Bypassing Wall StreetAs the Digital Revolution continues to drive costs down relentlessly, it has disrupted business models and transformed one industry value chain after another. One inescapable lesson from the carnage of the 20th century companies it has destroyed is that, just as in a tornado, the worst place to be when a revolution erupts is right in the middle.
For example, the Internet has disintermediated bricks-and-mortar bookshops, music retailers, and video stores, allowing consumers to order or download content from Web sites like Amazon. It has also enabled online services like Match.com and eHarmony to replace the human matchmakers who personally paired their clients with prospective romantic partners; for users of these digital services, the result is a lower-cost way to sort through a multitude of potentially compatible people.
Now, the same disruption is threatening the traditional providers in the middle of another type of matchmaking: the linking of investors with entrepreneurs who need capital.
The emergence of private market networks (PMNs) is driving this change. PMNs offer platforms that allow investors and businesses to find each other after narrowing down a vast number of potential partners.
For example, a PMN called AxialMarket allows business owners to list their companies for sale to hundreds of institutional buyers. These potential buyers can include public corporations that are hunting for new technologies or products, as well as private equity firms.
When the owner joins the network, AxialMarkets system automatically creates a brief that describes the investment opportunity without identifying the company, and then suggests potential buyers based on their preferences.
The business owner can select which of these buyers should receive the offer. The ones that are interested in the opportunity can then digitally sign online nondisclosure agreements to gain access to company management and virtual diligence rooms. By using the platform, both parties can track the progress of the deal until they are ready to negotiate in person.
According to Bob Rice, a managing partner of Tangent Capital Partners, PMNs offer many user-friendly options, such as:
? Opportunity discovery and recommendation engines ? Analytics and evaluation tools ? Secure virtual diligence rooms with tiered access rights ? Industry benchmarks and comparables ? Standardized documentation and fee terms ? Deal flow management systems for both the buy and sell sides ? Lists of experienced service providers to consummate transactions
Among the most prominent PMNs today are:
? Gust (formerly called Angelsoft), IndieGoGo, and Kickstarter, which offer early-stage funding ? SecondMarket, which is the largest PMN and spans several asset classes ? SharesPost, which focuses on later-stage prepublic stock ? AxialMarket, which facilitates lower mid-market mergers and acquisitions ? Xpert Financial, which provides growth capital ? EquityNet, which concentrates on multi-stage equity ? Hedgebay and Lincoln Square Advisors, which specialize in hedge fund investments
As Rice pointed out in a recent Strategy+Business1 article, PMNs are growing at blazing speed. Consider:
? In 2010, SecondMarket closed about $10 billion in illiquid securities transactions, a 400 percent increase from one year earlier. ? The number of ventures applying for funding through Angelsoft now exceeds 4,000 globally every month. ? Companies listed for sale via AxialMarket have combined revenues approaching $50 billion. ? The bid and ask listings on SharesPost have surpassed $1 billion.
One reason for the rising power of PMNs is simply creative destruction. Whenever a new technology emerges, it inevitably topples long-standing ways of doing business and threatens entrenched market leaders. In this case, the breadth of the Internet, and its inherent network effects, allow for a broader range of parties to make potential connections with each other. The frictionless flow of data over electronic networks reduces or even eliminates human activity, slashing costs while accelerating speed.
Another factor is the bearish mood in the capital markets. Due to the recession, large investors have generally become adverse to big risks, while lending from banks has all but dried up. In fact, banks are sitting on more than $1 trillion in reserves, a huge increase from the $50 billion in reserves they held as recently as the middle of 2008. With few prospects for traditional business loans, entrepreneurs desperately need a new source of funding.
The nature of the business life cycle is yet another reason why PMNs are growing. In the Deployment phase of the Digital Revolution, the Internet and e commerce have now finally reached the point at which the costs of information technology have dropped and functionality has soared. One result is that the costs of launching a company have plunged dramatically.
According to David S. Rose, the founder of Gust, the amount of capital needed to start a new business is dropping by more than an order of magnitude every 10 years. For venture capital firms, this means that investments in startups are rarely worthwhile; the entrepreneurs simply dont need to borrow enough money to give up a big chunk of equity in exchange. Many VCs wont get involved for less than $10 million, and today there are relatively few startups that need that much capital.2
How will the rise of PMNs play out? In the four forecasts that follow, well examine what this trend means for the four groups that will be affected:
1. Entrepreneurs 2. Investor 3. Private market networks 4. Traditional intermediaries
First, for entrepreneurs, PMNs will provide easy access to growth capital, merger partners, and strategic buyers.
Investments from PMNs will become the equivalent of micro-loans in India: a way for entrepreneurs to get relatively small amounts of capital, with a minimum of interference from investors, just when it is needed. Moreover, because the network allows business owners to select from a large number of potential partners, the likelihood of finding the right "fit" with investors is increased, thereby reducing the stress, conflicts, and even bankruptcy that can occur when a mismatch exists between the personalities and long-term goals of entrepreneurs and investors. This will spur the growth of small businesses, which will create jobs and provide a boost to the overall economy.
Second, for investors, PMNs offer an opportunity to maximize returns by spreading risk among several small investments that each offer the potential of high ROI.
For example, more than 750 groups of angel investors are using Gust to evaluate potential investments and negotiate deals with more than 125,000 entrepreneurs. Angels traditionally participate in the first stage of investment in a startup; in the later stages, VC firms have always provided the big infusions of capital that was needed to keep the business growing. But today, the costs of starting a business have fallen so fast that a consortium of angels can finance a firm on their own. Better yet, through the network, each of them can spread his or her investments across several startups.
Third, for the PMNs themselves, this is only the beginning of a paradigm shift that will unfold in their favor.
Venture capital firms will increasingly become irrelevant to the funding of new businesses. PMNs will disintermediate the traditional brokers in several industries, from financiers to art dealers. As they expand their power, however, expect a vigorous effort from banking and VC lobbyists to persuade the SEC to impose regulations and restrictions to slow their growth.
Fourth, for the traditional intermediaries, the emergence of PMNs will force them into specialized niches in order to survive.
VC firms will have to focus on a shrinking number of startups that need big infusions of capital ? but the competition for these opportunities will be intense, and several VCs will have to exit the industry or consolidate with their competitors. To survive, look for VCs and banks to establish their own private market networks in an attempt to remain relevant while capitalizing on their brand identity.
References List :1. Strategy + Business, Summer 2011, "The New Financial Matchmakers," by Bob Rice. ⓒ Copyright 2011 by Booz & Company, Inc. All rights reserved. http://www.strategy-business.com 2. Wired, August 29, 2008, "Tech Making Traditional VCs Obsolete," by Bob Rice. ⓒ Copyright 2008 by Conde Naste. All rights reserved. http://www.wired.com
