I’ve been working closely with the DaVinci Institute on some of its entrepreneurial efforts, and recently had a chance to interview Kevin Johansen, the sharp and charismatic head of the Entrepreneurial Standards Forum, about the world of angel investing and how it could be significantly improved. It’s a long interview, but darn interesting for anyone who’s ever thought about raising capital…
Q: I think that historically angel investing has been not just erratic and characterized by poor diligence on the part of investors, but also a crap shoot in terms of results. What are your thoughts?
Investing in startups is a gamble that’s more likely to pay off if you
know the rules of the game and play the percentages. By comparison, if
you go to Vegas and watch the professionals you’ll quickly learn that they
know the rules inside & out and that they play the percentages with a
great deal of discipline. This generally means that unless they know
*exactly* what their next move should be, they don’t move. The amateurs,
however, are there for fun and the off chance that they might hit it big.
As a consequence, they generally don’t think much before they act as
doing so lessens the element of surprise and can take the fun out it.
Investing in a business in the early stages of its development is
sometimes thought to parallel this phenomena, as one of the primary
motivations for an investor in an early stage Company is to roll up their
sleeves and make a contribution that goes beyond the dollar investment.
For a lot of investors, Angels in particular, ‘fun’ and the feel good
aspects of helping someone put their business on its feet are significant
drivers in their decision to invest. The difference is that in Vegas the
rules are more clearly defined and the odds are more easily computed.
Q: Isn’t one obvious area where angel investing could improve would be to
streamline the mechanism by which investors and startups are paired up?
Absolutely! The question is ‘How?’ and the answer is complex. This
complexity is generally where attempts at solutions fail. Historically,
the people trying to solve this problem have come to it from accounting,
legal or engineering perspectives. These are linear disciplines, and as
a general rule, they start by trying to scale the ambiguity from the
process. However, markets are dynamic, non-linear things. Were they as
simple as arbitrage, contract or software development they’d be more
predictable and yield more often to disective analysis & reductionism. As
a consequence, the result of the lawyers, engineers & accountants work is
generally a very linear process that’s easy to explain via flow charts –
but that sometimes has very little to do with reality.
Disective analysis and reductionism are great tools for figuring out how
simple, linear processes work, but with non-linear processes (Examples:
The weather and most anything involving people.) They’re an exercise in
frustration at best. Investing in early stage companies is a dynamic &
complex process that exists within a complex system. As it is a complex
system it requires a systems appproach to problem solving if you expect to
get anywhere. Unfortunately, the necessary computing power does not yet
exist that can effectively model this system. This relegates us to the
observers role when what we instinctively want to be is experimentalists.
So be it. There are still highly workable paths to solution available if
you can step away from linear perspectives on problem solving. One of
them is open source.
Q: Tell me how you think the process of doing “due diligence”, of fairly
evaluating the strength and probability of success of a startup, can be
There is no mystery to due diligence. It’s just work. Like most
processes that are “just work”, it can be made more efficient through
standardization. The problem with standardization, however, is that the
validity of a standards is tied directly to the number of people using it.
A standard is only a standard to the people who have agreed to work with
it as a standard. So the question then becomes: “How do authoritative
standards develop?” In markets they evolve through two processes. One is
through accretion of market share – you buy & earn your way through to
being the dominant service provider and then dictate the standard to which
everyone else comforms. The other is through open source in which the
community of Users makes decisions collectively about what the standards
should be. Autocracy works well with simple systems. Democracy works
well with complex systems.
The Entrepreneurial Standards Forum [link] is being built out to be an
open source, investor-centric initiative in which the community sets the
standards. If enough of a community forms around it the standards
developed will have validity. Building this standards development
community is the challenge in front of the ESF.
Q: Your team has been talking about a model of angel investing that’s
based on the stock market. I love the idea! Tell me a bit more about the
One of my favorite Internet words is “disintermediation”. It means
getting rid of the middleman, and over the last 10 years we’ve watched
information technologies disintermediate the middlemen in market after
market as the providers of a product or service figured out how to go
direct to the consumer without using a broker. Using the airlines as an
example, they began the disintermediation process in the early 90’s when
they started charging the consumer less for tickets if they bought direct
from the airline and not from an agency.
This change in business process was made possible by information
technologies and the Internet. As a consequence, the number of travel
agencies has dropped from about 36,000 in 1990 to about 27,000 today and
it continues to decrease. Good examples are everywhere. And there have
also been some exceptional success stories by companies that aggregate
access to products and/or services and then facilitated transactions
between parties without taking enough of a percentage to disrupt the
transaction. eBay, Google & Amazon come to mind. These are very
effective middlemen in part because they’re easy and inexpensive to use,
but also in part because they’re ‘long tail’ aggregators.
[The 'long tail' is a concept integral to the Internet's value to business. You can learn more about the long tail at wikipedia, but, in simple terms - and
for the purpose of this conversation - it means that when the marginal
cost of selling a product or service is the same regardless of the volume
of product sold, the whole of a market can organize itself under a single
Q: A big buzzword for startups seeking angel investment is “qualified
investor”. Can you explain what a qualified investor is and why it’s so
important when raising capital?
“Qualified” has several interpretations when it comes to Angel investing.
The most common usage is the one that is equivalent to “accredited”, which
generally means “millionaire”. The definition of “accredited” are
different State by State, but they generally means that the investor has
at least a $1,000,000 in assets and/or make something more than $200K a
year. The assumption on the part of the government is that if you have
that much money you know enough about investing to make informed
decisions. There are also ‘blue sky’ provisions in most States that allow
unacredited investors to invest in private equity deals. There is
generally a limit to the number of unaccredited investors that can invest
in a deal per State. In Colorado it’s 35.
But these are just the definitions. The prospecting process is more
important to the final result as most Entrepreneurs that need capital to
get their business going simply don’t know enough millionaires to get
properly funded. And as of this writing, there is no commonly accepted
process that an Entrepreneur can use to source capital, or that an Angel
investor can use to source investment opportunities. This is not
because there have been no attempts at creating them. There have
simply been no visibly successful attempts. This is in great part because
the entities that have attempted to create bizdev processes that become
standards didn’t build means into the developmental process for the
standards to become valid and authoritative.
Valid is a function of market share. That which is the most valid is that
which gets used the most. Authoritative is a function of effectiveness.
That which is most authoritative is that which works best. Without valid
& authoritative standards the only draw to a standardized bizdev process
is money. Designing a process with money as a primary draw is
problematic, as the majority of new businesses don’t need it, or don’t
need it enough to rationalize the effort necessary to get it from Angel
investors outside their personal networks. As a result, ‘money centric’
processes designed to generate deal flow for an Angel network or a VC
don’t address the needs of the larger market. And this generally means
that the community of Users that organizes itself around the process never
gets large enough to become self sufficient and operate independent of the
investors running it.
The solution, then, is to design a process that works for everyone, with
those businesses that need investors being a subset of the larger whole.
We think the only way to do this and get validity & authoritative
standards from the process is via an open source initiative. If the
community that organizes itself arounnd the Entrepreneurial Standards
Forum gets large enough, there will be enough critical mass in this subset
to customize a service offering for. One of the services in discussion is
a stock exchange that growing businesses could source capital from. The
ESF value proposition in this conversation is speed. Businesses that are
developed within ESF approved protocols will have less time & dollar cost
to the due diligence process.
Kevin Johansen is the founder and CEO of the Davinci Business Catapult, a Director for Capital Markets Group, the Entrepreneur in Residence at the Davinci Institute and the founder of the
Entrepreneurial Standards Forum. With a deep
concern for the ecology of commerce, he works with select companies and nonprofit organizations whose purpose it is to improve the overall health of the business environment. [more]