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Wednesday, 18 March 2015 00:00

Venture Capital Misallocation, Illiquidity & Disintermediation: Veritas Use Case #1 Featured

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Vertias Driven Disintermediation

Following up on yesterday's research, "The Evolution That Is Veritaseum: Benchmarking It To Venture Funded Competition", I wiush to lead into the first publsihed use case of Veritas - our commoditized, tradeable intellectual capital. This particular use case is a real life story  - mine. It is a solution that I used Veritas to come up with after pondering the state of the venture capital industry. Please read on...

Everybody is piling into the venture capital space, including angels, websites (ex. Angelist), and corporate venture funds. Corporate funds have taken more than 12% of the total VC takedown. California had more than 50% of all corporate VC deals last year, followed by New York (Veritaseum’s home turf) and Massachusetts. Google Ventures did more investments than any other corporate VC last year. As you may know, Vertitaseum’s founder recommended the Long GOOG/short APPL pair trade in 2012 and introduce Google Glass to Wall Street on CNBC.

Here are the top 20 corporate venture funds in terms of activity:

CB Insights on corporate VCs

It does seem that raising money with the big brand name professional VCs leads to much larger rounds, and it seems those rounds are often more profitable than with smaller VC funds that don’t seem to have the same connections to capital and deal flow. The chart and list below was sourced from the CB Insights article: If You Raise From These Smart VCs, You’ll Raise More Money:

The smart money investors analyzed include:

    1. Accel Partners
    2. Andreessen Horowitz
    3. Battery Ventures
    4. Benchmark Capital
    5. Bessemer Venture Partners
    6. CRV
    7. Felicis Ventures
    8. First Round Capital
    9. Floodgate Fund
    10. Founders Fund
    11. Google Ventures
    12. Greylock Partners
    13. Index Ventures
    14. Khosla Ventures
    15. Kleiner Perkins Caufield & Byers
    16. New Enterprise Associates
    17. Redpoint Ventures
    18. Sequoia Capital
    19. Spark Capital
    20. Union Square Ventures

Notice that many of the companies listed here are funders for the Bitcoin company rounds listed in "The Evolution That Is Veritaseum: Benchmarking It To Venture Funded Competition". Be aware, looking at the amounts raised and who raised them is only a small part of the real story.

We’ve solicited each and every one of the funds above, and many of them two and three times. The advantage of being better positioned as a larger VC may be a red herring, a misnomer, after all we have circumstantial (albeit first hand) evidence that deal flow may not be vetted empirically, but subectively, and (more importantly) very expensively for the investor and entrepreneur. The legacy vetting process may be more akin to the “membership to the club” methodology vs. picking the best opportunity available. If this is true, there’s potentially a very profitable arbitrage opportunity. (We’ll come back to this point in a minute after reviewing the Veritaseum business model of disruptive disintermediation.)

The Inefficiencies of the Venture Capital Industry Will Lead To Veritaseum-style Disintermediation - Before or After the Bubble Bursts

Our analysis exposed some market inefficiencies, such as clients of hedge funds having nearly as much expertise and bandwidth as some of the funds they were investing in, yet paying said funds 2 and 20 (or more, such as 2.5 and 30) to deploy their capital anyway. This is a point that I must expound upon. The reason that most VC funds do not have a hurdle rate (a minimum amount they must generate in profits before they can participate in said profits via their "carry") is not to disincentivize risk taking. After all VCs (particularly seed and early stage VCs) are in the business of funding high risk ventures, and if their compensation structure discourages this due to the possibilty of losing a big paycheck already earned, then said compensation structure work's against the interests of the LPs who chartered their money for high risk/high reward investments. This situation is called distorted compensatory motivations. 

Looking a Bit More Closely At What You, the Client Pays a Typical VC

But... (yes, there's always a but), this methodology of avoiding distorted compensatory motivations can actually distort compensatory motivations. The management fees, normally 2- 2.5% of the assets committed to be invested, are designed for a fund to be able to meet its ongoing expenses as a business as it goes about its business of finding, vetting, and (allegedly) nurturing companies that have promise. This works out practically for smaller to medium sized funds. The problem is, with worldwide NIRP and ZIRP, fund sizes are growing ridiculously large. A $100 million fund (it appears to be thought that sub-$100M funds are uneconomical) would receive $2-2.5M per year. That's enough $7k per month rent, an analysts and 2 partners (one senior, one junior) taking a low range comp package (to be made up with a larger carry bonus) a secretary and SG&A and marketing/contingency expenses. The point is to make the partners work for the carry, not the salaries - and at this level it works fine, even with a cushion or safety net.

With larger funds, the meritorious compensation rubric becomes dramatically distorted...

Venture Capital Compensation

  1. Analyst $ 80K - $ 150K
  2. Associate $ 130K - $ 250K
  3. Vice Presidents $ 200K - $ 250K + $ 0-1MM carry bonus
  4. Principal/Junior MD $ 500K - $ 700K + $ 1-2 MM carry bonus
  5. Managing Directors/Partners $ 1MM + $ 3-9MM carry bonus

(Much like private equity compensation, venture capital pay also includes a carry bonus, which may result in a large payout.)

These venture capital salary figures are an approximation and rough range based on the user registration data on Wall Street Oasis as well as the thousands of discussions on venture capital compensation that the community has had around compensation at these levels (source: http://www.wallstreetoasis.com/)

As funds break the billion dollar mark, these distortions become considerably more intense. As you can see from he $1.5B fund raise modeled below, the partners are pulling in$35 million per year, by hook or by crook. That is a lot of money to make annually before the first cent of profit is ever (if ever) generated!  

VC fund expenses 3

Ten partners can pull down $3 million salaries plus pay associates and analysts, while horribly and spectacularly failing - see below under our "adverse scenario" where GPs can produce a near 1,400% return while the LPs take a near total loss - and that's including the GPs 1% equity contribution to the fund. In such a scenario, the carry can be the investor's call option from hell - or the GPs call option from heaven - really depending from which side of the fence you are standing!

VC fund expenses 4

As more insight and better tools (such as Veritas) become available, I see these institutional investors competing directly with the VCs they invest in as financiers. 

Why, you Ask?

While not being an expert in the field of venture finance, I'm damn good at finance in general, and looking at how capriciously our offerings have been glanced over without any inquiry, there is circumstantial evidence that VCs aren’t paid to generate above market returns. That 2.5% fee that you see modeled up above puts a considerably higher risk-adjusted reward on being an asset gatherer rather than an asset investor. As an investor myself, I modeled my startup after what I thought would be the prime investment opportunity. Alas, it is high risk and there's much lower risk (if the fund manager has enough traction) to raise $1.5B at 2.5% yield than to invest in 20 - 30 companies with one hitting 10,000% return, 2 hitting 100% an the rest trailing towards zero or complete loss. Even when the funds do well, carry is not disbursed until successful exit, likely several years after the raise closes. You know what they say, a bird in the hand is worth two in the bush. Plus, one should recongize that they would likely not be able to deploy the full $1.5B unless they engaged in very large rounds, hence putting even more pressure on the entrepenuer for ROI.

In addition, Entrepeneurs are being pushed to deliver returns on 100% of capital despite only recieving 85% of it. Yes, that 2.5% is not only expensive for the investors, but for the entrepeneur as well. The funds ROI is not calculated net of mangement fees, hence the entrepenuers efforts are guage gross of management compensation, not net. It would have been more favorable to the entrepeneurs to source the capital themselves, they would feel and immediate 15% bump in return for their investors.

These perverse incentives quickly and dramatically misalign the incentives of the GP in relation to both the investors and the entrepenuers. I feel I've explained the misalignemnt between GPs adn LPs above, but how about entrepeneurs? 

This Quora question inquired about whether a $100k salary for a startup was inappropriate. All VCs answered basically yes, with the reason being it looks like you are acting like and employee rather than an owner. Here are some key quotes:

David S. RoseManaging Partner, Rose Tech Ventures; CEO, Gust: ... in my experience, that fact pattern (a pair of founders, $500K seed round) would typically see them each taking $50-$75K, at least until they either start generating revenue, or raise a larger round. At that point, $100K (which is pretty close to market) might be a little more palatable.

Which would be similar to the management fee capped at 1% and scaling upward after successful subsquent rounds at higher prices for GPs and the fund. If the investors would manage VCs the way VCs purportedly manage entrepeneurs, this is what we'd see.

Sean OwenUK early stage tech VC: It is normal to draw a minimal salary, not market-rate salary. At this early stage, everyone needs to be investing in the business. Investors put in money; founders put in work. Someone drawing a market-rate salary is being fully compensated in cash and can't be said to be investing; this only makes sense if said person is not getting equity in the business.

This is exactly the point that I made above, re: management fees, particularly with thebigger funds. It's good to see that we agree on this, no? :-)

Nicholas ChavezReceived VC funding: In life you don't get what you deserve.  You get what you negotiate.

Anonymousit sounds like he's negotiating for a job, not making an investment.

Bingo!

VCs expect entretpenuers to have put skin in the game, yet the industry practice is for GPs to put only 1% in as a fund contribution, and many of them don't invest that 1% from personal assets - they pledge it from expected management fees!

If investors structured funds with the same structural expectations VCs have from startups, investors would see both lower fees and much less overcompensation for underperformance while allowing the funds to bathe in appropriate compensaion for overpeformance.

The VC industry has failed to innovate, and that usually presages disintermediation

Outside of Angelist and similar online ventures, not much has changed in the VC space over the last 20 years except for fund sizes getting larger due to the ZIRP. As ZIRP either tapers or backfires (either way, we'll likely find out within two years), the hedy VC rerturns will revert to mean, but not before overshooting the target to the downside.

U.S. Venture Capital Index Returns

The Cambridge Associates LLC U.S. Venture Capital Index® is an end-to-end calculation based on data compiled from 1,522 U.S. venture capital funds, including fully liquidated partnerships, formed between 1981 and 2014 and the U.S. Growth Equity Index is based on data compiled from 164 U.S. growth equity funds, including fully liquidated funds formed between 1986 and 2014.
1 Pooled end-to-end return, net of fees, expenses, and carried interest.
*Capital change only.

Static technological advancement is usually the precursor to disintermediation. Ask the media industry, they know all about it. Between the lack of innovation and the cyclical change about to run its course, this is a ripe opportunity for a different way to access this asset class to come about. I propose investors be able to  various aspects of VC exposure - both long and short - on a liquid basis, and without the massive fees associated with it. How's that for rapid innovation in a short period of time. Read on to find out more...

 The Veritaseum business model is usually executed through a two pronged approach, but each prong has a common theme: disruptive disintermediation.

Disintermediation 1.0: Take out the inefficient middleman

  1. We are directly soliciting the clients of those we initially sought to finance us. I’m personally soliciting the institutions and investors who fund the VCs to teach them about the new commoditized intellectual capital product we’ve launched (Veritas) and how it can assist in their investment efforts, namely:

    1. Angels or former clients from BoomBustBlog literally cold called me to invest. These are smaller amounts in the 6 digit range, but every amount helps when you’re bootstrapping. Thus far, these are the only outside equity investors. There were some ex-clients who were willing to put in much more, up to $20 million. I’m going down the list of all 10k or so subscribers to spread the gospel.

    2. Family offices who are now competing directly with the VC funds they are investing in.

    3. Large sovereign wealth funds. The result so far? BINGO. They absolutely love the concept, the team, the execution to date, particularly the middle eastern funds. 

Disintermediation 2.0: Take out the middleman and the distribution network

  1. As we’ve reached out directly to the potential (and actual, since we are the first to actually have a product up and running) users and started financing ourselves Kickstarter-style by pre-selling our software and services (through Veritas). This is very similar to what Microsoft does with its unearned revenue annuity model or Macy’s does with its gift cards. The difference is that purchasers of Veritas (our gift card for products and services) can:

    1. redeem them immediately (because we have both products and services available now as well as a portfolio of upcoming offereings),

    2. horde them,

    3. turn around and resell their gift cards (we call them tokens) OTC or on an open exchange if they wish.

One cool part? They’re divisible. (Try regifting half of your Target gift card and see how far that gets you.) The selling and trading of these tokens allow for the tokens to be valued by others through word of mouth, thus validating the value of our products, services, and brand via the public opinions and actions of others.

Please be aware that these are not financial investments. They are not stocks or securities. They are direct economic stakes in access to our actual products and services (direct purchases of said products and services as opposed to purchases into our company or operation). These products and services are essentially and literally built directly upon the backbone of the Bitcoin network. Our software/services token is called Veritas, which we refer to as the “Capability Commodity” because it encapsulates tradeable intellectual capital (ours). That is the Veritas difference! From day one, it is backed by actual, definable, quantifiable value that has already proven itself in the market as sure as you can find only one wallet that will allow you to short JPM and go long the EUR/USD pair at the same time at 100x leverage without fear of margin calls, negative equity, or counterparty failure. And you can redeem your Veritas (capability commodities) for our services.

 Click here to view as full page presentation.

Here you have three distinct differences between Veritas and many other token sales:

  1. Immediate backing by something of demonstrable, historical, and provable value;
  2. The ability to redeem the token to the issuer for products or services - effective immediately - with plans to rapidly expand the ways in which Veritas can be redeemed in the near future; and
  3. The existence of intrinsic value and marketable value from the outset.

What Are Veritas- 4

What Are Veritas- 5

How Is Deploying Capital Into Veritas Better than Buying LP Units from a VC Fund If Veritas Are Not Securities?

Unbridled, Unmatched Expertise - For instance, we can show you how to disintermediate your own illiquid investments in VCs and funds and make them liquid

One obvious answer is that you get instant expertise. If you have any questions related to our Veritaseum platform and its use, there is no better source for the answer and its implementation than the people who made it. Few realize how powerful and answer this can be. For instance, you can use Veritaseum to create synthetic, liquid “LP-like units” that track and mimic the value of that sold by specific VC funds for 2 and 20. The difference? You pay 50bp instead of up to 2,200 bp - and you can go long or short! Yes! You can actually use our product to disintermediate the funds, and we’d be happy to show you how, and build out the entire implementation for you. Veritaseum, the value transfer platform, is vehicle that you’d use to do this and Veritas is the Intellectual Fuel that you’d purchase for us to put that vehicle together for you.

You can purchase Veritas in bulk and use it all at once, or purchase it piecemeal, or buy a large amount and sell it off to other parties if you feel you don’t have any further immediate use for it.

Remember, tech VC funds are highly correlated to the NASDAQ, with such a high correlation many institutional investors have concentration and diversification risk that they are not aware of. It would actually be imprudent not to consider an exploratory purchase of Veritas of you have such a high concentration. If you are a high net worth individual, family office, sovereign wealth fund, or pension fund that deploys more than $500,000 into this asset class, you should buy some Veritas then talk to us.

Financial capital commitment is flexible, even while the intellectual capital deployment can be aimed at a longer term horizon

You can buy, sell, and trade your Veritas immediately.

There’s a High Correlation Between Economic Revenue and Equity Valuations

Veritas are essentially pre-sold products and services. There’s a high correlation between revenues, economic profits, and equity values. Basically, if we do well through product and service sales, you do well. If you do well using our purchased products and services, we do well. There’s a wealth of research to substantiate this synergy:

  1. Revenue Growth and Stock Returns
  2. Relationship Between Market Share and Profitability

Your purchase of our product, whether in real time delivery or through Veritas, enriches both you and us. How?

Each purchase of Veritas increases our sales, which increases our brand equity and value, which enables us to deliver even more fantastic products and services, which increases the impetus to purchase Veritas for our products and services, which increases both the value and the market price of our products and services, and thus increases the value and market price of Veritas, which is the key to our products and services. 

Get it? Yes, there's sometimes a method to the madness of circular logic! Buying our products and services through Veritas allows you to compete head-to-head with the leading venture capital funds, and Veritas owners already have a significant head start! Veritaseum was likely the first entity to apply for patent protection for many of the key technology applications and uses illustrated above. 

Veritaseum has a very, very diverse management team with expertise in IP law, software engineering and architecture, investment stategy, forensic/fundamental/global macro strategy and analysis—and we're just getting started. The CEO has a strong media presence as well:

The Business Media Sees This as DISRUPTION!

image001.jpg

"You're going to put JP Morgan out of business! The banks are going to hate you!"

image002.png

"At least one of the top global money center banks have approached us, and I expect to hear from at least 3 of the top 6!" “MP3 technology combined with innovative business models have cut the music industry profits in half, and they're not coming back!  I query all banking execs, 'Do you want to get MP3'd?'"

image003.jpg

"You are building a virtual Goldman Sachs on top of Bitcoin!"

image004.png

“Middleton sounds a bit like an 18th-century pirate striking back against the Empire when he declares that ‘…what I’m doing right now is a direct threat to fiat merchant banking.’”

image005.jpg

“It’s the perfect storm of disruption, as it renders trading fees, brokerage fees, and those infamous Wall Street bonuses obsolete. The sheer scale of disruption this technology brings with it makes it something to watch.”

image006.png

“Veritaseum is ripe for a strategic investor to approach us before the end of the calendar year, likely payment processors, global banks, and innovative technology companies such as Google, Facebook, Microsoft or Apple.”

Why Go Veritas Instead Of Venture Capital?

The majority of successful entrepreneurs and professionals will likely be solicited by (or seek the opportunity to participate in) a VC and/or private equity fund. Technology has changed the way things can be done and disintermediation is not constrained to the media industry and P2P file sharing anymore:

  1. The number one, universal, irrefutable characteristic of private equity, regardless of the source of that private equity exposure (fund, online aggregator, bank, or adviser) is a lack of liquidity. At the very least you’re stuck with your capital outlay for 3 years, but more likely 5 to 10 years. Since these are capital appreciation plays, that is dead money until an exit occurs, if it occurs. The reason to invest in private equity is to garner higher than mean returns on a risk adjusted basis. As you can see from the chart below, the larger the fund the greater the return (on average) but all funds of all sizes drop precipitously in performance as the horizon stretches. Then there’s that 2 and 20! Trust me, it can really add up.

Source: Pitchbook

In addition, the field is getting crowded as high returns bring a higher level of competition—meaning more people at the table looking to eat—diluting returns as prices get bid up and payouts are split more even thinner. Alison J. Mass, the co-head of the Financial Sponsors Group, Investment Banking Division of Goldman Sachs, recently said there were now 500 funds worldwide with assets of more than $1 billion.

So, diminishing returns due to being awashed in capital, bypassing potentially lucrative investments due to “club mentality”, and—oh yeah—those fees....

These are the reasons to learn more about Veritas and Veritaseum to gain exposure to this asset class (venture capital, as well as broader private equity and hedge funds) without giving up liquidity.

In closing, I urge all to read Using Veritaseum's Free Crypto 2.0 Valuation Tool To Value Tokens, Crypto Assets & Smart Properties. Feel free to download the model, tweak the assumptions to your liking or value any other Crytpo 2.0 venture you desire. The results are sure to be illuminating.

Team Veritaseum is uniquely trained, and highly motivated. Specialists with few equals, immune to the concept of “can’t”!

—Reggie Middleton, CEO and Founder of Veritaseum

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