Going Direct: A New Paradigm in Venture Capital Investing

White Paper: Best practices for leveraging FinTECH to overcome inherent challenges with direct investing

The goal of this paper is to provide institutional investors, managers, and originators with a greater understanding of best practices for leveraging FinTECH to overcome inherent challenges with direct investing: liquidity, adverse selection, diversification, volatility, performance, scalability, access to best managers, and valuation.

Background

Institutional adoption of FinTECH platforms in the P2P sector has been robust. Prosper’s (leading P2P originator) lending origination grew by 347% in 2014 (YOY) issuing $1 billion worth of loans in just 6 months surpassing the $2 billion mark for the first time in the fall of 2014. Highlighting this accomplishment, it took Prosper 8 years to reach its first $1 billion in originations. Ron Suber, President – Prosper, terms this explosive growth “Escape Velocity” or escaping the gravitational pull of traditional lending practices and constraints (~banking industry).

And what accounted for Prosper’s escape velocity? Institutional capital! Hedge funds have been the primary catalyst for Prosper crossing the $5 billion mark in loan originations (October 2015). On the equity side, institutional capital is gaining access to early-stage technology and scaling capital primarily via investor syndicates (~online venture funds) participating both as “lead” syndicators (~Arena Ventures) and members of syndicates managed by esteemed investors.

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Group Intelligence, There is no Substitute

“Every week, Who Wants to Be a Millionaire pitted group intelligence against individual intelligence, and every week, group intelligence won.”
The Crowd! The phrase elicits a range of emotions from extremely pessimistic, “Either the Crowd is never wise, never reasonable and doomed to be extreme,” (Charles Mackay, publisher of Extraordinary Popular Delusions and the Madness of Crowds) to profoundly optimistic:

“This intelligence (~collective), or what I’ll call “the wisdom of crowds,” is at work in the world in many different guises. It’s the reason the Internet search engine Google can scan a billion Web pages and find the exact piece of information you were looking for. It’s the reason it’s so hard to make money betting on NFL games, and it helps explain why, for the past fifteen years, a few hundred amateur traders in the middle of Iowa have done a better job of predicting election results than Gallup polls have.”
– James Surowiecki in
The Wisdom of Crowds

So which is it?!

Chasing the Expert

“Chasing the expert is a mistake, and a costly one at that. We should stop hunting and ask the crowd instead. Chances are, it knows.”
– James Surowiecki in

Is the Crowd causing the death of experts?  Not yet but the Crowd is having a measurable impact in select industries including finance as evidenced by the growing reluctance of investors to select experts over index funds (exchange traded funds – ETF’s) given their outperformance. “Between 1984 and 1999 almost 90% of mutual-fund managers underperformed the Wilshire 5000 Index, a relatively low bar. The numbers for bond-fund managers are similar: in the most recent five-year period, more than 95% of all managed bond funds underperformed the market.”

As illustrated above, it is not always wise to chase the experts and the body of evidence supporting this thesis is growing as the Crowd has increased access to data and tools to share knowledge with each other. With the advent of the Internet (Crowd’s access to data), advancements in social media (sharing amongst the Crowd), ability to tag, quantify, and personalize data (Crowd learning and collaborating), the Crowd can be heard and participate like never before. Being heard is one thing, contributing value is another.

There is little doubt the Crowd comprises some of the most intelligent humans on the planet. But it also includes those who are not. That is where basic statistics plays a major role:

“Then why do we cling so tightly to the idea that the right expert will save us? And why do we ignore the fact that simply averaging a group’s estimates will produce a very good result? Richard Larrick and Jack B. Soll suggest that the answer is that we have bad institutions about averaging. We assume averaging means dumbing down or compromising. When people are faced with the choice of picking one expert or picking pieces from a number of experts, they try to pick the best expert rather than simply average across the group.
– James Surowiecki in

So if we can agree the Crowd provides valuable information/data collectively (oftentimes more accurate than the “experts”), the next step fueling this evolution entails the development and proliferation of tools encouraging the Crowd to contribute. One popular tool enticing the Crowd’s input resulting in “the collective” becoming more intelligent are Ratings & Reviews. Widely used in eCommerce platforms (~eBay) and growing in FinTECH (Peer-to-Peer, Equity Crowdfunding), Ratings & Reviews are pivotal for steering consumers/investors to those with the highest ranking from the Crowd and, as a byproduct, encouraging product/service providers to outperform. Ratings & Reviews implies “data in motion,” continually moving in a positive, negative, or neutral positions based on the Crowd’s sentiments over time.

Read more or download a pdf of this article here.

Social Media is Revolutionizing Alternative Investing

Digital Marketing/Social Media is Revolutionizing Education, Awareness, and Understanding of Alternative Investing

by Scott Jordan

“The Future of Peer-to-Peer Loans?
The Interview with Ron Suber, President of Prosper Marketplace”

Joseph Hogue, CrowdFunding Beat

Crowdfunding Beat – “How about the future of the industry? Where do you see peer loans in, let’s say, three years? Maybe even in five years?”

Ron Suber – “Continued integration of these peer-to-peer (P2P) platforms into the social network and the social community. If you look at Facebook today and go to the Prosper page on Facebook, you see thousands, tens of thousands of people telling their stories, sending in videos about how we helped them, and sending in photographs about the benefits of using Prosper. And you’ll start to see more and more of these technology firms embracing peer to peer (P2P) finance and payment. I think that will be a major driver in the next year or two ahead.”

Prominent FinTECH (Financial Technology) executives like Ron Suber, (President – Prosper), are realizing the benefits of marketing to borrowers/lenders on Facebook, Linkedin, and Twitter given social media’s “reach” (over a billion members on Facebook), and ease of sharing/building communities online including Friending” “Following” “Messaging” and “Liking.”

Below are the primary value propositions shared “virally” on social networks by leading FinTECH companies:

P2P (Prosper) TO INDIVIDUAL BORROWERS
►    Refinance consumer debt, major purchases, small business loans

P2P TO LENDERS (INDIVIDUAL INVESTORS, INSTITUTIONAL CAPITAL/HEDGE FUNDS)
►    Secure premium yields after default rates and fees

EQUITY CROWDFUNDING (HEALTHIOSXCHANGE) TO COMPANIES RAISING EQUITY
►    Raise capital on a direct basis at lower fees (~Seed, Series Rounds)

EQUITY CROWDFUNDING TO INVESTORS (ACCREDITED, INSTITUTIONAL/VENTURE CAPITAL)
►    Access to premium deal flow, lower fees, higher IRR

P2P/Marketplace Lending (Prosper) and Equity Crowdfunding platforms (HealthiosXchange) are increasingly utilizing social media platforms (~Linkedin) to build stronger relationships with existing members/customers stimulating repeat “purchasing” behaviors (lending, borrowing, investing), and reinforcing referrals to colleagues, friends and family.

Linkedin’s 1st (direct) and 2nd degree (indirect) connections directly influences user behavior facilitating communication, referrals, testimonials, “Followers,” and sharing/messaging.

Let’s now look at some of the leading social media strategies facilitating referral behaviors.Some of these strategies are basic while other complex, regardless, used in combination and with frequency, social media tools empower “Escape Velocity” or exponential member growth …

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CrowdFundConnect Services

CrowdFundConnect designs, builds and manages funding portals for broker/dealers, self-issuers and commercial real estate developers to post curated deals that connect companies seeking funding with investors.

Regulatory Compliance Services

Full audit tracking using single integration of SalesForce, DocuSign and other leading industry providers.

  • Accredited investor verification
  • Online document signing including PPMs
  • Subscription agreements, W-9 forms and others
  • Works with your third party escrow service
  • Works with payments via wire, ACH, or check
  • Full reporting of complete deal flow on all investors

Web Design Service

We can build pretty much anything you need to the highest quality and at a competitive price.

  • Web and graphic design
  • Custom coding html/css/php/mysql
  • Corporate identity and branding services
  • Develop marketing collateral
  • SEO services (Search Engine Optimization)
  • Email newsletter design services

Product Development Services

CrowdFundConnect offers a full range of superior process-driven product development services.

  • Product Development Services
  • Conduct focus groups and surveys
  • Usability testing
  • Document product requirements
  • Develop wireframes and prototypes
  • Develop interaction designs

Operations Support Services

We have a commitment to our customers to provide quality support services at competitive prices.

  • Host and administer your site
  • Technical support
  • Define systems and processes for customer service
  • Develop management reports
  • Train staff

Engineering Services

We provide an extensive range of turnkey, à la carte, and third party integrations and engineering services.

  • Development to customize and enhance core platform
  • Third-party integrations
  • Perform system administration and maintenance

Marketing Services

We are a quality solution to your design, branding, marketing, social media, web and all things marketing.

  • Integration with webinars and event registration
  • Low cost CAN SPAM compliant email services
  • Less than 1/4 cent per email
  • Enhanced analytics support campaign tracking
  • Perform A/B testing to optimize conversion rates

 

Will Equity Crowdfunding catch up to P2P lending?

Peer-to-Peer (P2P) lending has been an unstoppable force. Loan originations ($’s) recently surpassed $7 billion and market leading P2P online marketplace, Prosper, originated $172 million in September 2014 vs. $7 million year-over-year.

What’s behind Peer-to-Peer’s meteoric rise or what some are now calling “Marketplace Lending”?

  • The emergence and adoption of FinTech. From Daniel Gorfine/Chris Brummer’s “FinTech Building a 21st Century Regulator’s Toolkit,” October, 2014 – “Online finance and investment platforms are increasingly challenging the providers of traditional financial services with efficient, low-cost, and user-friendly products and platforms”
  • Investor thirst for yield. Low investment rate environment motivating investors to source deal flow from innovative online platforms including Peer-to-Peer
  • “Convergence” or the adoption of online investment marketplaces by institutional investors including hedge funds, family offices, and lending institutions (traditional banks)

So will equity crowdfunding catch up to P2P lending? It’s up to institutional capital!

If YES, what similarities exist between P2P and equity crowdfunding?

Innovation

Like P2P marketplaces, Equity Crowdfunding portals (AngelList, CircleUp, HealthiosXchange) are launching innovative financing vehicles repositioning the goal posts on how Accredited investors gain access to premium deal flow at lower fees (most likely correlated to/resulting in higher returns), institutional capital (venture capitalists) sources deal flow/invests in promising companies, and private companies reach the 8.7 million accredited investors in the United States. Equity Crowdfunding innovations include: investor syndicates (~online venture funds), eBack Offices (electronic documents, compliance, regulatory, payment), and crowdsourcing (scoring, “following” companies).

Large Markets

Like the debt/lending industries, private equity is a huge market as measured by invested capital. Over $1 trillion in capital was invested in Reg D companies in 2013. These financial marketplaces, controlled by established intermediaries (venture capitalists, broker dealers, banks), are rife with inefficiencies/high fees for participating investors including management fees/carry (“2” and “20” – venture capital) and front-end fees/loads (10-15% on non-traded REIT investments – broker dealers). But for most accredited investors the primary issue still remains access to premium deal flow. Like P2P, Equity Crowdfunding allows all investors to participate, no preferential treatment or connections required.

Convergence = Institutional Capital Sources Meet Retail

Convergence’s imprint is everywhere within Equity Crowdfunding from FundersClub’s “Partnerships” (invest alongside premier venture capitalists), to HealthiosXchange Ex.PR.E.S.S. portal (co-investments), to Limited Partner “direct investing” in AngelList syndicates (Maiden Lane), to “celebrity” investors (Gil Penchina/Tim Ferriss) leading AngelList syndicates. Like debt/lending, private equity/venture capital is migrating online. Why would it not? Technology is the ultimate leveler (“democratization” of capital), and there is immense untapped wealth available to private equity sponsors online (only 7% of the 8.7 million investors participate in private equity). As opposed to the zero-sum game mantra viewed by many incumbents, Equity Crowdfunding’s gains are institutional capital’s losses, direct investing is complimentary and additive to existing funding structures (Limited Partners funding venture capitalists). In fact, platforms like HealthiosXchange’s Champion’s Program, mimics institutional structures consolidating investors into special purpose vehicles (SPV’s) acting like Limited Partners (~Accredited LP’s), but without the management lockup restraints.

Adoption of Technology to Increase Adoption

Direct investing/crowdfunding portals are employing “Best-in-Class” social media/analytic technologies to reach investors globally. For example, incorporating many of the viral tools employed by social media giant Linkedin and Facebook to reach investors and foster engagement, portals like SilverportalXchange (real estate) create communities wherein members “friend,” “follow,” “message,” and “share” with the resulting member-generated data then personalized (match deals to investor preferences ~text analytics).

Equity Crowdfunding is also closely following P2P’s playbook by incorporating strategies for easily performing due diligence (online documents), transacting (electronic back-office), assessing risk (scoring), communicating with companies (interacting with management via online forums), and participating in investment communities (groups, follower companies).

Equity Crowdfunding Leverages Technology to Reduce Risk, Increase Investor Returns

Equity Crowdfunding portals are striving to reduce the risks associated with private equity investing by launching innovating financing platforms including Investor Syndicates. Given the risks associated with private equity investing (~illiquid, “hits” based business, high failure rate), investor syndicates were created to make it easier for investors to diversify across a number of promising companies/high-profile lead syndicators (esteemed investors with successful track records) via low investment thresholds (<$5,000 per investor per company).

Portals also aim to reduce investment risks by providing information/data online required to assess investment opportunities. Online tools include scoring (Crowdsourced, Proprietary), ability to message potential/existing investors online, and leverage events-based forums (webinars, road shows) to interact with management.

If NO, what will prevent equity crowdfunding from matching P2P’s performance?

P2P Investor Onboarding Easier

The nuances of loaning money is well understood by investors given the prevalence of/familiarity with the banking industry and lending activity between friends and families. Debt is attractive to investors given it provides current income (yield) while protecting principal (return of capital at loan maturity). The financial markets have fed the market appetite for yield/protection of principal by providing robust analytics, reporting, ratings, and transparency contributing to the prevalence of debt (bonds) in most investor portfolios.

Given P2P loans are not classified as securities nor the organizations facilitating the lending activities identified as brokers or RIA’s, P2P platforms can more easily source deal flow (members fund loans directly from bank accounts). Ease of use and understanding/familiarity of debt has correlated to high rates of investor adoption similarly to those associated with eCommerce (~Amazon).

Investor onboarding via Equity Crowdfunding is more difficult. Investors are required to review and sign (electronic signatures available) term sheets/offering memorandums, and wire capital into escrow. As a result, many investors do not understand the process and/or given the number of additional steps (vs. P2P), do not complete the investment process.

P2P – Stimulates Institutional Adoption

Institutional capital is embracing marketplace lending platforms (about 66% of all Prosper loans in 2014 were sold to institutional investors). Peter Renton – Lend Academy, mentions in “Orchard Lands a $12 million investment from some of the industry’s biggest names,” October 21, 2014, the advent of the third lending model, “Historically, there have been two different business models in the lending industry: balance sheet and securitizations. What Lending Club (~Prosper) has proven is a third model is possible: the marketplace lending model.” Equity Crowdfunding is still pursuing institutional adoption.

P2P – Easier to Build Diversified Portfolios, Assess Risk

The P2P industry provides easy-to-use analytical tools assisting lenders with selecting and diversifying loan portfolios effectively smoothing returns. Prosper provides members value added tools on their website. Equity Crowdfunding still strives to be understood.

P2P – Establishing Liquid Markets

Secondary markets stimulate institutional engagement by providing a marketplace for liquidity; an exchange where positions can be built or liquidated in real-time. Equity crowdfunding is still focused on building its primary market.

Read more, or download the entire article, here.

Image © Can Stock Photo Inc. / kentoh

Online Venture Capital … Why not?!

If there is one industry that has successfully resisted change, it is Venture Capital. There is no doubt Venture Capitalists (VCs) play a vital role in the capital markets assisting companies raise seed/growth capital to advance development programs. Major VCs devote significant amounts of capital from their Limited Partners (pension funds, endowments, foundations) investing in emerging growth companies following extensive due diligence by seasoned industry veterans, introduce valued networks assisting portfolio companies with operations, and facilitate successful exits (IPOs, M&A) given strong relationships with bankers and strategic buyers. For these services they are well compensated.

This sounds impressive. So what is the problem? Over the past 10 years VCs struggled to provide alpha (premium to established benchmark returns like the S&P 500) to reward investors for participation in a risky asset class. Though the recent IPO window and robust M&A activity will surely improve these metrics moving forward, many still feel the incumbent fee structures (“2” and “20”), long-term lock-up’s (~10 years), and reluctance to invest in early-stage opportunities and those companies located outside of San Francisco/Boston, is forcing companies to seek capital from alternative sources (accredited investors, family offices, limited partners direct).

Enter online venture capital

Fueled by advancements in social media (~Linkedin), passage of the JOBS Act (expanded shareholder cap and approval of general solicitation), and increased adoption of direct investing by alternative investors (i.e., Peer-to-Peer lending ~Prosper), the funding landscape is drastically changing! Whether in the consumer goods industry (CircleUp), technology (FundersClub and AngelList), healthcare (HealthiosXchange, Poliwogg) or real estate (Reality Mogul, SilverportalXchange) industries, investors are increasingly sourcing and investing in deal flow (private equity) directly. As with the discount brokerage revolution (rise of online public equity trading platforms including Schwab and TD Ameritrade), technology is altering the landscape of how investors participate in private equity.

Convergence

One area where technology is reshaping the investment landscape is what many are calling “Convergence.” This term describes the merging of retail and institutional pools of capital resulting from the proliferation of online platforms including Peer-to-Peer Lending (P2P), and equity crowdfunding/direct investing (AngelList, Fundrise, Mosaic).

A recent article, “Has Peer-to-Peer Lending Turned Into Hedge Fund-to-Consumer Lending?” by JD Alois, Crowdfund Insider, highlights convergence:

  • “While P2P lending started out by matching an individual borrower with an individual investor things have rapidly changed. The outsized returns generated by the various P2P platforms have not been missed by institutions and hedge funds.”
  • “During the last quarter, almost 60% of the $1.1 billion in loans originated on California-based Lending Club – the largest P2P lender in the US – were snapped up by asset managers, banks, hedge funds, insurance companies, pension funds and other institutions. At Lending Club’s main competitor, Prosper Marketplace, 66% of loans went to these same types of investors.”

Though the merits of institutional capital’s involvement in the P2P industry can be questioned (hedge funds have acquired large portfolios of P2P loans and securitizing them to attain leverage), there is no denying the evidence supporting how technology is facilitating convergence between retail platforms and institutional investors.

Investor Syndicates

It is just a matter of time until blue-chip venture capitalists launch their own investor syndicates. Why make this bold statement? Because the value propositions associated with leading investor syndicates are too compelling for Fund managers and professionals start-up investors to ignore including:
•    Online presence to build a following
•    Turnkey fund management tools to run venture funds (i.e. HealthiosXchange’s Reserve system)
•    Access to a marketplace of tens of thousands of accredited investors
Convergence is on the move. Institutional capital is “crowding out” retail capital (Peer-to-Peer), strategic buyers are moving online to meet promising emerging growth companies, and venture capital firms are launching investor syndicates to tap into additional sources of capital. Catch the wave!

Read more, or download the entire article, here.

Image © CanStock / tashatuvango

Crowdfunding + Crowdsourcing = Going Viral

What if emerging growth companies could easily reach 20 million investors! Sounds impossible but wait a minute. Last time I checked my Linkedin account it suggested I am connected to 20,882,416 contacts via 1st connections, 2nd connections (aggregate 1st Degree networks) and group members on Linkedin. Given I am a “top” 1% member of Linkedin (connected to 2,700 members), this reach may be unrealistic for most. However, even emerging growth company executives with 500-700 Linkedin members may have access to upwards of 5-10 million contacts.

What does this really mean in the context of private equity investing? It means under the new 506 (c) general solicitation rules (ability to solicit people with no existing relationship) companies can virally spread their message (via social networks) to those who otherwise may not become aware of the opportunity to invest in the next private “Google.” Couple this awareness with the ability to invest at lower investment thresholds (more readily diversify within private equity allocation), and this is a cocktail for adoption by Accredited investors.

Online investing in private equity is truly going viral! With the advent of advancements in technology (social media), emergence of crowdfunding (donation, reward, peer-to-peer, equity), and unprecedented legislation (JOBS Act approved in 2013), there has never been a better time for leveraging direct investing platforms (crowdfunding portals) to reach investors!

Empowering Networks

Crowdfunding portals “empower” company and investor networks (“rolodexes”) via the same technologies utilized by leading social media companies Linkedin, Twitter, and Facebook. Crowdfunding engines leverage text analytic (XML) technologies to collect data (from member profiles/company profiles), tag data (investor preferences/deal terms), and present data (match crowdfunding members with company offerings) via advertising, notifications (email, workflows).

The first and most obvious network to empower is Friends and Family. Empowering personal networks (friends, family co-workers, former co-workers, and prospective/current investors) is essential when seeking capital at earlier stages (seed), given many capital providers (venture capital) have moved to later-stage opportunities. HealthiosXchange, an equity crowdfunding portal serving the healthcare industry from “Seed to Exit,” empowers member friends and family networks by:

•    Providing tools for tracking referrals (personal ref codes sent to networks requesting referrals to join portals/follow companies/invest in deals), event participation (webinars, road shows), and company page visitors/activity
•    Keeping networks informed of catalysts (achievement of key milestones); encourage them to become investors (“Follow” companies and receive updates in real-time)
•    Encouraging page “Followers” to conduct due diligence by interacting with management, members (friend, follow, message, share) and by reviewing online documents, scoring etc.
•    Encouraging page “Followers” to share portals joined and deal activity with networks via social media platforms (Linkedin, Twitter, Facebook)
•    Incentivize page “Followers” to persuade networks to “Follow” and “Invest” in private equity offerings (i.e. if a broker dealer, ability to receive commission; if not, eligible to receive carry)

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Lead image © Can Stock Photo Inc. / cienpies