Crowd Funding - Challenges and Opportunities

[Original Post Written @http://startupiceland.wordpress.com]
I have written about Crowd Funding and how I want to throw my weight behind this. I think this is an important topic in the blog sphere and many lawyers are weighing in on the challenges. Here are a couple:

1. Crowd Funding – A Critique for Entrepreneurs and Investors by Bill Payne, Angel Investor
2. The Great Crowdfunding Train Wreck of 2013 by Antone Johnson, Business Lawyer

Both these articles are good starting points to think about the challenges of building a Crowd Funding Platform. Antone goes on to say that this whole Crowd Funding thing is going to end in a disaster and Bill is a little bit more balanced in his critique. I think both of them have valid points to make. Antone, actually starts with defining what he construes as the Crowd Funding a.k.a Crowd Investing platform, the definition is as he describes it is very similar to the ones in the IPO documentation definition of a company going public. So, what are the main challenges in building a Crowd Funding Platform?

1. Radical Information Asymmetry
2. Valuing Early Stage Companies and evaluating the Risk-Reward can be done only by Experts
3. Cost of Transparency and Accountability is too high for small early stage companies

I will go into the details of each one of the below.

1. Radical Information Asymmetry: The Securities and Exchanges Commission (SEC) in the US or in any other country basically have a number of requirements that protect the small investor, i.e defining all the Risk factors, ensuring that companies wanting to raise money from the public are not fraudsters (the perception is that but there have been exceptions and I have always wondered how do they ensure that?) etc. The most important of all these requirements is that the Founders/Company Managers have more information about the company than the general public so they could potentially "hide" the detrimental information from the investor thereby "cheating" money away from the investor. On a theoretical level I agree with this information asymmetry, but practically I don't think this is a problem because companies in their early stage don't have any complications in their accounting or operational procedures, so it should be simple enough to basically share all the information that the company has and most early stage companies usually do.
2. Valuing Early Stage companies is hard and measuring Risk-Reward ratio is best left to experts and experienced professionals. I could not disagree more with this assessment. Valuing companies in their early stage is very hard and I have written about it. That is the reason why private placement of securities i.e shares in a company require the investors to be accredited investors, the definition of who an accredited investor is weird, according to the federal securities laws define the term accredited investor in Rule 501 of Regulation D as:
   1. a bank, insurance company, registered investment company, business development company, or small business investment company;
   2. an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
   3. a charitable organization, corporation, or partnership with assets exceeding $5 million;
   4. a director, executive officer, or general partner of the company selling the securities;
   5. a business in which all the equity owners are accredited investors;
   6. a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person;
   7. a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
   8. a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.

So basically if you are not rich or work for a Financial Institution you cannot be an investor! what a bunch of baloney! It really makes me mad they actually put Banks and Financial Institutions above Individual Investors. I have worked in a Bank and I know many of the people who make the investment decisions, I think an Entrepreneur would be more careful and weigh the options better than what I have seen done. So I don't buy this argument. I also think there is too much emphasis given to "protecting" the small investor, I am not so sure that is such a problem. I also do not believe a person working in a financial institution has better understanding of Risk than a person who has nothing to do with finance. I am big fan of Nassim Taleb and Daniel Kahneman. Go and read their books if you really want to understand how we as humans just don't have a good grasp of probability which in Financial jargon is Risk.

3. Cost of Transparency and Accountability for smaller companies will be prohibitively high that would prevent them from actually going through the exercise of full disclosure.

I think the above 3 major hurdles are the biggest opportunities for a Crowd Funding Platform. I believe we can solve these above challenges, I believe too long we have waited to be told that you cannot do something because it is not good for you. I say lets jump into the pit and wrestle with the beast, no I do not mean your lawyer! I am going to devote time, effort and money to solve the above problems because I think there is a huge global opportunity. To start with I am committing to work with a team in Iceland... they have good ideas and are thinking about the right things but they need to solve the above problems before they can be a platform. Check them out Karolina Fund, the Star of the Crowd Funding movement ProFounder.com just shut shop and the reason they gave was the regulatory environment is not conducive for Crowd Funding Platforms, something to think about.

Related articles

• Developments in Crowd-funding (growthology.org)
• Crowdfunding and the ninety nine percent (sciencetoprofitsblog.com)
• Crowd financing in return for start-up equity? (thesuitblawg.wordpress.com)
• Should Equity-Based Crowd Funding Be Legal? (online.wsj.com)

DataMarket - A Startup Profile

DataMarket.com is a startup out of Iceland. I have met with Hjalli a couple of times, spoken to him quite a bit and used DataMarket services on some of the presentations and have been following the company. The company started in June 2008 and Hjalli has been around the block in the startup journey a couple of times, he successfully created and sold a company in Iceland and I believe he is a 3rd time entrepreneur. You can read all about him in his blog, he has a distinct voice within the Icelandic startup culture and he is a big proponent of Transparency and DataMarket was way to address that issue. Although a lot of his opinion and comments are in Icelandic, so I glaze over them :) Initially, I really felt that DataMarket's business model was weak because you don't see the light of the day if you are an intermediary for data and given the advent of new visualization technologies it is quite easy to hack a graph from structured data. The customers of data want data from reliable sources and you had to be a source of data to be able to sell data and typically people buy data from a Credible and Authentic Source like the IMF or the World Bank or The Economist etc. I believe the market for data is big but probably getting smaller with all the publishing tools out there. I could not put my fingers on the Value Proposition of DataMarket.

DataMarket just announced that their portal and services can be utilized by third parties to publish data, I believe that is a very interesting value proposition. In addition, they are getting credible sources to use DataMarket's portal to channel their data. I don't know the financial performance of DataMarket to comment whether they are able to make progress or not but given that they just announced they were able to secure a significant round of funding in Icelandic terms, I presume they are on track. I think breaking into the international market needs a different kind of thinking. The team composition that Hjalli has put together needs work IMHO. I have a big issue with Startups who emphasize to much of their importance on the idea and very little on the team, the strategy for customer acquisition and putting together a truly international team.

#BMD - Value Proposition II

This is the second of the posts related to defining the Value Proposition. The original post is here and the first post is here. I am using Startup Iceland as an example. Value proposition needs to address multiple stakeholders. The first post was the value we bring to the Entrepreneur, this post is going to focus on the Value to the Investors and Limited Partners (LPs) of Startup Iceland. We invest money on behalf of our investors and LP: What value do we deliver our Investors and Limited Partners? Traditional methods of measuring Return on Investment or Return on Capital Invested are good metrics, however the biggest value we bring is transparency. We plan to run the operations of the Venture Capital Fund in a transparent, inclusive and open manner. We clearly state our investment thesis, the timeline of investment, decision criteria for investing capital, our performance, time invested and effort in a team. Which one of our customers problems are we helping to solve? Mentoring, advising and creating an environment where the entrepreneurial teams get motivated to execute, win and be a world class company on a tough compressed timeline is a lot of work. We solve that problem for our limited partners and investors. Typical investors are passive and look at Venture Capital Asset class as risky, we asked the question ourselves why is that? the answer is it takes a lot of effort and handholding to make startups succeed. Eric Rise, the author of the Lean Startup defines Startups as an "Organization dedicated to creating something new under conditions of extreme Uncertainty". We strive to reduce the uncertainty through our disciplines approach, working harder and smarter, bringing the power of the network to increase the odds of success and following the time tested methods of building companies. We are entrepreneurs at heart, we have had experience building companies and we want to ensure that our experience gets translated into our portfolio companies. What bundle of products or services are we offering to each Customer Segment? Investors and LPs are always looking for avenues to invest their capital. We believe we provide a platform that is underserved. Venture based investments have outperformed typical asset classes over a 15 year period. A Venture Fund dedicated to creating valuable internet based companies out of Iceland is a unique value proposition. Our intention is to use Iceland as a good testing ground to validate the product quickly and help launch it in the global market place. We understand the world of Technology, being technologists, architects and geeks. We understand the direction the social networked world is moving to. A platform to invest in this new trend is the product and service we provide to the customer segment of Investors and LPs. Which customer needs are we satisfying? Diversification in capital allocation. High Return on Invested Capital and Being responsible stewards of capital. We want to earn the trust of our partners. We understand we do not exist without their trust. Our values of Integrated, open, transparent, fair and trusting relationships in building wealth and return to our Investors is our gospel. We don't just say it we live it every day. We will NEVER put our interest before that of our investors. We will measure ruthlessly our performance and we will be transparent about communicating our failures and wins. Transparent Governance is the core belief of our operation.

Related articles

• Limited Partners Deal With Venture Industry Contraction, Restructuring (blogs.wsj.com)
• Bill Gates: It's 'Crazy' How Little Is Invested in Clean-Tech (blogs.wsj.com)
• Conference Showcases Promising Clean-Tech, But Funding Remains Uncertain (blogs.wsj.com)

What does it take to be a great Mentor

Mentoring is by far the most rewarding and challenging role anyone can take on. It is much like parenting, but in a mentoring relationship there is no hierarchy. It is mainly give from both sides. David Cohen had a fantastic post a while back about the Mentor Manifesto. David is the CEO of TechStars, Boulder and has had the experience to work with hundreds of mentors and entrepreneurs. I could not agree more to the post. We have a challenge in Iceland, there are very few experienced, committed mentors. Whenever, I bring up the topic of mentoring, that question is always followed with What does the mentor get back for their time and effort? The whole point of mentoring is NOT TO EXPECT ANYTHING BACK! it is about giving, like unconditional love to your child. It is a service one does to pay forward. Why is it so hard to grasp?
When I joined Ernst & Young in their Management Consulting practice a long time ago, the first thing I was introduced to was my Mentor who was different to my Counselor. What a fantastic concept. The organization had made it a institutional practice to make sure everyone who joins the team has a mentor and a counselor. Mentor guides the new team member on the workings of the organization and helps in any challenge the new team member encounters. A mentor to me was a friend, a buddy actually that is what EY called it. a "Buddy" is usually there for you to talk about anything related to work. Some of buddies become full fledged mentors and helped me shape my career at EY. I have played the role of a mentor to many of my friends and I take the role of mentoring very seriously.

Related articles

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• Mentor? Mentee? Mentos? - How to make the most of a mentoring relationship (ask.metafilter.com)
• Missions Mentoring (missionmusings.wordpress.com)
• Understanding the relationship (talktotheyouth.wordpress.com)
• Generous Mentors - Bob Metcalfe (ibmsmartcamp.com)
• TechStars Launches Accelerato.rs, A Common App For Startups And A Results Tracker For Accelerators (techcrunch.com)

Autonomy-Mastery-Purpose Incentives that work

Daniel Pink is a Career Analyst or that is what the Ted biography describes what he does. I have seen both the videos embedded here. Daniel has been studying what motivates people to perform at their best. If you have not seen these videos it may surprise you. Ask yourself what is your incentive and motivation to do what you do everyday. Entrepreneurship is a funny business your success is so uncertain and you are in constant flux of going bust to hitting one out of the park, what keeps you going? well, Daniel explains it in his book Drive. I have written about how the world has been changing right in front of our eyes because a lot of what we do has to do with Cognitive skills and not conveyor belt mechanically repetitive stuff. But our companies and management methods were created in the industrial age and we are always trying to implement them in this new world. The sad part is we complain that this management and money/benefit/perks based incentive stuff does not work! of course it does not work because our environment has changed. We need new ways to motivate, incentivise and engage with each other. The new incentives that work are Autonomy, Mastery and Purpose. If you are an entrepreneur and want to be successful in what you are creating make sure you have answered the questions to the above 3 incentives.

Autonomy: The desire to be self directed, if there is one thing common with all the entrepreneurs that I have met and the most successful ones, they exude this attribute.

Mastery: The urge to better at stuff. This created Linux, Apache Software Foundation, Wikipedia and every entrepreneur that I know whats to get better at something. They learn music or run marathons or do yoga or get better at managing their own time, help other entrepreneurs etc They seek challenge and mastery

Purpose: More and more organizations are looking for the Transcendent Purpose and he explains that the reason for this is that it attracts the best talent, it is more fun place to work and what is even more interesting is if the purpose gets misaligned due to the profit motive it basically makes people do bad things. Bad customer service, illegal or even criminal activities, crappy products etc. Profit is important but should not be the reason you are doing what you are doing. This goes totally against what was going on in the banking world before the financial crisis. I remember what motivated me to work with Glitnir, it was the emphasis on Renewable Energy and Sustainable Fishing, we did a lot of things that aligned with that strategy. It energized me everyday that I was doing something that actually impacted how energy was created in the world and our customers were not killing the source of fish in the sea. But we kind of lost our way during that journey and  we all know what happened next.

Related articles

• Daniel Pink's Theory of What Motivates Us (managebetternow.com)
• Do you know what drives your team? (mariadelamo.wordpress.com)
• The Power of Intrinsic Motivation (rdulde.wordpress.com)
• The Business of Entrepreneurship (darrengarman.wordpress.com)

Validated Learning in Hospitality Development

I will be speaking in the "Ferðaþjónusta og fjárfestingar" conference sponsored by Landsbanki and the Ministry of Industry, Iceland and organized by Promote Iceland. The words in Icelandic mean "Tourism and Investment" thank you Google Translate. I wrote about it when I got invited. The message of the presentation is "Apply the Lean Startup principles even before launching a hospitality development project". Especially validated learning, Google Insight for Search is a fantastic tool that I have been using for all our projects. I highly recommend that you do too. It can give you insights on anything that you are working on or plan to work on. 

When we embarked on this journey to develop our presence outside of India in 2009, we wanted to build a scale able business which means we build teams around specific themes that we wanted to invest in. What we believe works well in Hospitality development is vertical integration of the value chain. What do I mean by this? Our company in India whose core business is to invest, develop and manage Hospitality projects owns a number of support businesses

1. Furniture Manufacturing and distribution company specifically to serve our Hotel developments
2. Food and Beverages distribution company that supplies our hotels
3. Food Service business that runs all our restaurants in our properties
4. A Taxi service company that runs a fleet of cars for all our properties

All our investments outside of India are in businesses that move up the value chain of Hotel development

1. Buuteeq - A Digital Marketing system for Independent hotels (selling rooms)
2. Clara - A Community analysis company for the gaming industry (to understand future buying trends)
3. Boutique brand - A new boutique brand that is truly international and can be applied to any geography
4. Hotel interior design company - A company that designs high end interiors for hotels and private residences
5. Furniture distribution company - A platform to sell the furniture manufactured in India

Related articles

• Archetypal foreign visitors to Iceland revealed (icenews.is)
• China FDI In Iceland. Soft Power Done Hardly Well At All. (chinalawblog.com)
• Hotel Marketing Platform Buuteeq Helps Travel Destinations Build Rich Facebook Presences (insidefacebook.com)
• Iceland president buys Borgarnes distillery (icenews.is)

Vision without execution is Hallucination

Image via Wikipedia

Thomas Edison said that and I just finished reading Steve Case's opinion piece on Washington Post, where he refers to that as well. The title of the opinion piece is "Give entrepreneurs room and they will grow the economy". What is interesting in Steve's note is that he alludes to how America is loosing its competitive edge in Entrepreneurship and what they are doing about it. A number of bills are being proposed in Congress to support Entrepreneurs, including allowing for Crowd Funding... can this concept work here in Iceland? What is being done in the Parliament to support Entrepreneurs in Iceland? I have the advantage of not being worried about what is discussed in the Parliament because if it was important and affects me, I will hear about it. Never the less, it begs the question. How can Iceland be more competitive in this space? If America the quintessential country for Entrepreneurs is worried about its leadership what should countries in Europe do? What do you think?

Here is what I think needs to be done, first things first, we need to get visibility to the Entrepreneurship community here in Iceland and we need to learn from those who have done this successfully before. It is not enough if we meet amongst ourselves and talk about family politics. We need to invite people who are not part of the system. I have been talking to a bunch of people about organizing a conference and to get my own validated learning I have a sign up page http://signup.startupiceland.com. My goal is to get 500 to 1000 signups then I know we can host a conference and bring prominent investors, entrepreneurs and thinkers in this space so we can learn from them. Couple of ideas on the table are to run a workshop on Lean Startup and Business Model Canvas, A Hack Day and a day of lectures and discussions. All those who have signed up, thank you. You should receive an email shortly requesting your input on a bunch of things. For those who have not signed up, please do and share it with your network, you never know there could be someone who has a job doing something they are not very interested to do but wants to try their hands on Entrepreneurship, it is a great way to start. Learn from the best and other entrepreneurs, find international mentors and networks and launch your dream.

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• More Chinese interest in Icelandic tourism sector (icenews.is)

Is a bubble forming in Iceland?

This is from the publication of Statistics Iceland on Household Expenditure Survey 2008-2011 -

"Average household expenditure is 442 thousand ISK a month or 183 thousand per individual, i.e. 3.1% lower than in the previous survey per household. The expenditure per individual declined by 4.6%. The CPI rose by 5.4% between 2009 and 2010, hence the real household expenditure declined by 8.0%. This is equivalent to 9.5% decrease per individual in real terms. Disposable income rose by 3.6% per household and by 2.0% per individual."

The graph above shows the changes between years in CPI from 1988. What is interesting to note is that CPI has been going up irrespective of Capital Controls since 2008 and a hawkish stance from the Central Bank of Iceland. What this tells me is that the policy tools in Iceland employed by the Central Bank of Iceland does not work. How does one fix this problem? I have written about one solution. Inflation is a bad thing, one simple reason why this is the case is because it is like a cancer that eats into the asset values in an economy that is why every Central Bank takes an Hawkish stance to control the supply of money or not, like Zimbabwe or Greece before they joined the EU. Central Banks have the authority to print money but there needs to be something worthwhile against those printed currency if the economy does not produce valuable goods and services then it only leads to too much money chasing too few goods and services and result in Inflation. The trend is Iceland is giving me a heart burn. There have been no new industry or goods and services created, overall household consumption is going down, the government consumption is going up and change in CPI between years is upward trending, in addition to this the Real Estate market prices are being driven up by all the pent up currency before the collapse. All this can lead to only one thing rising prices of assets and which ultimately leads to a bubble and we all know what happens to bubbles.

Related articles

• Some companies in Iceland benefited from 83 percent debt write off (icenews.is)
• Bauhaus to finally open its Icelandic store (icenews.is)
• Fairy (icelandeyes.blogspot.com)
• Group layoffs and bankruptcies continue in Iceland, despite some positive changes (icenews.is)
• Medical costs to increase in Iceland (icenews.is)

2011 has been a record year in Iceland... for bankruptcies

I wrote about the GDP growth in Iceland and wondered where the growth was coming from. I was right, 2011 was a record year for Corporate Bankruptcies since the collapse of the financial system and we have data only until November. What is more interesting is that for the first time in the last 11 years the number of companies formed (1533) has never been closer to the number of companies that were insolvent (1427).
I think we should also look at wage and employment numbers to see if that is driving the growth. The second graph is the total labor force as can been seen that has dropped since the financial collapse. The third graph is the unemployment %, 2011 is my estimate as we have data only till the 3rd quarter of 2011. I estimate 7.25% unemployment for the whole year, please don't hold me to it because I don't believe in estimates. As can be seen the macro variables don't look all that great for a GDP growth but IMF, the Central Bank of Iceland and the Ministry of Finance all say there is GDP growth so we all just have to take their word for it. I can say one thing the sentiments are improving, I saw the following news published by one of the investment companies Eyrir Investment, that they have successfully convinced a Pension fund to invest in them and they have started a new venture capital focused fund called Eyrir sprotar slhf. This is very encouraging. 


"Eyrir Invest ehf. has today decided to increase the number of shares in the company by approximately 10% by selling 101 million new shares at the price of 24.25 ISK. The total number of shares after the issue is 1,108,681,220 each share is 1 ISK of nominal value. The new shares will be purchased by Lífeyrissjóður verzlunarmanna (The Pension Fund of Commerse).

The issue of new shares increases the investment capacity of Eyrir Invest. Simultaneously with the issue Eyrir has founded an independent investment company for investments in venture capital; Eyrir sprotar slhf. Eyrir sprotar will emphasise supporting promising ventures for international growth and value creation."

Although the skeptic in me says lets see what they do with the raised capital. They have raised almost $25,000,000 that is a decent size for Iceland if all the capital is going to be deployed in venture companies but I fear they will invest in companies that will take a long time to establish themselves like Ossur or Marel. I really would like to understand their investment thesis. I think what is needed are companies that are growing really fast outside of Iceland.

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Startup Communities - My open letter to Brad Feld

Image by TEDxBoulder via Flickr

Brad Feld one of my virtual mentors has embarked on a journey to write a book with the following working title: "Startup Communities: Creating A Great Entrepreneurial Ecosystem In Your City". In typical Brad style he has created a new Blog that documents the journey and has asked his community of followers to participate and share a story on the topic. I believe Iceland can be a fantastic story, but usually when one tells a story we need to have a beginning, the plot, the drama and a hopefully a happy ending. I think the journey in Iceland is still in the beginning stage. I have written the following open letter to him: 


Dear Brad,


I am really excited and inspired by your passion to build communities around startups and entrepreneurship. I agree with you that great startups can be built from any community and it does not have to be in Silicon Valley. I think I have a story to tell about how Iceland rose from the ashes of the biggest financial collapse of a western country because of its startup community. The story does not have a happy ending yet and I hope it does not have one, as we have just begun and we want it to continue through the generations.


The beginning
The collapse of Iceland after the financial crisis in 2008 is well document. Iceland is a small country and I moved from the US to work for one of the banks in 2006. I was fascinated by the energy, ingenuity and innovative nature of Icelanders. In addition, I was impressed by how much a country of 300,000 people could build in a relatively short period of time. The financial collapse has resurrected the entrepreneurial spirit of Icelanders as before the collapse everyone and their mother wanted to work for one of the banks or  financial companies in Iceland.


The story so far

Since the collapse a number of things have happened that I believe are the right ingredients to make a startup culture and community. We for the first time in our lives had to think about what are we going to focus on? and the jury is still out on that question but we got the time to think about where we are and what we wanted to do. I decided that I wanted to do something worthwhile and create real value. I convinced some of my family and friends into starting a company that invested in Startups in Iceland. We have invested in a team of incredibly talented individuals, the company is called Clara they are building a text analytics platform that helps everyone understand their communities. They are focusing on the Gaming communities now but we believe it can be applied to any community. 

I have met many passionate entrepreneurs and startup companies in Reykjavik and I am incredibly excited at the wide range of problems that are being solved by this grass root group. I have cataloged over 165 innovative companies, more getting started everyday and more than 80% of those were started in the last decade. After meeting, talking and working with this group I have come to the conclusion that the community exists, it is buzzing, but it is disorganized. I plan to bring them together by starting an incubator built using the Techstars affiliate program and a VC fund. I think this will bring mentors, entrepreneurs, investors and capital together and that is what is needed to build an ecosystem.

2012 and beyond

I have been blogging extensively about my vision and strategies through my blog http://startupiceland.com and I am in the most excruciatingly painful stage of my own entrepreneurial journey, yes you guessed it right I am raising funds to kick off the plan. 

The startup ecosystem in Iceland does have some support from the Government run grant programs, a venture fund and a growth fund. However we could do with some favorable policies, I plan to lobby with the Government on that. What I believe is lacking is also private individuals and enterprises actively investing time, effort and resource in the ecosystem. I am confident that we will solve this problem. I can write and talk about this forever, but I will stop now. I would like to personally invite you and Amy to visit Iceland, it was one of the Top 10 destinations for 2012.

It would be great to have your thoughts and ideas contributing to our journey here in Iceland. 

Regards,

Bala

Related articles

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Education level in Iceland

I have written about my vision and investment thesis for Iceland. Important element of this thesis is the young and well educated population in Iceland. This blog post is facts and data to support that investment thesis. The first graph shows the number of Doctoral students enrolled in the Universities in Iceland, the trend has been increasing since 2003 so this is not a new phenomena. The second graph shows the number of students in the Masters degree program. The third one shows the total of all students in Universities pursuing basic degree and all the rest. The total stands today 18869. If you consider that the population of Iceland on 1 January 2011 was 318,452 almost 6% of the total population is pursuing University degrees. The final graph is the total education attainment of the population age between 16 to 74 years from the year 2003 the total number in 2010 stood at 222500, which is a very high percentage of the overall population. 

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VC fund allocation and Conditional Probability

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I had a very interesting discussion with a friend of mine yesterday. I was suggesting to him that Venture Capital funds should allocate funds such that 15% of the capital goes into VC companies, 5% goes into growth companies (i.e companies that have stabilized the products or services, are generating cash and have broken even) and 80% should be cash or cash equivalent.

He made an argument that an investor wanting to invest in a VC funds would not choose the above allocation. I asked him to ellaborate and he said that the investor will not get the total bang for his buck... he said that if the above fund´s VC allocation returned say 100% of the allocated capital the investor would only get 15% of that 100%. Sounds logical but this is precisely the problem with our view of the world and our ability to calculate probabilities. We think about only the success scenario, we don´t think about failure and the proabilities of failure.

Lets do a thought experiment of comparing two funds:

1. A fund that invests all the capital into VC companies

2. A fund that does capital allocation similar to the one described in the first paragraph

We need to think of alternative universe of outcomes to calculate the expected return from the above two funds, lets conjure one for simplicity:

VC companies return 100% of capital invested with a probability of 50% and return -100% (i.e you loose all the capital) with a probability of 50%. Growth companies return the capital invested and Cash returns the same at the end of the investment time for simplicity sake.

Given the above outcome what is the Expected return for the above two funds, say for an investment of $100m?

Expected Return = P(success) x Return + P(failure) x Return

Fund 1: 50% x $200 + 50% x (-$100) = $50m

Fund 2: 50% x $30+ 50% x (-$15) + $5 + $80 = $92.5m

Even the above simple payoff matrix gives the second fund a return higher than the all VC fund. However the real world is much more complex and the payoffs and probabilities are much harder to calculate. In addition to the above when we do capital allocation there are time frames, return expectations and conditional probabilities involved, this further skew the results.

The above payoff matrix gives us different results when we add conditions to the problem:

What is the probability of Fund 1 giving a lower return than Fund 2 given VC companies all return 100%? or we can flip the question

What is the probability of Fund 2 giving a higher return than Fund 1 given VC companies all return 100%?

The above question needs us to calculate the probability of a VC company being a success or a failure and the distribution for VC success follows a Power Law. I think most VC fund managers understand that but I don't have data to prove it. My fear is that maybe fund managers do not compute probabilities using the Power Law but the Normal Gaussian Bell Curve, when we do that all the above analysis and results are incorrect.