The Makeover

For 75 years, the rules and classifications governing capital formation for high growth enterprises in this country have been fundamentally the same. Two categories … public companies (“pubcos”) which float equity securities, almost always common stock, in public offerings whose shares become publicly traded on various exchanges (principally three, the NYSE and NASDAQ and the OTC); and private companies which are financed by private placement, to a limited group of investors pursuant to exemptions from federal and state registration requirements, the shares of which change hands infrequently until and unless the company goes public. Many marginal changes in rules and market conditions have eventuated since the start of federal securities law in 1933 but the fundamentals have remained in place: If your firm is private, the shares are issued to investors from time to time but trade rarely until an exit occurs … IPO or trade sale. Once a pubco, you hope for a liquid market and active trading.

Significant change began in 2000-2001 and a brief look at recent history is in order. The dotcom bubble burst, the IPO window closed in 2001 and has stayed largely closed ever since (although there are some signs of revival in social media and life sciences). The sell side analysts were forced out of business for mid-caps, meaning institutional appetites for mid-cap IPOs largely dried up. The arbitrage opportunity for private equity lay in taking pubcos private; as a rule, the enterprises operated more profitably once no longer public … no green mailers (newly named “shareholder activists”) chasing short term profits; no predatory class action plaintiff’s lawyers; no Sarbanes-Oxley. Ironically, the PE firms realized, a la the Gibson Greeting Cards exemplar, you could do the high wire act again and again … borrow money and take the newly leveraged pubco private, operate profitably as a private firm for five years or so; pay the debt down; and then go public, selling the pubco stock and investing in the profits in another pubco target.

Institutional investors in the public markets have largely become infatuated with “short termism” (Chancellor Leo Strine’s[1] phrase), i.e. take the money and run, turn over the portfolio annually in the hunt for flashy (aka flash) trading income and move on. Hedge funds took advantage of volatility: short the IPOs, and bet with the activists for 15 minutes or so. And so the public capital markets lost much of their appeal … fewer listings as many of the smart money investors and company managements remained content to operate as private firms, resulting in the so-called public market “eclipse.” Further, the lack of IPOs took a fierce bite out of the venture capital asset class, traditionally the starter fluid of the post WWII U.S. economy and the envy of the industrialized world.   IPO exits had been the “portfolio makers” in the typical fund’s portfolio, jacking up the track record so as to enable closure of commitments to the next fund. As post 2000 vintage year track records headed south, the VCs either gave up or headed north, meaning they largely abandoned early stage investing and focused on “mezzanine” or “growth” capital, chasing lowered risk and being closer to an exit, largely in an effort to convince limited partners that track records no longer needed to rely on the IPO portfolio makers. To be sure, certain VC funds exempt from the law of gravity, i.e. top decile, survived; but the remainder, at best, have struggled or otherwise given up. Abandonment of early stage funding was devastating to early stage companies, as they risked heading into the so-called Valley of Death after funding sources from “family and friends” rounds were fully tapped out.

A major new factor is that the angels have filled in the gap in large part. The numbers are extraordinary:   $22.5 billion invested by angels in 66,230 U.S. companies in 2011, well above venture capital’s contribution. Indeed, the numbers show that the level of equity investment in private companies and funds, relying on the safe harbor exemption in SEC Reg D, is now well ahead of the capital flowing into pubcos.

The recitation above leads us to the key development: The dramatic upsurge in angel investing, including professionalized angel networks which are members of the Angel Capital Association (“ACA”). And, continuing in this vein, changes post September 23rd of this year (when the ban on general solicitation in Regulation D is lifted), are highly likely to be dramatic once private companies become entitled to source capital on the internet from investors rich enough to be qualified as accrediteds.   The companies under discussion are often called “gazelles,” meaning companies organized to journey from, as I put it, the embryo to the IPO (or equivalent exit).

As per the previous narrative, the division between public companies and private companies is no longer a bright line. For a variety of reasons, there is a new entrant … HPPOs, standing for, in the vernacular of the NVCA, hybrid public private companies. The HPPO shares are not listed on the NYSE or NASDAQ (or the OTC) but they can be traded on secondary exchanges and provide liquidity to longtime employees (compensated in large part by equity), founders, friends and family and angels. The dividing line, individually, is likely to be between those who have held the shares for five years or more and the late comers, courtesy of another new development, … I.R.C. § 1202 (assuming it is made permanent), meaning no federal tax on the capital gains. Companies, if they keep the shareholders “of record” to under 2000 (up from 500) can remain HPPOs for a long lifespan. If they look like they are going public, the secondary market in their shares can really rock. Indeed, the NASDAQ’s welcome mat is out to HPPOs … list on NASDAQ SharesPost, trade actively and establish a price and then go public. Moreover, under the On Ramp IPO reforms (Title I of the JOBS Act), a sell side analyst can provide coverage while the company is still in high school, meaning institutions can show their hands in advance: If the IPO seven figure transaction cost seems intimidating, the company and its underwriters can hold the road show first and get a read on the market, before the lawyers even start drafting the registration statement and billing their hours.

Next, with Title II in place, private companies can go “public” without filing any paperwork other than an Advance Form D 15 days before the PPO (my word for a private public offering … a hybrid) launches on the web. No underwriters, no S-1 registration statement, no tedious SEC review and in some cases no audited financials. But the shares are “restricted” meaning they can’t be resold into the public markets, a limitation that the new secondary market structures, SharesPost and SecondMarket, seek to overcome. The distinction between public and private is fuzzed over in the case of both the companies … HPPOs … and the investment process … IPOs vs. PPOs. Put another way, PPOs amount to crowdfunding to accredited investors.

Now that we are in a new world of hybrids, the distinction between public vs. private offerings and public and private companies is fuzzier and fuzzier, what are the possible results? Arcadia in terms of new business formation, jobs, wealth, tax revenues, ground breaking products? Or, no significant change, except a wide opening for on line fraudsters. Or something in between?

The best answer is that we will see as facts develop. That said, here are some predictions, merely summarized to keep my comments brief, but more fully worked out in published papers listed in the Appendix.

The internet is in fact and will remain the “elephant in the room.” Its influence and impact may be in the “remains to be seen” category but there is no chance it will be a minor factor in the operation of future capital markets.

The trick is to figure the right way to take advantage of a new force of nature … the Internet … a phenomenon which has the inherent power to accommodate and empower a Gazelle herd squared or even cubed. Returning to plain English, the census (many more than at present, at least) of successful start-ups setting sail could double in the U.S. or triple if each and all could access early stage capital sufficient to empower the added candidates to make it to the next stage of the Conveyor Belt[2] … (let’s call it the Angel Round for purposes of this discussion) … and then beyond, meaning over the Valley of Death (discussed below) and into those precincts to which the conventional VCs have retreated.

By a process of elimination, the questions become: is the amount of capital realistically available for feeding the Gazelles enough? If it is, is it accessible? Are the providers able to pick their investments intelligently? Can their investments, once on the Conveyor Belt, be chaperoned to the finish line with the help of professional overseers?

As a force of nature, Internet in this respect is like the Mississippi River as described in John McPhee’s book on The Control of Nature. It finds its own way to the Gulf regardless in the Mississippi’s case, of the Corps of Engineers’ attempt to influence the river bed with dikes, dams, channels, etc. Post a business plan and pitch book online and the Gazelles are immediately in front of millions of pocketbooks, meaning millions of dollars.

What if there were a system to channel that capital into companies which, according to the critical standard … common sense … are worth a focused look by a given cohort of investors? This would be a gargantuan booster shot for internet-based investing. But, of course, the devil is in the details.

Thus, can it be imagined that sophisticated investors, just the crowd we would want to bring to the party, would find it “dignified” to patrol the internet for deal flow? My first response is affirmative, given that the evidence is clear: those investors … VCs for example … with access to the largest deal flow are the most successful. The more deals you have to choose from (assuming the choices all meet your standards) the more likely will your track record be superior. But, why would anyone with connections in the innovation space waste time looking for the most promising deals on the internet, where anyone can present? “Undignified” is too mild an epithet … as I pointed out to a young asset manager, who laughed and responded as follows: “Joe! 20 years ago, looking for a romantic partner on the Internet was undignified. Now, you old goat, everyone over 30 goes on the dating service to find a soul mate.” What is truly extraordinary about his response on the dignity issue … platforms are lining up to chaperone the Internet enabled deal flow as this is written and they in effect function like dating services as outlined in the following forecasts.

The venture capital asset class will rebound, but less so conventional venture funds. In fact, again the hybrids (my nickname) venture funds, energized by the SEC’s AngelList and FundersClub No-Action Letters, which are structured as so-called pledge funds and raise capital, deal by deal, by generally soliciting investors on the web. The general partners (or managing members) of the hybrids are registered as investment advisers but not as broker dealers. The classic 2% management fee and 20% carried interest are the sponsors’ rewards and, given deal by deal opt-in financings, the carried interest profits could arrive a good deal earlier in the hybrid fund’s life span. The expenses incurred in organizing each such fund must come from pockets other than the investors in the deals; but, that cost is a fraction of the expense of organizing a conventional venture or private equity fund …and the time expended in getting up and running an even smaller fraction.

With the global Internet available for online pitches accredited investors … accredited crowdfunding as we call it … the web will (presumably) be totally cluttered with deal flow but the smart guys, hopefully a very high percentage of the eligible accrediteds, will look for dating services which can either be Super Platforms (again my term)[3] or hybrid VCs, each focused on aggregating and packaging quality deal flow into buckets and arranging like-to-like exposure … the buy and sell side. Industry sector buckets will be comprised of, e.g., medical devices; solar and wind; digital media (broken down into sub buckets for the sake of convenience); foreign high tech moving to the United States; spin outs from, established companies plus the back ends of syndicated angel deals.

The deals on the web defined (by me) as “quality” will meet various criteria of excellence. For example, investors will be offered a chance to review the valuation and deal terms tools provided by, e.g. VCExperts, and the waterfall analysis tool unlocking the economics of various deal terms such as a tool originated by VCExperts and now offered by Solium Capital.

The role of broker dealers in PPOs will be defined by future market forces. One school of thought anticipates that PPOs will eat into broker dealer profit opportunities, at least as placement agents. Who needs a placement agent if the opportunity is elegantly packaged and introduced via the internet, particularly if the issuer is chaperoned by (i.e. lodged in a portfolio LLC managed by) a hybrid venture fund? The opposing prediction is that brokers will bring deal flow to the hybrids, perform certain back office services such as verifying investor status as accredited (an SEC staff favorite) and provide, e.g. back office and custodial services. They then can, if they choose, enlist as the financial adviser / investment banker selected to manage the Gazelle’s Series B, C and D rounds, plus the exits. They will take advantage of the fact that, as one sage puts it, they are the regulators’ (i.e. the SEC’s) “best friends”: they understand the process, its rules and will have a natural self-governing motive, with a lot at stake, to maintain the integrity of their license.

“Platforms” which “curate” deal flow on line are arising as paid intermediaries, although separate from the hybrid venture funds. “Curate” means to bring deals to the web and assist in closing, having provided what the JOBS Act Title II legislation describes as “ancillary services”. Platforms can align themselves with broker dealers and charge the issuers for services such as model forms, perhaps a modest level of due diligence, setting up facilities for issuers and investors to communicate with one another and keeping an eye on Rule 506(c) compliance for advertised “private” placements.

The Likely Outcome

No doubt the media will be eager to publicize failed or possible fraudulent Title II offerings, shocked, shocked that many of the on line deals fail to pan out … as, indeed, do a substantial percentage of venerable VC firms’ investments. That said, there will inevitably be an example or two of 10 x returns, which will energize investors the way lottery winners do.

The historical fact is that, in 1980, Congress passed legislation designed to democratize venture investing … then a lush asset class which was not generally accessible to investors other than institutions and very high net worth individuals. But the Business Development Company amendments to the Investment Company Act did not procure the desired result. The jury will return to judge whether Title II has that effect, at least for the “average” accredited investor, of which there are about 4,500,000 to 6,000,000 in the U.S..

Much depends, of course, on the ability of issuers and investors to navigate the new rules. The good news is that the SEC and its senior staff are open to evidence-based suggestions to reduce the frictional cost of compliance without giving away the store. The Angel Capital Association is likely to play a role in that process, surveying the angel community vis-à-vis the good, the bad and the ugly. And those law firms which are innovative in the emerging growth asset class are likely to step up to the plate, providing modestly priced compliance services to clients, providing someone experienced in trolling the web to unearth “pieces of the puzzle” (SEC staff slang) in order to allow the issuer to validate accredited status of its investors without calling for tax returns or bank accounts.

The above narrative is of interest, in my view, to the extent that Title II works to fulfill the hopes and aspirations of the Congressional champions, in view of the fact that Gazelles, indeed recently launched Gazelles, are the primary source of growth in the U.S. economy. To put this in context, the latest Kauffman numbers show that U.S. GDP, growth is “Gazelle dependent.”   According to a Kaufman study, firms (ages three to five years) which comprise less than 1% of all companies yet generate 10% of all new jobs in any given year. A similar study from the National Bureau of Economic Research, using the same database, found that, after controlling for age of a small business, startups account for almost 20% of new job creation. From 1980 to 2005, firms less than five years old accounted for all net job growth in the United States.[4] In short, as the “Gazelle herd” grows or stagnates, so goes our overall economic performance. Other factors contribute, of course – government and consumer spending; manufacturing revenues; commodities; agriculture – but the leading indicator is the Gazelle growth pattern.

If the above is true enough for this purpose, what are the constituents which drive the size of the Gazelle herd and speed the same along what I refer to as the Conveyor Belt, meaning the roadway from the “embryo to the IPO (or trade sale) …in other words, survival an maturity. Is there an opportunity realistically to supply the herd with additional, Internet-enabled food and drink which will induce it to multiply?

The answer is not right at hand but I can preface the wind up with excerpts from a paper by two gifted students of mine at NYU Law School. [5] This analysis is over 15 years old but I believe the conclusions, transposed into today’s numbers, is compellingly sound:

“The potential societal effects of increasing funding to start-up ventures are largely speculative and difficult to quantify. Exactly how many new advances or useful products that become lost when research leads are not followed up is questionable. .. Many observers debate the existence and the size of a start-up funding gap. Some claim that no such gap exists, arguing that if there were such a gap, market participants would immediately rush to fill the gap and take a profit. However, as this paper suggests, there are many non-economic reasons that an existing gap may remain unfilled. Investors in small enterprises prefer to invest in companies that are nearby. Since most investors with the money necessary to fund start-up companies are not spread evenly across the country, many companies do not have access to capital. Likewise, government regulation may limit participation in the market. Existing securities laws currently bar smaller investors from investing in start-up enterprises and closing any local gaps or national shortfalls. Due to many non-economic factors, the funding gap exists and has broad economic and social consequences. The economic impact of the seed money gap is staggering. At a conservative minimum, at least $4 billion is lost to the United States economy each year. More realistically, the economy loses closer to $100 billion per year because of the funding gap. Socially, the losses are just as great. Products and services that would improve the lives of countless people are either never developed, or significantly delayed.” (emphasis added)

One hundred billion dollars is a big number, of course. That said, today’s potential is even more dramatic. Take, and only take, the amount of angel investment in Gazelles each year … $27 billion in 2012. Concede, if you will, the existence of the Valley of Death in this business … the aperture between friends and family and Series A rounds, a gap perceived by countless entrepreneurs as too wide to cross … they give up. To be sure, angel financing is critical as Gazelles enter the Valley but assume that Title II expands the available funding by twofold, working in tandem with the dating services such as Super Platforms and Hybrid Venture Capital Funds. And assume the job growth number … 20% per annum courtesy of the Gazelle herd … grows twofold, to 40%. Imagine the impact on the U.S. economy.

The skeptics, of course, will respond How can one cavalierly extrapolate 20% to 40% out of hand? Maybe the 20% number is romantic.  And how about the white elephants? What good does it do to double the number of companies which join the herd and then keel over in their tracks. Maybe all (or most of) the eligible companies in fact get funded; more capital, no matter how much will just produce more lemons.

Point taken. We have to wait and see. But, for those of us who have been out and about in the early stage vertical for a number of years … over 50 in my case … the odds are attractive. The advance in science and tech in the U.S. appear to be accelerating exponentially. At least a number of highly qualified scholar / observers have gone on record to that effect. Standard IP is liberated from the labs and curated / chaperoned onto the web. The promise of, in a word, is extraordinary. Maybe it will remain unfulfilled. But what is the argument that it’s not worth a try?


  1. Reasonable Steps to Verify Accredited Investor Status,”
  2. Unregistered Finders: The Kramer Case, etc.,”
  3. Finders As Broker-Dealers: The Plot Thickens,” April, 2013
  4. Quiet 506: A Study in Irony,”
  5. The JOBS Act – Title II: Online Solicitation of Accredited Investors The Platform as a Dating Service,”
  6. Another New Paradigm: Multiplex Venture Capital Fund – A Quick and Inexpensive Way to Get into Action,”

[1] Bartlett, “Public or Private? Review of the Eclipse of the Public Company in the Current Environment.” Journal of Private Equity Summer 2011.

[2] Bartlett, “From the Embryo to the IPO, Courtesy of the Conveyor Belt (Plus a Tax-Efficient Alternative to the Carried Interest) “The Journal of Private Equity, Winter 2011,

[3] Bartlett, “The JOBS Act – Title II: Online Solicitation of Accredited Investors: The Platform as a Dating Service

[4] “Business Dynamics Statistics Briefing: Jobs Created from Business Start-ups in the United States,” January 2009; “Supplemental Information From the Angel Capital Association, U.S. House of Representatives Committee on Small Business Subcommittee on Investigations, Oversight and Regulations Hearing, ‘the JOBS Act Implementation Update, April 11, 2013.

[5] Keller & Materfis, “Got Money? The Impact of the Seed Money Gap,” unpublished paper delivered by students in my class on venture capital at NYU Law School, Fall of 1998.

This publication is for informational purposes only and is not offered as legal advice regarding any particular matter. No reader should act on the basis of this publication without seeking appropriate professional advice.