: I’m fine with that, but I’m interested in learning why I’m wrong.
• This is not fully baked; it’s lacking many necessary terms, covenants, warranties and representations; I haven’t introduced the “Qualified IPO” concept,or “drag-along” rights and protective provisions on sale, I’m not sure about the nature of the convertible shares and liquidation preferences (participating? preferred or common?), maximum conversion clause, there are decisions to make on share vesting schedule, anti-dilution, Board of Directors, tax implications, etc… I’m looking for the discussion to help flesh out the details, point out holes and hopefully add new ideas that may help investors, consultants and entrepreneurs.

Inspirations and Resources:

• Yokum Taku, Startup Company Lawyer. Fantastic resource, easy to spend a day or two or ten just digging through the posts on the legal details behind venture capital investing.
• Basil Peters, The One Page Term Sheet for Angel Investors. Great resource for angel investors.
• Michael Lewkowitz, Kudos for Equity. The inspiration for the Kudos for Compensation idea.
• Ted Wang in VentureBeat, Reinventing the Series A
• NVCA Model Venture Capital Documents
• The CRV QuickStart Seed Funding Program
• Fred Wilson, CRV Quickstart
• David Cohen of TechStars, TechStars Model Seed Funding Documents
• Y Combinator Series AA Documents
• Sachin Agarwal, Quick Compare-and-Contrast of the Y Combinator and TechStars Series AA Model Documents
• TechCrunch, Y Combinator To Offer Standardized Funding Legal Docs
• Discussion on Tech Stars Documents on Hacker News
• Yokum Taku, What is upgradeable Series A preferred stock?
• Brad Feld, What’s the Best Structure for a Pre-VC Investment?
• Venture Hacks, Should I raise debt or equity?
• Dick Costolo, Convertible Debt Jeopardy
• Josh Kopelman, Bridge Loans vs. Preferred Equity
• Basil Peters, Exchangeable Shares
• Jeff Clavier, Debt or Equity in your seed round
• Julien Wallen, Web funding norms are a context, not guidance
• Mark MacLeod, Is Web 2.0 the great VC return equalizer?

Updated: Mentioned in the Wall Street Journal online Venture Dispatch column The Daily Start-Up.

By far the most interesting thing about this to me is what it means for future software M&A deals. Tweetdeck is funded by betaworks, which is also an investor in Twitter. Betaworks also sold Summize to Twitter, which became known as Twitter Search.

I’m sure the geniuses at USV and betaworks have been brewing these strategies for a while, but it’s very cool to see an M&A market built on companies that create value using an API.

My comment:

Mark MacLeod wrote about the “era of the small exit” a couple weeks ago; what we’re seeing is the result of what happens when people can create products (or even businesses?) based on creating new “skins of data” on top of platforms using public APIs.

As I commented on his site:

Not only might the M&A market might become an efficient hiring market for talent and products, but finding and executing the right acquisitions and partnerships sooner and quicker might become a more important core competence than planning and executing product extension development.

From an investor standpoint, I wonder if there is more value in funding the “skins of data” or the “platforms of data”?

I don’t think that the same investor will fund multiple skins of data on a shared platform; it creates too many conflicts of interest and consolidates the investment dollars into a single platform.

Implications? In the latest iteration of the “build v. buy” and “built to flip” debates,

• The best strategy for building product extensions is giving access to the platform via an API and 1) learning to create and share value with the ecosystem as easily as possible and, depending on the strategy, 2) buying the best products / businesses created.
• The best way to get hired might be to create your own job.
• Entrepreneurs and their investors should revisit and perhaps refocus on early exits as they are creating operational goals and capital structures.
• The best investment strategies might be to focus on either platforms or skins; but note that each strategy requires very different operational, funding and entrepreneur support strategies.

In a skittish entrepreneurial and investment climate, I am doubtful that entrepreneurs will commit the time and effort to build new platforms, especially with investors less likely to fund the gap between costs and revenues.

Until then, creating, funding and acquiring “skins of data” will likely be the locus of activity even if they do not create the most long-term value.

Point
Claire Cain Miller and Brad Stone, New York Times, Angels Flee from Tech Start-Ups:

Angel investors are the optimistic financiers who give entrepreneurs their crucial first infusion of cash to bring their ideas to life. Now, in the midst of a punishing economic downturn that is sparing few companies, these patrons are cutting back on their bets and threatening the very foundation of the technology economy.

Unlike venture capitalists, angels invest small amounts of their own money — as little as $10,000 and usually less than $1 million — in very young companies. But like all investors, many angels suffered deep losses when the market plunged last fall.

That has left them skittish, investing in fewer technology start-ups and demanding more of those they do consider, leaving founders struggling to find money at the stage they need it most. The slowdown, entrepreneurs and investors say, could stunt the growth of new companies and have long-term effects on innovation.

“If we don’t have angels, that hurts us. Where are we going to be getting our next Series A deals if those entrepreneurs aren’t out there with the ability to move their idea forward?”

Counter-point
Roger Ehrenberg, The Straight Deal on Angel Investing Today:

One could argue that today’s environment has made for better, more effective angel investing, since lots of “dabblers” have been scared away while the “professionals” (full-time angels, small venture funds, etc.) are seeing an increasing number of high-quality deals. Are fewer companies getting funded by angels? Of course. Should all the companies that had previously been funded by angels, many of them dabblers, gotten funded? Definitely not. So is value creation in the early-stage space really being inhibited by a dearth of angel investment? I don’t think so.

Maybe there are less funds available for entrepreneurs: but why is that a bad thing?

In my opinion, uneven economic conditions scare away exactly the kind of entrepreneurs and investors that our economy does not need:

The interesting thing is that many of the dabbling angel investors are exactly the type of “dumb money” that entrepreneurs should shy away from taking. Investment $ are not fungible resources: a $ from “smart money” is worth a lot more than a $ from “dumb money”.

Less angel capital will not threaten the foundations of technology innovation. “Dumb money” investors and short-sighted entrepreneurs chasing poorly-conceived ideas are inefficient allocators of our economy’s capital, time and talent; as a whole, our economy could use a little more focus on bigger issues.

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Related: Is there a funding gap between “testing ideas” and “building businesses”?

Someday I’ll tie this back to the immense difference in social capital between “smart money” and “dumb money”…

The big companies are not going to be the answer. We are going to need more people going out on their own. Some will raise venture capital, but the vast majority will not. They’ll bootstrap a business that hopefully can cover their cost of living. I think that is a more scalable model for replacing 3mm to 5mm jobs per year.

In other words, instead of looking for a job, create your own. It won’t be the best strategy at all points in time, but it could be right now. Creating your own job is the best way to get hired.

Falls in line with something I’ve been thinking about for a bit…

Recent declines in venture fundraising…

Shouldn’t we be worried about the recent decline in venture fundraising?

Venture capital funds raised only $3.4 billion in the last three months of 2008, according to new data from Thomson Reuters and the National Venture Capital Association. Unsurprisingly, this is a big drop (about 70.9 percent) from the same period in 2007, when venture firms raised $11.7 billion, and also a substantial decline from the $8.4 billion raised in Q3 of 2008.

Was the amount of capital raised in Q4 2007 or Q3 2008 a meaningful base for comparison? Is a measure of venture fundraising over a short period of time meaningful? Is this a signal or just noise?

Wouldn’t we expect some venture capital funds to fail, struggle and close up shop in an economic downturn? Isn’t that part of a healthy cycle of creative destruction?

In any case, less venture capital isn’t necessarily a bad thing; more money doesn’t necessarily lead to better startups and innovation.

David Hornik, Innovation doesn’t take a vacation in an economic downturn:

So why am I optimistic about investing in 2009? Because entrepreneurship is an addiction, it isn’t a choice. Great entrepreneurs aren’t driven to create companies because it is easy, or because capital is plentiful, or because the public markets are swallowing anything the venture community will throw at them. Great entrepreneurs start companies because they can’t help themselves. They see a problem or a solution or white space or an opportunity and they have to do something about it.

Innovation doesn’t take a vacation during an economic downturn. Innovation is a constant. While the resources an entrepreneur may be able to bring to bear on a problem may vary with the economic climate, the desire — the need — to innovate never goes away. And Venture Capital is the fuel of that innovation.

… combined with a shift in investment strategy…

A more meaningful trend, however, may be the increasing deployment of “risk capital” to fund follow-on investments, even as seed-stage valuations are decreasing.

Based on everything I’ve heard, venture investors are using funds to keep their current bets alive rather than making new bets. It’s a reasonable strategy given the structural math behind venture investing, the Darwinian nature of startups and the resulting need to give possible successes the chance to be “moonshots”.

… is helping create a gap between funding for “testing ideas” and “building businesses”.

A wide range of business, cultural and technological trends created the need for new models to support early-stage ventures, and the resulting rise of seed-stage and venture-launch funds investing in the $5K – $25K range have created many new opportunities and paths for entrepreneurs to test ideas.

But what comes after the ideas have been tested and “proven”? From what I have heard, entrepreneurs are finding it difficult to raise funding in the next level of investment, the more traditional seed-stage $100K to $500K range. If I’m wrong, please correct me.

Why?

Is this funding gap a sign of economic conditions or a deeper structural problem in venture investing?

As usual, the answer is not either / or but both. In the last decade (especially the last five years) the M&A market has been a popular exit strategy for startups looking for funds in this range, but current economic conditions have forced many strategic investors to the sidelines. Traditional Series A institutional capital will find it difficult to make the math “work” for deploying smaller amounts of capital. And even though the recent shift has been towards focusing on follow-on investments, the new early seed-stage funds really do not have the capital or the investment focus to make the follow-on investments to take their “proven ideas” into businesses.

Which leads me to ask: what is a bigger problem for the venture community: not being able to find funding to test an idea, or not being able to find funding to take a promising idea forward?

Bemoaning the structural gap between venture capital math and the new operational and economic realities behind new ventures is pointless.

What’s the path forward?

If it’s a structural problem, venture investors will figure out an operational and investment model that works. The recent rise of the early seed / test / launch phase investors is one of the newer evolutions in venture investing but hardly the last. I would be surprised if investors do not figure out how to bridge this seed-stage gap. Perhaps we’ll see tighter angel networks, strategic shifts from institutional Series A-stage investors, follow-on funds run by the early-seed funds or even new entrants with new investment models.

If it’s part of the broader economic downturn, then we’ll see good investors succeed and less-successful investors fail until the next run-up in venture fundraising and investment creates new opportunities. It’s not the death of the industry.

And on the other side of the coin, entrepreneurs will figure out how to build new businesses regardless of the funding climate. All new ventures have to have a business model “built-in” from the start; it’s the entrepreneur’s choice when to turn it on. [1] Right now is the time for entrepreneurs to focus less on raising nonexistent capital and focus more on turning on their “built-in” business models.

Need help figuring it out?

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[1] I think I read that line somewhere, but I can’t seem to remember where…

Kevin Allison in The Financial Times, Founders take aim at a bigger target:

… some entrepreneurs factor the unexpected into their business models, eschewing business plans that rely on a single big idea. Instead, they set up companies in which small teams of engineers work on several ideas simultaneously. The hope is that one or two will take off – a “shotgun” rather than a “sniper” strategy.

How does it work? Consider James Currier and Ooga Labs:

… Mr Currier says that, unlike earlier business “incubators” such as Idealab, which rose to prominence during the dotcom boom by spinning off companies such as eToys.com and CitySearch, all of Ooga’s ideas are home-grown and not reliant on venture funding.

“All of the ideas are ours,” he says. “We come up with them ourselves.”

By contrast, he says, Idea-lab was founder-driven. “They’d have people come up and pitch them. A lot of the companies weren’t synergistic.”

To encourage the teams to work together, Mr Currier has developed an unusual “cross-equity” ownership arrangement. “We have five different companies at Ooga Labs and everyone owns equity in each of the projects regardless of which one they’re focused on.”

Is this a socialist model of venture development?

The real question:

It is too early to tell whether the ideas being pursued by entrepreneurs taking the shotgun approach will lead to free-standing companies capable of standing the test of time – as opposed to, say, quirky products designed to be acquired by an existing social network or website.

Does the “shotgun” approach to testing ideas lead to products or businesses?