Trends – Should the Average Investor Gain Entry into Venture Funds?Several Firms Say Yes –

Who should invest in venture capital? The answer long has been wealthy families and individuals – a category that now includes many entrepreneurs – and institutions, such as pensions and endowments. The average wage earner, even the above-average wage earner, had not been invited to take part … until recently.

Typical Americans have gained entry to other parts of the investing world, initially joining the stock market through mutual funds, and most recently managing direct investments through online trading. In addition, many people today plan retirements around their 401(k) program earnings, rather than traditional pensions, and a host of companies offer their employees stock options.

But recently, investment opportunities have been getting a little broader for the common man. Draper Fisher Jurvetson (DFJ) founder Tim Draper and Inc. Chief Executive Andy Singer are the latest investment professionals intent on bringing venture investing to a wider audience.

Draper sees lots of future venture opportunities in the Internet, and he wants to share it with people whose incomes traditionally fall below VC investment standards. “It’s a thing I’ve wanted to do for years,” Draper notes. Nevertheless, he also wants to ensure those individuals know they could lose all their money.

The Newest Entrant

DFJ, its nationwide affiliate funds, and DFJ portfolio company meVC in December filed with the Securities and Exchange Commission to raise a $500 million information technology fund from the general public. According to its prospectus, meVC Draper Fisher Jurvetson Fund I, plans to sell 25,000,000 shares at $20 each, requiring investors to purchase at least 100 shares each for a total of $2,000. DFJ and its affiliates will oversee day-to-day investment management, while meVC will handle customer service, investor relations, marketing, legal, accounting and regulatory issues.

A meVC Draper Fisher Jurvetson Fund I backer must have either a $150,000 net worth or have at least a $50,000 net worth, not including his home, and pull in $50,000 in gross income a year, the prospectus says.

The meVC Draper fund will be listed on a national exchange three to 12 months after the stock offering, and the vehicle will feature a 2.5% management fee and a 20% carry. Draper expects the SEC to sign off on the plan by the end of January and fund raising to begin in February.

To be sure, venture capital in its present form has not suffered for lack of capital in recent years. By mid-December, VCs had raked in $36.4 billion, setting an all time high following a string of fund raising records set in the late-1990s.

In one sense, the public funds are a return to this industry’s early days, when groups such as Safeguard Scientific raised publicly traded funds. By the mid- to late-1960s, however, VCs shifted their attention to wealthy families and individuals, noted Harvard Business School Professor Josh Lerner. In the late 70s and early 80s, private equity started becoming an acceptable asset class for institutions and fund-raising efforts shifted to pensions, endowments and foundations.

Today, individuals can invest in the few remaining publicly traded venture groups operating in the United States, perhaps the best known of these being CMGI Inc. of Andover, Mass. (see stories, pages 20 and 37).

Draper and meVC are not wading through today’s public waters alone. Technology Funding of San Mateo, Calif. and Santa Fe, N.M., returned to individual investors two years ago with the launch of its 12th public fund, a $100 million-targeted diversified, later-stage vehicle (VCJ, March 1998, page 8). Tech Funding Venture Capital Fund 6 (VC-6) – which was to be raised entirely over the Internet, including all marketing efforts – had raised about $500,000 by press time and was planning to seek a two-year fund-raising extension from the Securities and Exchange Commission. The venture firm originally tried to rely on banner ads to drive investors to the fund’s Web site, explains Julie Ann Overton, Technology Funding’s director of communications, but the results were disappointing.

An investor in VC-6 should have a net worth of at least $45,000 – not including his home, furnishings or car – and should have an annual gross income of at least $45,000 or a net worth of at least $150,000. VC-6 shares cost $100 each, and every investor must purchase at least 10 shares totaling $1,000. As in the meVC fund, no investor can put more than 10% of his net worth in VC-6.

Meanwhile, mutual fund manager J&W Seligman Co. Inc. has had better luck raising its first “crossover” fund, which will invest in both public and late-stage private companies. Last summer, the New York and Palo Alto, Calif., firm quickly raised about $680 million from retail investors for a fund that invests in information technology and communications companies.

Technology Funding raised most of its investment vehicles from the public, and as a mutual fund company Seligman raised all its funds from individuals, this time with the opportunity to invest in private companies. The popularity of Seligman’s fund – the firm sold more shares than expected in three weeks – seems to reflect a public demand for private equity investment opportunities.

Is it Worth It?

Despite enthusiasm for bringing venture capital to the masses, the practice does raise questions: Is venture capital an appropriate investment for the general public? Is it even worth it for the average Joe investor to put his money in a venture fund? Will the general public threaten the position of institutions in venture funds? And why would a VC firm want to bother with individual investors anyway? Pat Mitchell, chief investment officer for the $107 billion California State Teachers’ Retirement System (CalSTRS) questions whether the average person should assume certain risks involving illiquidity and manager selection – issues inherent in venture capital investing.

Mitchell also wonders if public investors should be satisfied with such high numbers as Nasdaq’s 63.9% gain from Jan. 1 through Dec. 9, especially when they can choose mutual funds with virtually no fees over paying the carry and fees associated with a fund like the meVC Draper Fisher fund.

FLAG Venture Management L.L.C.’s Peter Lawrence thinks enthusiasm for VC funds catering to the general public is a sign that the industry is at the top of its market. He emphasizes the importance of choosing the right fund manager in achieving high venture returns, adding that unsophisticated investors are at a disadvantage in choosing which VCs to back – especially when there are so few venture firms even willing to take public money right now.

CalSTRS’s Mitchell asks why venture capitalists already raising so much money from individual institutions would take on the hassle of working with numerous smaller investors. Lerner, however, points out that demographic shifts, such as employees assuming more of their own retirement investing responsibilities from large pension mangers, are part of the answer. Additionally, Baby Boomers will be retiring over the next 10 to 15 years, leaving fewer new workers with traditional pensions.

Taken together, those trends mean pension managers will have less money to invest in the future, while individuals will have more.

What the Future Holds

Lerner doesn’t necessarily see venture firms managing relationships with a multitude of individual investors, but he does anticipate intermediary groups taking on that part of the investor relations grunt work.

In a sense, meVC fills that precise role for Draper Fisher Jurvetson’s joint fund.

Singer and co-founder Peter Freudenthal launched meVC in San Francisco last summer with $800,000 from hedge funds and individuals and raised $4.5 million from DFJ in October. Singer says he’d like to create a sort of Fidelity Investments for venture capital – a family of funds for individual investors – while at the same time develop a national venture capital brand around meVC.

Draper Fisher Jurvetson, for example, already has satellite operations all over the U.S. What meVC plans to do is let a venture group such as DFJ concentrate on making and managing investments nationally while meVC takes on the fund-raising and administrative tasks.

But fund raising sometimes is a major challenge. Technology Funding’s difficulties in this area led the firm to step back in the first quarter of 1999 to reevaluate its marketing approach. The firm conducted meetings with some 25 focus groups to determine the demographic and “psychographic” profile of individual investors who would be interested in a venture fund, Overton says. Likely investors include people who: are attracted to the thrill of higher-risk investments; believe in the power of technology and that today’s start-ups will be tomorrow’s blue chips; want to get in on the game; believe that an aggressive growth opportunity like VC is not limited to high-income investors, those who are long-term investors and are willing to wait for a VC fund to mature.

In December, Technology Funding was honing its marketing strategy, weighing whether direct mail would be a viable means of reaching potential VC-6 backers.

When launched in 1997, the fund was criticized by investment advisers who expressed concerns about VC-6’s fees and the fact that it didn’t set a minimum number of shares to be sold to make a go of the fund (VCJ, September 1997, page 13). Without a minimum, a small pool of investors could potentially be hit hard by fees, and the firm could have difficulty executing an investment strategy designed for a certain size fund. VC-6 initially was to have a first-year management of 4% plus uncapped operational expenses estimated at 3%, plus an unspecified organization fee at cost. The 4% first-year fee was lowered to 2% for all years before the vehicle was launched. The firm estimates total fees of 4% a year. There also is a 20% carry.

Seligman began placing 1% of its mutual funds’ assets in venture capital with its flagship fund, the 1997 Communications and Information Fund, says Managing Director and Portfolio Manager Storm Boswick. The firm wanted to benefit from its venture investing in two ways: first, through returns, and second by learning about upcoming threats to long-term technologies, thereby allowing the mutual fund to avoid companies about to be hit by new competitors.

For example, because Seligman saw Ariba Inc. and Commerce One Inc., two e-commerce companies that connect buyers and sellers of goods, coming through the VC pipeline, the mutual fund operator expected Sterling Commerce Inc. to be challenged and opted to sell its stake in that company, Boswick says.

Through its venture arm, Seligman has identified five technologies it expects will continue to change the world: business-to-business and business-to-consumer Internet commerce, broadband and fiber optics, wireless platforms, digital platforms and biometric software.

Since 1997, Seligman has made some 65 to 70 venture investments in companies such as Inktomi Corp., Interwoven Inc., Cobalt Networks Inc., Inc., Juno Online Services Inc., Crossroads Systems Inc., iVillage Inc. and Preview Systems Inc., reaping returns that would put Seligman among top-performing later- stage venture firms, Boswick says.

The group aims to make investments of $5 million to $7 million, and when other venture investors seek exits, Seligman seeks to get more money into a company. The mutual fund group wants to invest in companies from its initial round of financing to its initial public offering and its secondary offering.

With that strategy, Seligman launched the New Technologies Fund last July, raising it in three weeks through outside brokers. The vehicle is actually composed of two funds, a $580 million domestic fund and an offshore fund totaling a little more than $100 million. The two invest side-by-side pro rata. Half of the offshore fund and 35% of the domestic fund will invest in private companies.

Offshore shares were sold for $100 apiece while domestic shares were priced at $24.25 each. The fund features a 2% management fee for domestic investors and 2.25% for offshore backers. Investors exit by selling their shares to other buyers.

Shares were trading at 50% over the offering price at press time, he said, and those gains were made entirely on the fund’s public investments, Boswick adds.

Seligman wants to create similar funds to meet the enormous demand, he says. The firm would not reopen the New Technologies Fund, but it will launch another family of funds with different parameters and fee structures. Seligman’s funds have not taken carries, but to retain talent the firm will have to think seriously about its incentive structure for the next group of funds, Seligman says.

Not Everyone’s Interested

Foundation Capital General Partner Paul Koontz finds individual investing in venture capital interesting to ponder on the macro, industry-wide level, but on the micro level he says his own firm isn’t biting. The firm likes its institutional backers – mostly university endowments and large philanthropic foundations who are long-term minded, understand the venture business and let Foundation go about its work without a lot of oversight. “We have no reason to want to change that,” he adds.

Foundation recently closed its third fund on $275 million. The fund, Foundation Capital III, will back early-stage business-to-business e-commerce, Internet infrastructure and telecommunications, Koontz says.

He does see the public shifting from defined-benefit to defined-contribution retirement plans and eventually becoming more sophisticated. Whether venture funds will become viable instruments for the average person is an interesting question to debate, but in the meantime, Koontz suggests the public consider buying CMGI stock or look to incubators planning to go public to gain access to venture investments.