Patently Absurd

April 15, 2010

The topic of software patents has been getting a lot of coverage lately, and I think it is one that angel investors need to take note of, as it can — and invariably will — impact software companies in their portfolios. In the interest of full disclosure, I have been on both sides of the patent issue in my software career: as the sponsor of patent filings; co-inventor on patent applications (one still undergoing review); deponent for defense in litigation; and admittedly as an investor asking the question: “what sort of IP protection do you have?”

With the exception of the one instance being sued by a patent troll, I never gave the topic a lot of thought. When in small companies, I thought of patents as a fair way to provide some added defense in the ongoing battle against competitors large and small. When in larger companies, I accepted patents as part of the larger armory of legal tools that kept big competitors from suing each other into oblivion – a form of mutual assured destruction for the business world.

But that once instance with the troll was really, REALLY annoying. It taught me that there is a special class of company – typically small and unsuccessful at their core business – that doesn’t really value innovation, but instead sees the opportunity to use a legal instrument to build a business around. They are the bottom feeders of the technology world, and unfortunately their numbers are growing.

As an investor today, I often catch myself asking companies if they have any IP protection. In truth, I’m not all that biased by the answer, but want to know if the company has thought about it and how deep their innovations go. Essentially, the existence of a patent or patents tells me how the entrepreneur is looking at the market: a “better mousetrap” entrepreneur starts with IP, but a “change the world” entrepreneur starts with the customer and the business opportunity.

The reality is that for small companies – startups and even established SMBs – patents are an ugly trap. In a post earlier this week, Brad Feld talked about the various types of software patent plaintiffs, and referenced a previous post by his secret lawyer friend, Sawyer, entitled Why the Decks are Stacked Against Software Startups in Patent Litigation. I suggest that entrepreneurs give both of these a good read to understand the dynamics of the patent litigation process. Those who have been through patent litigation know that the answer is never as simple as did or did not infringe, because so many software patents are vague and over-reaching.

So litigation is the key, because without litigation a patent doesn’t have a lot of value. If a company wants to defend its patent, it will have to sue – or be sued. And therein lurks the struggle for the entrepreneur: many believe that a patent will help them attract funding and protect them from evil competitors – a magic talisman for startups. In practice, it often becomes a useless time- and money-sucking exercise that never comes into play, because to defend it costs more than the startup can afford. Entrepreneurs have to ask themselves if chasing alleged patent infringer is in their business plan, or even in their DNA. If you want to build great products and solve hard problems, you typically don’t start by hiring lawyers (apologies to my lawyerly friends).

Thinking about this issue, I tried to fit the dynamics into the ubiquitous 2×2 matrix, with company size (big and small) on one dimension, and patent strategy (defensive or offensive) on the other. The result left a void: large companies pursuing an offensive patent strategy (“offensive” meant here in the “aggressive” and not necessarily the “odious” sense). None came immediately to mind, but a recent NY Times article on Intellectual Ventures (IV) in the Seattle area provided a possible candidate. Admittedly, the IV strategy isn’t perfectly transparent, but they are very well funded and are attracting lots of customers and impressive revenues. For now, I take them at their word that they are trying to improve the marketplace for patent cross-licensing, and providing value to companies both large and small.

So we have a complete picture of the world:


On examination, I ask myself which of these strategies we (as an industry and body politic) really want to encourage through the issuance of software patents. With the exception of providing the software startup with some kind of short-term defensive tool during their earliest stages, I can’t see that any of these are more than manifestations of the inefficiencies inherent in the market today. And for the software startup, copyright and trade secrets should provide adequate protection while they raise money and enter the market.


Quitcherbitchin Ferchrissakes

January 12, 2010

A colleague active in the angel community dropped me a nice note encouraging me to keep writing here, but asking if I’d gotten negative about angel investing. He pointed out that angel activity was higher than ever, in spite of the challenges organizing all the parties involved. If that was the impression, I apologize: was just my cynical humor coming out. As I noted in my first post, I’m a big believer in the need for angels and a variety of means for gaining access to early-stage capital. I just believe that the current environment is in need of some shaking up.

The main reasons for starting this blog were to underscore the issues angel organizations face, and to start highlighting some new ideas. I felt the first part was necessary because the arguments around what to do differently often ignore the realities of the constraints. For instance, I was whining kvetching explaining to another colleague about the challenges operating an angel group sustainably. He’s an outspoken critic of angel groups charging entrepreneurs, and his advice boiled down to “raise your revenues, lower your expenses, but DO NOT CHARGE ENTREPRENEURS”. Okay… [Dude… Am I wrong? Am I wrong?]

Suffice it to say, I hope the previous posts illustrate that the problem is somewhat more complex in execution. However, I’m happy to say that innovation is alive and well in the angel community, and a number of people are applying brainpower to create new funding paths.  For the next few posts, I’ll look at some of the emerging models.


The Three… Two… One-Legged Stool

January 6, 2010

The previous few posts established the environment in which organized angel activities operate: a need for revenue to support increasingly professional operations and hired management, combined with limited means of assessing fees to participants in any transaction. The result today is that angel groups and events predominantly function on the basis of flat fees collected from investors, entrepreneurs, or sponsors. Charging each of these audiences has issues.

Investors are usually seen as the best source of fees to run angel activities: after all, they are the ones with the money and stand to make the most from the deal, right? Well… if you put yourself in their shoes, it’s not so simple: there is a limit to how much anyone will pay for what effectively boils down to a club membership or trade show attendance. For angel groups, I have heard investor memberships across the country ranging from $1000 to $5000 annually. Any less, and there isn’t enough income to support a manager; any more, and the investor expects the manager to provide a lot more service: such as screening deals independently, conducting due diligence, and negotiating terms. Those activities, of course, are viewed by the SEC as streng verboten, so most groups keep the amounts in line with value delivered. The same is true for events: investors are willing to pay a few hundred to a few thousand dollars, depending on the lavishness of the venue, headline acts, and extra-curricular activities.

Sponsors can be either public or private, though service providers like law and accounting firms, investment banks, valuation companies and the like are the most common targets. They make the big bucks, so they must have a lot of money to spread around, right? Well… as anyone who produces events can tell you, there are two problems with this assumption: there isn’t as much sponsorship money as there used to be, and sponsors have an annoying habit of expecting value for their contributions. Over time, sponsors start filling more of the seats in the audience, appearing in signage on every visible surface, and showing up on the agenda for “brief” welcomes, thank-yous, and overviews.

Finally, we come to the touchiest constituency: the companies seeking financing. There is enough debate in this topic for a separate – and upcoming – post, but suffice it to say this revenue channel has challenges. Whether couched as application fees, presentation fees, coaching fees, boot camps, or any combination, most entrepreneurs view these costs skeptically – often for good reason. Still, these fees persist, and aren’t necessarily indicative of some deep-seated class warfare against struggling entrepreneurs.

So, for better or worse, the organized angel sector today depends on these three revenue sources. Take away any one, and it becomes a balancing act to keep a group going. And more than likely, at some point you’ll lean back and land on your ass, wondering what the heck happened.

Who’s not writin’? John the Regulator

January 2, 2010

The Securities Acts of ’33 and ’34 established some interesting dynamics in the financing of private equity investments. At one end of the spectrum, we have funds (venture capital, buyout, distressed asset, mezzanine, and many variants). These are usually established as limited partnerships; restricted to at least accredited investors (individuals and/or institutions); and operate on a combination of management fees and carried interest. To date, funds have to date been mostly unregulated: the assumption being that if appropriate disclosures are made to a limited class of investors at inception, investors and fund management agree on terms, and the fund managers don’t run off to Brazil with the investor’s money, then everybody’s done their bit.

At the other end of the spectrum are transaction agents: variously called brokers, dealers, merchant and investment banks. These entities don’t typically manage money; instead they bring together investors and opportunities for a fee. Fee structures range from fixed amounts for capital formation advisory services and retainers, to a percentage of the capital raised. These organizations are very highly regulated: requiring testing and certification of the professionals; registration of the firms with an industry self-regulatory organization such as FINRA; indemnification and capitalization minimums; audits and other compliance measures. Not surprisingly, engaging an investment bank to raise startup capital can be prohibitively expensive. 

Somewhere in the wilderness between these two are “finders”: consultants, advisors, networkers and others who bring together investors and entrepreneurs for something in return. The securities industry has a less flattering name for these folks: “unregistered broker/dealers”, implying a level of sophistication that is usually absent. Instead, finders are often primarily engaged in some other business, but on occasion take remuneration for connection-making. Sometimes that remuneration is cash, sometimes equity. Irrespective, the law (sorta) says that if you want to be compensated for raising money for someone else, you have to be a registered broker or dealer. If found guilty of impropriety, the finder is not only subject to individual penalties (fines and presumably incarceration), but the transactions they have been involved with are forever tainted, and can trigger exercise of investor rights all the way through to an IPO. 

I’m fine with establishing a level playing field for private equity fundraising, but the current situation falls way short. The reason is simple: finders aren’t strictly policed, and as anyone who has been around private equity for a while can tell you, the rules aren’t very clear. Granted, the SEC is pretty busy with nuisances like Madoff, Stanford and Rajaratnam, but the lack of clarity in legislation means very uneven enforcement, often based on the priorities of regional SEC investigators. Finders who fall potentially under this restriction, then, never know if they have ridden into Dodge City, or Tombstone

So why should angels care? Theoretically, organized angel groups fall under this classification if they collect fees from any of the parties directly involved in the transactions: i.e., the investors and the companies. Practically, this has been enforced only in the case of success-based fees, no matter which party bears the cost (investor or entrepreneur), and regardless of whether the fee is flat or a percentage of the raise. This leaves the professionally managed angel group with limited options for revenue (hence, sustainability), and takes away the potential to align the interests of parties to the transaction from the outset. I’ll look at the implications in the next post.

The Snipe Hunt

December 30, 2009

Growing up in California, I spent a lot of time in the High Sierra at a family cabin. One of the popular games the parents organized was “hunting snipes”: taking the kids out after dark armed with paper bags and flashlights, stomping around in the woods shouting “Here snipe!” while shining the lights into the bags hoping to catch one of the elusive bird/mammal/reptiles when it ran toward the light. At some point in affair, the kids would notice the parents were all gone, as were the flashlights. Alone in the dark, lost in the woods. Panic and crying. Huge laughs from behind the trees!

Trying to connect the right investors to the right deals feels a lot like that. If you are an investor, you’d probably like to collaborate with other investors with complementary skills and interests, and it’s hard enough to find a few of those.  Then you have to find deals that fit your profile, and do it as efficiently as possible.  Somewhere out there, just beyond the light, is an entrepreneur with exactly the kind of deal you are looking for, if only they’d make themselves known. 

For some investors and entrepreneurs, this is no big deal. If you’re well-established in the community, visible and accessible, and have a track record on the appropriate side of the transaction, you’re going to get deals done.  You’ll have great access and say or hear “no” a lot. But for the new investor or first-time entrepreneur, it’s a tougher hunt.  Perhaps somewhat obviously, this is why organized angel activities survive and evolve: to minimize the friction in the opportunity discovery process. All the rest is really secondary and more sociological than functional.

The most fundamental human organizing principle is a group. Big and small, formal and informal, groups help us navigate life… even when we’re reluctant members.  Not surprisingly, organized groups persist as the most common way for angels to engage entrepreneurs. These might be informally managed by a few members, or a large organization formally run by paid professionals, but the principles are pretty much the same: find deals; vet and screen them; discuss, vote, dig deeper.  Having groups focused on specific market sectors allows them to be smaller; larger groups allow for more pooling of skills and broader industry reach.

Events are another popular means of getting the party started.  Whether monthly dinners, quarterly breakfasts, or annual blowouts, events get entrepreneurs in front of more investors (hopefully), but there typicallyisn’t a structured follow-up process, so the entrepreneur is often left working with a bunch of individuals, individually.

Investor directories and match-making sites are becoming more popular, and provide a great way for investors to search out deals that fit their profile without enduring a lot of social activities.

Finally, angel funds are a small but very interesting means of pooling investor resources and using the skills in the network.  There is a fair amount of management complexity to be discussed, but this may provide the best means of getting more potential investors into the mix. I’m going to consider incubators with a co-investment strategy a special case of funds.

With these options, it’s no surprise that investors and entrepreneurs have trouble figuring out where to invest their time.  But there’s another wrinkle: almost all of these activities costs money, and figuring out who pays for them is the source of a lot of angst.  Before I dig more into that, let’s look at the unnamed participant in the whole ecosystem: the regulatory environment.  Queue spooky music…

Mind the Gap

December 29, 2009

One wrinkle that has really impacted the angel investment sector is the VC trend toward later-stage investing.  This has been documented in many places, but the VC industry has effectively stopped investing in seed stage ($500K and less) and startup-stage ($2M and less) opportunities. [Note: Predictions abound that 2010 may see a return to smaller funds that participate in earlier stages, which will be good for everyone.]

Drawing on another slide from the 2007 ACEF presentation already referenced, there is a resulting condition that has developed — large rounds left unfilled by either individual angels or venture firms:

This gap has been increasingly filled by organized syndicates of angel investors, either through managed groups, angel funds, formal and informal networks.  When it works, this syndication has been credited with a number of positive outcomes:

  • more professional deal screening and due diligence efforts;
  • less reliance on institutional (venture) investors for businesses that aren’t attractive to VCs;
  • better preparation of those businesses that do chose to pursue venture investment;
  • faster closing of rounds, with more consistent and reasonable terms;
  • better returns to angels (see the excellent study by Rob Wiltbank and Warren Boeker for the Kauffman Foundation, which I’ll be referencing later)

It’s this condition — inefficiency, desperation, and large amounts of money in flux — that has led to a lot of innovation in the angel investing sector, as well as a lot of questionable behaviour.  But as we’ll see in an upcoming installment, it’s a no-win situation.

Profiles in Courage

December 29, 2009

Knowing the number of angel investors who are in the game, and believing that most of them have not been duped by someone, one has to wonder what are some of the reasons why they do it. There’s undoubtedly some psychometric research out there that outlines the personality traits and life experiences that make for an active angel investor, but just through observation over the years I have noticed the following:

  • they are generally successful business people with an entrepreneurial streak;
  • they may be retired or recently exited from another gig, so they have some time on their hands;
  • they are still excited about the energy of the business (esp. startup) world;
  • they are reasonably patient, but have human lifespans;
  • they want to put some cash to work outside the public markets.

In terms of what they hope to get out of the experience, the rank looks something like:

  1. Financial return
  2. Opportunity to help grow a business (get their hands dirty; use their brains, skills and contacts)
  3. Giving back to their community (call it for-profit philanthropy: a recognition that they were helped along the way and want to do the same for someone else)
  4. Financial return

The last isn’t a typo — it’s just a reminder that in the end, if an angel loses money in a deal or it takes forever to pay off, s/he’ll probably be disappointed by the experience no matter how well the other bits went.

Angels tend to invest in things they understand as a by-product of their business and life experiences. While highly technical angels might be willing to invest in deeply technical startups, in my experience most look for opportunities they can understand at a “visceral” level: a better mousetrap, a tastier soft drink, a new service, a better way to deliver old services, etc.  Taking the “magic” out of the business proposal means they can focus on fundamentals like the team, market, channel, and so on.

Angels have also learned over the years to avoid capital-intensive markets, where their meagre investments will be stepped on repeatedly by much bigger feet just to get a product to market.  This is why only the most intrepid and knowledgeable angels (and a few hapless gamblers) participate in startups in the pharmaceuticals, biofuels, solar cell, semiconductor and other research-intensive or infrastructure-centric sectors. While the upside potential is impressive, the long durations and high expenditures are enough to keep most checkbooks unopened.

In most of these ways, angel investors differ from their VC counterparts.  As professional investors with funds whose horizons may extend ten years or more, VCs can play more of a bet-and-hold game, re-upping their bets as needed down the road.  Once VCs enter the deal, angels rarely have the staying power to remain “whole” for long.  VCs can also play more of an opportunity matrix strategy, scattering a few investments around several major sectors and riding the big waves.  For these reasons and others, angels and VCs aren’t inherently symbiotic: they may interact occasionally on certain deals, but the success of each is not dependent on the other.