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Door to Venture Capital Cracks Open to Small Investors

Ian McDonald

Getting in on the ground floor is nice, but what if you could get in before that?

More and more, individual investors are clamoring to invest in companies earlier in their life cycles -- that is, before they go public. But the door to venture capital has basically been shut to non-millionaires. Recently, it opened a crack -- and if demand is any indication, the opportunities could soon proliferate.

"A fund that gives my clients access to venture capital could spread risk further and add to returns -- and that's the Holy Grail," says Frank Armstrong, a financial planner with Managed Account Services in Miami.

While Holy Grail might be overstating the case, Charles Schwab (SCH Quote) did announce on Nov. 1 that it was joining with San Francisco-based online investment bank OffRoad Capital to offer shares of private companies to Schwab customers and clients of Schwab-affiliated financial advisers.

If Schwab and OffRoad aren't bringing the private-equity market to the little guy, they're at least reaching out to the more modest millionaire. You need at least $1 million in investable assets to get in, but the minimum investment is just $25,000.

If that sounds like a lot of money, consider that it's the cheapest deal around for a venture capital investment. Historically, the well-heeled set that qualifies to invest in pre-IPO companies has done so through private venture capital funds with investment minimums that start at $100,000 and reach into the millions.

Part of the reason venture capital investing remains so exclusive are regulatory restrictions. The Securities and Exchange Commission limits access to private equity investment to "qualified" investors -- those with $1 million in investable assets -- and also limits private company investments to 15% of a mutual fund's assets. These regulations have kept retail fund companies from launching private-equity funds.

For investors who can afford them, there are typically two types of venture capital, or VC, investments: a single fund containing investments in a handful of companies, or a VC fund of funds, which provides access to many more private companies by spreading an investor's money among several VC firms' portfolios.

These funds of funds are offered by firms like Bear Stearns (BSC Quote), Goldman Sachs(GS Quote) and Donaldson Lufkin & Jenrette (DLJ Quote) to their most prized customers. Popular among individuals seeking diversification, industry observers estimate that there are more than 50 funds of funds currently available.

Both types of VC funds swing for the seats, looking for the next Microsoft(MSFT Quote). But it's a hit-or-miss proposition because many of these young companies are betting on niche products or services.

"Out of five companies that you see [on the private market], two are going to be real dogs," says Dave Root, a financial planner in Pittsburgh. Others say this ratio may be optimistic.

OffRoad is probably the closest most individuals can get to these VC funds. But investing through OffRoad could entail a bit more risk. Instead of spreading a customer's assets across a portfolio of private companies, OffRoad presents investors one company at a time. This can lead to heavy bets on few untested companies.

Emory Winship, OffRoad's director of strategic planning, says the firm limits risk, like any venture capital firm, by focusing on companies closer to an initial public offering. OffRoad also screens each company's business plan, looking for an exit strategy that will provide profits to investors, typically through a public offering or an acquisition by a competitor.

Maybe the most interesting prospect on the potential private-equity mutual fund front is the July partnership between highly regarded Boston leverage-buyout shop Thomas H. Lee and the $193.3 billion Boston fund manager Putnam Investments. Putnam said it made the move to offer alternative investments to brokers' wealthy clients. The firms' first venture fund, TH Lee.Putnam Internet Partners, just made a $20 million investment in online retailer wine.com. Since July both sides have been mum on whether the marriage will lead to a retail fund offering down the road.

In the meantime fund investors who want to put money into young companies have two choices: post-venture funds like (VWPVX Quote)Van Wagoner Post-Venture, (WPVCX Quote)Warburg Pincus Post-Venture and Warburg Pincus Global Post Venture, and IPO funds like (IPOSX Quote)IPO Plus Aftermarket and the Hambrecht & Quist IPO and Emerging Company fund. Both types of funds have performed quite well (the H&Q fund is too new to have a record), but none are VC fund proxies because, for the most part, they don't invest in private companies.

In addition, a few small-cap and aggressive-equity mutual funds dabble in private equities. Van Wagoner funds might be the most well-known. But the firm's private-company investments are occasional and never approach the SEC's 15% allowance, says Peter Kris, a managing director at Van Wagoner.

Still, regulatory issues aside, some venture capitalists think the private-equity club should stay closed. They don't think fund investors would be patient or sophisticated enough to be successful in the private-equity market.

But if investor interest grows, fund companies will be motivated to tackle the red tape and start finding ways to bring private-company funds to the masses.

One such company is Seligman Funds, which launched Seligman New Technologies fund last July. As a closed-end fund, New Technologies is outside the SEC's 15% limit on private company investments for open-end funds. According to its SEC filings, the fund can invest up to 35% of its assets in private companies. To address liquidity and redemption concerns, fund shares don't trade on an exchange and investors can only buy or sell shares quarterly.

Shares of the fund were offered to investors in July with a $10,000 minimum investment and a 3% load. Unfortunately for those who didn't get in, the fund's regulatory filings indicate that there is little or no opportunity to invest in the fund after its offering.