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Is the AIFM Directive bad for entrepreneurs?

There has been a call lately to entrepreneurs by people like Fred Destin or Seedcamp to meet tomorow’s deadline and bring their support against the AIFM Directive. Many prestigious entrepreneurs have already signed the petition and my attention was called to all this by my good friend Louis van Proosdij, who is a co-founder of and founder and CEO of FairPlay Interactive.

At, we try to promote commons that are favoring the all ecosystem. Which means we try neither to be on entrepreneurs’ or investors’ side, but try to promote what we think we’ll be good for the all community.

I must confess I’m like anyone else and tend to be very wary when I hear that the European Union’s technocrats will try to regulate something. But I’m also very deeply concerned, like everyone, by what went wrong with the financial system. I must also confess that reading the Directive, it seems very difficult to understand all the details (it took EVCA almost a year to produce several counter points). But I fail to understand why entrepreneurs are taking side with Venture Capital so rapidly.

So let me react to a couple of points to try seeing if things are so clear for entrepreneurs going against this Diretive.

Does the AIFM make sense?

I think there has been a quick parallel between what went wrong with Lehman Borthers and regulating funds. Lehman Brothers was a bank and was acting as a lender and borrower on many transactions. The fall of Lehman created the seed of what is called a systemic risk – a potential complete subside of the financial system through a domino effect.

Is the regulation of alternative investment funds addressing the same exact issue? I don’t think so, but let’s give credit to the EU that probably not everything is working as it should be in this part of the financial system and that anticipating problems could be a good change from what happened before.

Should Venture Capital be included in the AIFM?

When I first heard a couple of months ago that VC will be included in the regulation concerning hedge funds, I thought this did not make sense. Hege funds can be short (taking positions backed by a money they don’t have), VC funds are never short. Then, I rationalized that VC funds are such a tiny part of the financial system that including them or not would not make any difference for the purpose of the directive.

Is this bad for Venture funds?

I believe this is bad for Venture funds to be included in the Directive. But then, they also suffer from being part of Private Equity – which they are a small portion of. The most substantial part of Private Equity is made of  growth, distressed, mezzanine, secondaries,.. and there are issues there that, even though quite different from hedge funds for several aspects, is very similar concerning the use of leverage and the inherent risks that were poorly addressed prior to the crisis.

So Venture funds are caught in a regulation that is targeted at a much broader category, but for their own detriment, they are clearly currently assimilated to this category

Is this bad for entrepreneurs?

Here, I’m a bit puzzled why entrepreneurs accepted so readily the arguments of the EVCA.

  • Discriminatory disclosure requirements and administrative burden affecting startups backed by venture capital
    There is a clear bias against VC here in favor of familly offices and sovereign funds. Is this bad for the entrepreneurs? I’m not sure. Money could find alternative routes to come support young startups, but it is sure that VCs will be at a disadvantage
  • Cost of compliance estimated at €30,000 per year for your companies
    This cost was estimated by the EVCA. I don’t have the details of the computation, but I’d like to know what is the cost supported by companies for the reporting to venture funds, and I’m just wondering if there is no compensation in the reporting done that would lower this figure
  • Absurd capital requirements imposed on venture firms
    Here, I don’t really see this as a negative for entrepreneurs. The Directive says that funds below €100M will be exempt from the corresponding regulation and that fund management firms handling less than €500M will be exempt as well. EVCA would like to see the threshold raised to €1B for funds, but haven’t big funds – with the associated power -been a problem entrepreneurs have been complaining a lot. Funds entrepreneurs love – like Seedcamp – will not affected by the Directive. If we see more of these funds – as we do right now for other reasons (because big funds are fleeing Europe) – won’t the situation be better for entrepreneurs?
  • Requirement to use outside depositaries (i.e. custodians) and independent valuation agents, adding cost and complexity
    Having custodians and independent valuation agents will bring a cost, but is it as bad for entrepreneurs than for VCs. I’m not sure. Custodians will bring a much easier world for Limited Partners and bring transparency into the system (with some much needed industrialization of the VC backoffice). And independent valuation may bring quite a different setting: Is it really bad for entrepreneurs to have a third party valuating their company, when the EVCA argues that fund managers do that already very well. Anyone involved in a down round (subsequent round based on a lower valuation than the previous one) may have a different opinion on this.

So, all in all, the outcome of this Directive seems to me less clear for entrepreneurs than for the VC industry. We may even see some strong benefits because of the transparency it will bring to the financing of startups.

Are you giving equity to your VC to get their advice?

This post comes after a discussion through comments with Fred Destin on one of his recent posts. This is something I’ve been thinking for a long time, and I just thought it may be time for me to put this on paper: Nothing in the way term sheets are crafted creates an incentive for any of both parties to value advice from investors.

Let me just state first that I’m not saying that some VCs or BAs are not adding value to companies they’ve invested in. I know Fred and he’s definitely a nice fellow and very proactive investor, he’s for example participating in a lot of initiatives like Seedcamp. But, my point is that VCs or BAs are best viewed as pure financiers with the incentive structure put in place through current shareholder agreements: Their added value is in putting money in the projects that will be providing the best returns – with or without them on board.

Today, once the money has been committed, there is no incentive for the entrepreneurs to listen to investors’ advice – entrepreneurs are not paying for it. Furthermore, there is no incentive for investors to put extra skin in the game – if they do, other investors will benefit from these freebies on the same terms than they will.

OK, we regularly do see some investors providing extra help. But for me, their incentive belongs to either empathy or reputation management (providing value now to get a discount on future financing rounds with other startups). The carried interest, that is often cited, is not actually a hard incentive. Investors will receive it, whether or not they were really instrumental in the success of the company. Sure, investors have an incentive not to let the company fail, but the way to “fix” a company is certainly something that is not widely shared between entrepreneurs and investors, and I don’t think entrepreneurs see them as advice they have paid for when they issued equities.

So my whole point to entrepreneurs is that they should not expect particular help from VCs or BAs. Sure, they will get some “free” advice, but like everything that is free, you may like it or not, it may even have a lot of value for you, but you can not complain on the quality.

I’m actually thinking that we need alternate incentive structures so that entrepreneurs do pay for advice that have value for the project. There is a problem of assymetry in information products like advice, it is that you don’t know the value until you’ve consumed them, and when you’ve consumed them for free, you have litlle binding to pay their full value. My current thinking is that alternative currencies may be a good way to solve this problem: You can imagine that projects will be able to issue local currencies that will be backed someday by actual shares of the profit. But this is another story, a subject for another post…