VentureWoods

I’ve seen a number of posts lately discussing the ‘changing face of venture capital’. Paul Graham talks about the change in dynamics caused by the low capital requirements of technology startups. Fred Wilson discusses the need for a market for privately held common stock. There seems to be a general consensus about the growing role angels play in the startup ecosystem, and sadly there also seems to be a general consensus indicating that angels should basically write off their investments the moment they make them.

This last point rings true for me. Before coming to India I made a number of investments in tech companies. During my chapter in Los Angeles I also put money into a couple of independent films and a big event with uniformly poor results.

“family, friends, fools & freeman” - Joke by John Mullins at the Venture Capitalist development program at ISB.

While the returns on these investments were uniformly bad, the journey the ventures took was not. One tech company has seven figure annual revenues which support the two founders in adequate if not lavish lifestyles. The founders / promoters in each case saw money on the way. Little made it back to the investors.

In iAccelerator.org we’re fortunate to have a team as advanced as HashCube.com. They are profitable with a proven record of developing and deploying casual puzzle games for social networks and mobile devices. Recently MySpace opened up its platform to developers and HashCube has done well as an early provider of games for it. They see an opportunity to scale - more games, more platforms, more promotion, more revenues .. more investment required.

Even if HashCube can reliably replicate the success they’ve had with their initial games, the question of whether their success can translate into a meaningful exit for its equity investors remains uncertain. What if it is simply a profitable business heavily dependent on the founders? Far from being an aberration, this maybe the common case for technology companies. 37Signals.com promoter David H. Hansson argues that creating small (compared to Facebook) profitable companies which serve the needs of real customers is a far more reliable path to startup success, than the traditional Venture backed Big-Bang approach.

To address this scenario, I had the thought that HashCube could offer investors the right to invest in a pack of games taking a % of the revenue generated by those games until achieving a certain IRR. The goal being to produce an automated mechanism in which investors get paid as a normal part of the company operations rather than being dependent on an exit event. 

<p>Chetan Pungaliya spent some time here in Ahmedabad mentoring our companies, and had some interesting observations on this. He didn’t like the idea of selling the game pack as the founders needed the flexibility to apply both, the money and their time, where it would do the most good. This may be promoting the existing games rather than building new ones. For the same reason, he was resistant to carving revenues out for the investors early as he believed that HashCube could be ‘big’, and may need to reinvest all revenue back into the company to fully realize their potential. He suggested an alternative financing scheme as a compromise between the game pack based revenue share approach and the traditional equity model. His idea was to allow founders to reinvest all the revenue for the first few (say 3) years, but to cap founder compensation during this time. At the end of three years the rev share kicks in. This provides the founders with full flexibility to grow the business quickly during the initial period, and provides a clear path for investors to recoup their money if an exit isn’t apparent and the founders are taking the startup along a ‘lifestyle’ business route. Presumably, if the company raises a significant venture round angels at this stage would either be bought out, or would convert to shares on similar terms to those of the VC.

I’d be curious to hear from other potential angels about whether this kind of structure would make it more likely for them to invest in very early stage tech ventures.