RDVP Finance SIG (10/22/2004)

Greg, Margarita, Dave McClure and I met to discuss "Issue 1" on our SIG list: Micro-VC.

Greg described a company that he thinks would fit the MicroVC model for investments:

• Yachana, in Ecuador. A for-profit subsidiary of a non-profit organization, this producer and exporter of eco-friendly chocolate is seeking an investment.
  

We talked a bit about the specific challenges that make this harder than traditional VC:

1. Lack of an exit strategy: These companies generally don't fit the profile of an IPO, and are located in countries where the public markets aren't as well developed as the US.
   
2. Social aspect: In some cases, the justification for an investment is not purely the financial return. The "double bottom line" of social or environmental return helps make the case, but traditional VC investors can't always make that argument with their limited partners.
   
3. Difficulty of evaluating and managing investment: Many VC's don't like to consider investments outside a few hours' drive from their office. Being able to perform due diligence and participate in the board meetings and strategy of the company requires face time.
   
4. Smaller investment requirements: On top of all these factors that make it harder, the deals are generally smaller, so there's less upside because less money can be put to work.
   

Greg mentioned that Equal Exchange had raised money by selling restricted stock to the public, which paid dividends in product (coffee) and could be redeemed after 5 years for the initial purchase price by tendering it to the company.

Margarita mentioned a couple of different funds such as The Angels' Forum which makes small investments by forming a distinct limited partnership for each investment chosen by some subset of its 25 wealthy individual investors. Also, The Investor's Circle is a social venture fund focused on sustainability. Commons Capital is a more broadly focused social venture fund. She mentioned TiE as an example of a minority group that funded some entrepreneurs. She added from her own experience that funding under-represented groups without having syndicate partners made it tough to ensure that portfolio companies would have access to the capital they needed to grow. She also talked a bit about her time at Horsley Bridge Partners a "Fund of Funds" VC that took money from pension funds and invested it in a set of VC's that was diversified by geography, industry, and stage of investment. By investing in ~15 VC funds, they were indirectly invested in 250-300 companies. Alex Mendoza had created a fund (NuCapital Access Group?) that targeted underserved groups and tried to have the resulting investment vehicle look like a dividend based investment for his investors.

Looking at the typical "solution" for these investment seekers today, the lucky ones that acquire funding either get "one-off" funding from an individual or find a foundation that is willing to make a "Program Related Investment". Dave wondered whether there were some way of including a portion of the hard (real estate) assets as a piece of the pledged backing for the stock, so that at a minimum, an investor would have a supporting "floor" of the value of the land. This might be especially attractive in eco-tourism investments, where the land and infrastructure in the community is being improved to serve international tourists.
This led us back to the challenge of the exit strategy. It seemed one of 3 viable approaches:

1. Create a FannieMae like secondary market where a quasi-government entity can purchase.
   
2. Target investors with a long time horizon, those that would be content to get a stream of dividends generated from the operating cash flow of the company rather than capital appreciation
   
3. Link the investment in the company to the ownership of its land, making a more liquid market.
   

We talked a bit about other aspects of the "mechanics" to make a deal work. Most investors would prefer to have a US-based company, where they were confident of the accounting standards and legal protections offered. But these investors are increasingly comfortable with a hybrid, where some work is done in the US and some overseas. Margarita identified this trend as "micro multi-nationals", and said that it's not just engineering/development operations moving overseas. But again the problem of due diligence and company management from the US, especially for smaller sized deals, seemed intractible. So here, we proposed pushing responsibility down to the local level: creating a local general partner for the developing community, someone with some experience in VC (A Kauffman Fellow, recruited from that community perhaps?) who would deal in smaller stakes (putting perhaps $250,000 to work) but since he or she has the local knowledge and contacts can do so more cost effectively, plus operate in a lower cost environment. Margarita pointed out that UPS has historically been interested in supporting the creation of small business (new customers) and so could perhaps be approached for something like this. By creating a network of these local "Micro VC's", a parent company (partnership?) is essentially a "fund of funds" with good geographic diversity.

It may be possible to create templates of viable business kiretsus (networks), such as:

• Eco-tourism (to bring new money into community)
  
  
  • Resort lodging
    
  • Specialty agricultural production with export interest
    
  • Transportation
    
  
  
• Retail (to provide increased options to local community). The local equivalent of the "Starbucks, Noah's Bagels, Jamba Juice" triumvirate, but with Mom-and-Pop instances of each of the categories instead of chains.

Having this kind of coherence to the on-the-ground investments enables some shared expertise across the fund-of-funds, and perhaps allow the creation of relevant infrastructure that can be shared by all (a reservation system for eco-tourist sites, for example). Margarita suggested that the Pacific Community Ventures might be a model worth looking at, since a key part of their focus is the creation/retention of jobs in the community. Is the diaspora community a viable source of capital and talent (the local VC's) that could make this work? Would the governments of the other countries be willing partners (with tax breaks, matching funds?) to encourage this type of foreign investment?

What type of profile are you looking for for the local VC's: education? experience? ability to raise a portion of the fund (from personal resources? local community? diaspora?) How would that person be compensated (salary plus management fee plus percentage of carry? Are profits considered purely locally or at the fund-of-funds level?) What geographies? Ones with protectable property rights, what else?

This is different than microcredit. It is targeting a different audience: not the poorest of the poor as microcredit does, but rather the emerging middle or even upper-middle class that has experience (proven perhaps by successfully taking and repaying multiple microcredit loans), financial savviness. It aims to generate a quantum leap in employment, not the incremental addition of a one or two people to a micro-venture.

NEXT TIME: We agreed to go deeper on this topic. Personally, I'd like to get an understanding of how the model works.

• Could we "run the numbers" for one of these local VC's?
  
• Is $250K the right amount: can it support all of the needed investment?
  
• Is the management fee and generated revenue stream enough to cover costs (and attract the right level of people to apply for these positions?)
  
• What portion should the local VC be responsible for?
  
• Does it make sense to specialize to either the retail model, the ecotourism model or should the local VC be given total discretion?
  
  
• What's the roll-up plan (ie, how does the fund-of-funds look?)
  
• How much global diversity do we shoot for?
  
• What roll-out rate?
  
• What are viable sources of limited partners for the fund-of-funds?
  
• Is anybody else doing this?