For investors determined to be first in detecting the promise of a burgeoning technology, picking through publicly traded stocks can make for a disappointing approach.
Sure, if you'd discerned the promise of Microsoft back in 1986, you could've picked up some shares for the stock-split-adjusted equivalent of 9 cents. Or you could've picked up some Cisco for a split-adjusted price of 8 cents in 1990. Today those shares would be worth about $20 each.
But such gains, breathtaking as they are, represent the kinds of public market opportunities that come around only a few times in a decade. And even those returns pale in comparison to the returns of early backers who invested before those companies went public.
With U.S. stock indexes up markedly for the year, and bargains by traditional price-to-earnings metrics hard to find, risk-tolerant investors are increasingly looking to private companies. In the second quarter of the year, venture funds tracked by Thomson Venture Economics reported that investment inflows were up nearly 90 percent compared to a year ago. Across the country, where brand new startups seek seed funding from angel investors, organizers report that investors are also turning out in high volume.
The draw is obvious. Private equity investing is an incredibly lucrative proposition if done correctly. Take Sequoia Capital and Kleiner Perkins Caufield & Byers, two venture capital funds that invested $25 million in Google in 1999. The 20 percent stake in Google those funds purchased has a market value today of more than $15 billion.
The catch is equally evident. While a few investments produce fabulous returns, the vast majority go nowhere. Barry Motz, co-founder of the Prairie Angels investment group in Chicago, estimates that 90 percent of firms funded by angels won't make it.
Net worth is also an issue. Options for private equity investing are limited for those of us who aren't spectacularly wealthy. Securing a stake in a venture capital fund typically requires millions. Even so, for those willing to stomach extreme risk in return for potentially great rewards, there are a few possibilities.
Public venture firms: Most venture capital funds are private entities, but a few are publicly traded. For people with only a small amount of money for venture speculation, such publicly traded entities -- known as business development corporations -- are one of the few investment avenues available.
BDCs were very popular investment vehicles during the dot-com boom of the late 1990s and 2000. Public companies like CMGI (CMGI), Divine Interventures and meVC (MVC), which held stakes in a portfolio of startups, launched successful IPOs and secondary offerings during that period. When the market crashed in 2001 and investors lost interest in initial stock offerings from profitless internet startups, venture BDCs saw their fortunes wane as well.
"The experiences of CMGI and Idealab in recent years have been representative of the many disappointments that this sector has faced over the decades," said Josh Lerner, a Harvard professor who studies private equity investing.
Lerner believes the "opaque, long-term nature of private equity investing" doesn't mesh well with the volatile climate of the public market. Realistic private investors know it takes years for a startup to begin churning out reliable profits. Public investors, who are known to fixate on quarterly results, typically don't have that kind of patience.
That said, a few public venture firms are still around.
Harris & Harris (TINY), a New York venture firm that invests in micro- and nanoscale technologies, trades for around $12. CMGI, now profitable, trades under $2, well below its 2000 peak. The Waltham, Massachusetts, company describes itself as a supply chain management firm with a venture capital arm.
BDCs certainly aren't strictly devoted to venture capital. Many make equity investments or extend loans to private companies that are beyond the startup phase.
Newcomer Gladstone Investment (GAIN) went public in June. The company specializes in loans, mezzanine debt, preferred stock and warrants to purchase common stock of small and medium-size companies.
MeVC, launched in 2000 by the Silicon Valley venture capital fund Draper Fisher Jurvetson, has also revamped its business plan to focus on more-mature businesses. Renamed MVC Capital, the company no longer follows its initial charter of investing in information technology startups. Instead, managers say they are "concentrating our investment efforts on small and middle-market companies that ... provide opportunities to maximize total return from capital appreciation and/or income."
Beware the J-curve: One pitfall of investing in startups, BDCs have found, is that portfolios frequently decline in value before they're poised to go up. This phenomena is what Harris & Harris describes, in an August share offering filing, as the "J-curve":
"This J-curve valuation pattern results from write-downs and write-offs of portfolio investments that appear to be unsuccessful, prior to write-ups for portfolio investments that prove to be successful."
In other words, the curve illustrates what investors already know: It takes longer to see a good idea through to fruition than to give up on a flawed one.
Grounded angels: While the number of publicly traded vehicles for venture-type investing is limited, private investing offers a much wider array of options. Two of the most popular types are venture funds and angel investment groups.
However, private venture capital funds aren't an option for ordinary investors. Most require a minimum of several million dollars and take contributions largely from institutional investors or very wealthy individuals.
For people who are well-to-do, angel investing is a more viable alternative. Angel groups, which operate in most metropolitan areas, consist of investors who pool their money to back promising startups.
Even angel investing isn't open to all. To participate in most angel forums, one must qualify as an accredited investor. Basically, this entails having at least a million dollars in assets as a single person or married couple, or earning an individual annual income of at least $200,000.
If you can pass that test, the minimum investment needed to join a fund can be as low as $25,000, estimates Tarby Bryant, who organizes angel gatherings in New Mexico and other locales.
For Bryant, choosing a startup has little to do with homing in on a hot sector. The most recent meeting of his investment group, Gathering of Angels, featured startups ran the gamut from a medical device company to a toy maker and a firm providing birth control pills through the internet. Bryant says his basic methodology is to analyze the future cash flow potential of each startup and look for those that could provide as much as a 50 percent return on investment each year.
The other thing angel groups do is spread their risk. Because investing at the seed stage is so prone to loss, most invest in at least 10 or so startups.
"This really is your Las Vegas money.... It's not the type of investment you want for your retirement," said Prairie Angels' Motz.
For those undeterred by the risks, Active Capital, a site for matching entrepreneurs and private investors, posts listings of angel forums across the country.
As for people who like the idea of angel investing but don't qualify as accredited investors, Active Capital's president, Jay De Long, advises backing entrepreneurs one already knows.
"There's nothing that prevents you from investing in your friends and family, and that's where most entrepreneurs get their money."
Disclaimer: Wired News makes no representation as to the investment-worthiness of any companies mentioned in this article. Examples are provided for informational purposes only, not as a recommendation to purchase or sell any particular stock.
