Konamoxt, Inc.

One of my favorite Seattle area entrepreneurial focused blogs is written by William Carlet, an attorney at McNaul Ebel Nawrot & Helgrn PLLC. William has written several posts recently about how macro shifts in our economy may have big implications on how the traditional VC business model works.

The headline of course is that VCs operate on a “hits” model where their gains are always predicated on finding a buyer who is interested in purchasing the asset at a higher valuation then the last round. Some critics of this approach will go as far as calling this the “next bigger fool” approach to investing. But with all those hits come a lot of misses, and if the market for those “exits” is changing (or possibly disappearing) then the VC business model may be at risk.

As part of the response to the recent economic crisis, the current administration has proposed sweeping reforms of the financial regulatory framework. There’s been quite a lot or resistance and speculation about the uselessness of these changes and the negative impacts that these changes could have on startup companies.

William had a great post today about why he believes that these changes are inevitable and he suggests that the VC industry should stop resisting this change and instead focus their energy on trying to influence the details of the regulations to be the least painful for them.

[His] opinion is that VCs and the startup community should focus, not on opposing regulatory reform altogther, but on making the case that a VC’s registration and reporting should not encompass detailed information about its funds’ portfolio companies.

Although I agree with William in general, that resistance is futile. I’ll take it a step further. I believe that the bigger problem for the VC industry is that their business model looks exactly like the kinds of investment vehicles that the public is clamoring for greater regulation around. As much as VCs would like to disassociate themselves with the “Wall Street” crowd (no matter how credible their argument for differentiation might be), in the eyes of the normal public they look the same.

VSs will be hard pressed to avoid the “Hang’em High” atmosphere so pervasive in America toward those “Wall Street” types.

Consider for example, the parallel between Sir. Allen Stanford’s alledged fraud. CNBC reported that in late 2008 Stanford purchased property in Antigua and only a couple months later reported that same property’s value had grown more than 50x on statements to investors. Now I’m defintely not suggesting that reputable VCs would participate in the type of fraud that Standford has been accused of.

But the problem with private company valuations are that there is no standard methods for reaching a valuation. It’s all black magic which ulitmately boils down to the price that the highest bidder is willing to pay.

The reason, I believe that regulators will prevail in their efforts to regulate VC firms, is that for all intents and purposes VC firms are practically identical to “hedge funds”, which have become the “Boogeyman” of investment firms. The only real difference is the strategies employed by the funds to generate returns. But ultimately they are managed pools of capital, and any definition that covers hedge funds will likely cover VC firms.

As I said in a comment on Williams blog…

Unfortunately the two trends leading to this call for regulation may make the issue of disclosure a fait accompli.

The first trend is the concern of systemic risk. Although I agree with the assertion by the industry that their scale is so small that it is very unlikely for them to contribute to systemic risk, we must note that it was in fact leverage that created (or at least exacerbated) the systemic risk in the CDS market. And the concern over systemic risk will contribute to what I believe will ultimately be a call for the VC industry to also be subject to detailed disclosure oversight. Even at small scale, if the particular investment activities of a firm utilize leverage to create returns, then the war wounds from the recent melt down will drive a paranoid knee jerk demand for full disclosure of the strategies of the fund.

VCs aren’t inherently a leverage oriented investment vehicle, but they’ll be forced to disclose their actual strategies in order to “keep them honest”.

The second trend is the concern over fraud, ala Madoff and Stanford. Whether or not real fraud like these cases is common or not will hardly be the point, because these stories are simply so compelling that Politicians will make hay over the need for greater regulation and oversight. The idea that any kind of a fund would need to protect the details of their portfolio for confidentiality or proprietary protection flies in the face of the outright scams that took place under the current regulatory framework.

My bet is that regulation is absolutely going to happen, and that that regulation will require a pretty transparent disclosure framework around “portfolio” cost basis and current valuations, as well detailed disclosure of past performance of the funds. I agree that this will have a chilling effect on the VC model. But I suspect this is also just one more nail in the coffin of the existing VC model.

In the meantime, as entrepreneurs, we would be well advised to focus on building actual businesses that generate revenue and profits. What a novel concept?

Filed by Brad Hefta-Gaub at 7:11 pm under Entrepreneurship, Investing, Venture Capital
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