Dave Taylor:
I’ve been working closely with the DaVinci Institute on some of its entrepreneurial efforts, and recently had a chance to interview Kevin Johansen, the sharp and charismatic head of the Entrepreneurial Standards Forum, about the world of angel investing and how it could be significantly improved. It’s a long interview, but darn interesting for anyone who’s ever thought about raising capital…

Q: I think that historically angel investing has been not just erratic and characterized by poor diligence on the part of investors, but also a crap shoot in terms of results. What are your thoughts?

Investing in startups is a gamble that’s more likely to pay off if you know the rules of the game and play the percentages. By comparison, if you go to Vegas and watch the professionals you’ll quickly learn that they know the rules inside & out and that they play the percentages with a great deal of discipline. This generally means that unless they know *exactly* what their next move should be, they don’t move. The amateurs, however, are there for fun and the off chance that they might hit it big. As a consequence, they generally don’t think much before they act as doing so lessens the element of surprise and can take the fun out it.

Investing in a business in the early stages of its development is sometimes thought to parallel this phenomena, as one of the primary motivations for an investor in an early stage Company is to roll up their sleeves and make a contribution that goes beyond the dollar investment. For a lot of investors, Angels in particular, ‘fun’ and the feel good aspects of helping someone put their business on its feet are significant drivers in their decision to invest. The difference is that in Vegas the rules are more clearly defined and the odds are more easily computed.

Q: Isn’t one obvious area where angel investing could improve would be to streamline the mechanism by which investors and startups are paired up?

Absolutely! The question is ‘How?’ and the answer is complex. This complexity is generally where attempts at solutions fail. Historically, the people trying to solve this problem have come to it from accounting, legal or engineering perspectives. These are linear disciplines, and as a general rule, they start by trying to scale the ambiguity from the process. However, markets are dynamic, non-linear things. Were they as simple as arbitrage, contract or software development they’d be more predictable and yield more often to disective analysis & reductionism. As a consequence, the result of the lawyers, engineers & accountants work is generally a very linear process that’s easy to explain via flow charts – but that sometimes has very little to do with reality.

Disective analysis and reductionism are great tools for figuring out how simple, linear processes work, but with non-linear processes (Examples: The weather and most anything involving people.) They’re an exercise in frustration at best. Investing in early stage companies is a dynamic & complex process that exists within a complex system. As it is a complex system it requires a systems appproach to problem solving if you expect to get anywhere. Unfortunately, the necessary computing power does not yet exist that can effectively model this system. This relegates us to the observers role when what we instinctively want to be is experimentalists. So be it. There are still highly workable paths to solution available if you can step away from linear perspectives on problem solving. One of them is open source.

Q: Tell me how you think the process of doing “due diligence”, of fairly evaluating the strength and probability of success of a startup, can be improved?

There is no mystery to due diligence. It’s just work. Like most processes that are “just work”, it can be made more efficient through standardization. The problem with standardization, however, is that the validity of a standards is tied directly to the number of people using it. A standard is only a standard to the people who have agreed to work with it as a standard. So the question then becomes: “How do authoritative standards develop?” In markets they evolve through two processes. One is through accretion of market share – you buy & earn your way through to being the dominant service provider and then dictate the standard to which everyone else comforms. The other is through open source in which the community of Users makes decisions collectively about what the standards should be. Autocracy works well with simple systems. Democracy works well with complex systems.

The Entrepreneurial Standards Forum [link] is being built out to be an open source, investor-centric initiative in which the community sets the standards. If enough of a community forms around it the standards developed will have validity. Building this standards development community is the challenge in front of the ESF.

Q: Your team has been talking about a model of angel investing that’s based on the stock market. I love the idea! Tell me a bit more about the specifics, though?

One of my favorite Internet words is “disintermediation”. It means getting rid of the middleman, and over the last 10 years we’ve watched information technologies disintermediate the middlemen in market after market as the providers of a product or service figured out how to go direct to the consumer without using a broker. Using the airlines as an example, they began the disintermediation process in the early 90’s when they started charging the consumer less for tickets if they bought direct from the airline and not from an agency.

This change in business process was made possible by information technologies and the Internet. As a consequence, the number of travel agencies has dropped from about 36,000 in 1990 to about 27,000 today and it continues to decrease. Good examples are everywhere. And there have also been some exceptional success stories by companies that aggregate access to products and/or services and then facilitated transactions between parties without taking enough of a percentage to disrupt the transaction. eBay, Google & Amazon come to mind. These are very effective middlemen in part because they’re easy and inexpensive to use, but also in part because they’re ‘long tail’ aggregators.

[The ‘long tail’ is a concept integral to the Internet’s value to business. You can learn more about the long tail at wikipedia, but, in simple terms – and for the purpose of this conversation – it means that when the marginal cost of selling a product or service is the same regardless of the volume of product sold, the whole of a market can organize itself under a single provider.]

Q: A big buzzword for startups seeking angel investment is “qualified investor”. Can you explain what a qualified investor is and why it’s so important when raising capital?

“Qualified” has several interpretations when it comes to Angel investing. The most common usage is the one that is equivalent to “accredited”, which generally means “millionaire”. The definition of “accredited” are different State by State, but they generally means that the investor has at least a $1,000,000 in assets and/or make something more than $200K a year. The assumption on the part of the government is that if you have that much money you know enough about investing to make informed decisions. There are also ‘blue sky’ provisions in most States that allow unacredited investors to invest in private equity deals. There is generally a limit to the number of unaccredited investors that can invest in a deal per State. In Colorado it’s 35.

But these are just the definitions. The prospecting process is more important to the final result as most Entrepreneurs that need capital to get their business going simply don’t know enough millionaires to get properly funded. And as of this writing, there is no commonly accepted process that an Entrepreneur can use to source capital, or that an Angel investor can use to source investment opportunities. This is not because there have been no attempts at creating them. There have simply been no visibly successful attempts. This is in great part because the entities that have attempted to create bizdev processes that become standards didn’t build means into the developmental process for the standards to become valid and authoritative.

Valid is a function of market share. That which is the most valid is that which gets used the most. Authoritative is a function of effectiveness. That which is most authoritative is that which works best. Without valid & authoritative standards the only draw to a standardized bizdev process is money. Designing a process with money as a primary draw is problematic, as the majority of new businesses don’t need it, or don’t need it enough to rationalize the effort necessary to get it from Angel investors outside their personal networks. As a result, ‘money centric’ processes designed to generate deal flow for an Angel network or a VC don’t address the needs of the larger market. And this generally means that the community of Users that organizes itself around the process never gets large enough to become self sufficient and operate independent of the investors running it.

The solution, then, is to design a process that works for everyone, with those businesses that need investors being a subset of the larger whole. We think the only way to do this and get validity & authoritative standards from the process is via an open source initiative. If the community that organizes itself arounnd the Entrepreneurial Standards Forum gets large enough, there will be enough critical mass in this subset to customize a service offering for. One of the services in discussion is a stock exchange that growing businesses could source capital from. The ESF value proposition in this conversation is speed. Businesses that are developed within ESF approved protocols will have less time & dollar cost to the due diligence process.

More here.