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February 24, 2009

When Angels Fear to Tread

It's the lack of exits that's a problem amid the deadly clamp of panic throughout the economy - a far cry from the irrational exuberance that drives entrepreneurs (and their investors) and which brings us trouble and fraud as well as greatness and "slumdog millionaires".

No matter how much we bailout the auto industry, there'll be less jobs making cars next year than there are this year – in fact cutting jobs is a condition of the bailout funds. There are going to be less bankers a year from now, too. New jobs will come from new industries, not from the ones on life support. So it is essential that there be some source of funds for entrepreneurs so that they can do what they do best (when they succeed) – create good jobs for future markets.

Tom Friedman suggested bailout money for VCs; Fred Wilson articulately pointed out that only the incompetent VC firms would take the money and that skilled VCS actually do have money and can raise more. Entrepreneurs pointed out in comments on Fred's post that there IS a shortage of money from entrepreneur's POV. In a comment on my post on the subject, Fred suggested tax breaks for angels.

Angels are motivated by fear and greed just like everyone else – angel investors, that is, who, in better times, are a source of funds for entrepreneurs launching the businesses of their dreams. Angels (I've occasionally been one) are just as perverse as all other investors; we're more likely to invest at market tops when everybody else is and less likely to invest in scary times like the present even though there's greater opportunity now.

There is a way to get angel money flowing again but it's not by subsidizing angels – even with tax breaks. Angels are claustrophobic; don't like going into investments without exits.

Angels generally step aside (but don't get cashed out) when a company gets its second round of financing. Often VCs step in with money, advice, and contacts for the next round of a company's growth. The angels and VCs (and entrepreneurs) generally get some reward when the company is either bought or goes public. But companies aren't getting bought or going public right now.

The result is a logjam. The VCs are concentrating their time and attention on companies which would have – in better times – been long out of their portfolios. It's true, as Fred said, that the good VCs can raise more money; but they can't clone themselves. Fred can only serve on so many boards at a time. That means that venture funds can't take responsibility from angel investors at the rate they used to – they have last years' hatchlings still in the nest.

An angel looking at a potential new investment not only confronts the risk of failure – that's always been there – but also the risk that he or she will be in an active role with the company – and perhaps its only source of capital –for a long time to come. We angels, like the VCS, still have the companies that we previously incubated in the nest. So we're not looking for new investments either. We're scared and there are no exits.

Only greed (the dream of an outsized return) can conquer fear. Tax breaks don't do it; you need to have some gain before you can use them.

An opinion piece in the Wall Street Journal today by Tom Hayes and Michael Malone entitled "Entrepreneurs Can Lead Us Out of the Crisis" suggests not only tax breaks for angels and entrepreneurs but also eliminating Sarbanes-Oxley to make it easier to be a public company. This has the virtue of appealing to greed (the IPO dream) and opening up exits; but even I'd agree that, in the dotcom generation, companies went public much too soon – eventually to the detriment of the companies as well as their investors.

We investors have to give up the dream of a QUICK outsized return. We can dream but we have to dream the patient dream. We probably even have to wait for companies to be profitable before we can make any money. That's OK; we can live with that as long as we can have the dream.

Turns out there is something government can do, however, to get investor juices flowing again: invest in infrastructure that creates opportunity rather than subsidizing zombie companies which are blocking the way. When the Erie Canal was built (funded by private investors buying government bonds), private money flowed to boat people and businesses all along the canal. Same kind of thing when the railroads with built with healthy doses of land grants and other subsidies – fortunately government DIDN'T elect to subsidize the canal boats which the railroads put out of business. DARPA (government) had a lot to do with inventing and funding the Internet; the Internet enabled and encouraged a wave of privately funded innovation.

I wish more of the bailout were focused on infrastructure – especially new enabling infrastructure. If transmission lines actually do get built, "alternative" power'll flourish with much less government intervention than is planned. The government does have a role in building those power lines. If the United States can become an e-nation with every citizen having access to a highspeed persistent connection whether at home or on the road, that infrastructure of connectivity will light the exuberance lights for a new generation of connected services. Government's role there is to create telecommunications competition we don't have today and to subsidize the last five or ten percent of connections as we did with rural electrification and telefonication because the network as a whole gains value when it is universal.

We investors and entrepreneurs have to relearn patience. Fair enough. We'll come back into the game once we can't stand to be on the sidelines any longer and when we see a future – almost no matter how distant – in which there is an exit.

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