CandidCapital

The Story so Far

Earlier this week we looked at how the sub-prime fall-out is impacting on growth businesses and we noted how reminiscent today’s market woes are of the dot.com bust. I suggested that the rebirth of Internet commerce as Web 2.0 provides a hopeful parallel for the current market uncertainty. The really interesting aspect of Web 2.0 is ‘the long tail’. And what’s more, not only did the long tail ‘save’ the Internet, it might even be the way out the perennial funding gap experienced by promising young firms.

The Long Tail

The long tail was first identified – in popular management literature at least – by Chris Anderson in an article in Wired magazine in October 2004 – which I urge you to read, not least because it’s like be present at the birth of an idea. The basic concept is that individual products with low sales volumes can collectively have a market share similar to or even greater than the minority of bestsellers – provided that the store or distribution channel is large enough. Now, with a conventional store that could never be the case but with a ‘virtual’ or online store, the problem CAN be solved.

Chris Anderson took the following examples. Even a big Barnes & Noble bookstore would only have room for 130,000 items. But Amazon (at the time he was writing) carried 2.3m titles. The secret is that Amazon does not need to have 2.3m titles all available physically in one place. Its ‘store’ is the website you can access form your laptop, and its ‘warehouse’ and stock do not even need to be within its own direct ownership. What matters is that it can locate stock from publishers to an agreed schedule (and manage your expectations as a customer with notices such as ‘normally shipped within 3 days’) or put you in touch seamlessly with private sellers via its market place.

Now Amazon is usually associated with shipping physical product, such as text books or running shoes. Long tail business models work even more effectively if products or services can be delivered digitally – think of music or software upgrades. This is how iTunes and other online music stores operate.

Using Chris Anderson’s 2004 examples again, a big physical store like Wal-Mart could carry 39,000 tracks, but an online music store (he chose the example of Rhapsody) even then carried 735,000 tracks. Digital retailers have no minimum stock issues (a high street store might only stock an album if it could reasonably predict sales or a dozen copies or so – the 6 inches of real estate required down town have to be paid for). Distribution costs are obviously lower, too. And good tracks no longer carry back ones: you don’t have to pay $12 for a whole album when all you wanted was 3 tracks.

Learning to Ski

It should by now be evident that the long tail is built on those qualities Tim O’Reilly identified as being key to Web 2.0 (used as a platform, harnessing collective intelligence, focus on content and services, co-operation not control, differentiated from high-street retail, consumer power, direct relationships) and that many Internet success stories rely on it, from eBay to Google to Netflix.

Chris Anderson eventually turned his original article into a book The Long Tail: How Endless Choice Is Creating Unlimited Demand (which unlike many good business articles expanded to book size does justify its greater length) and runs a website dedicated to the development of the fundamental idea.

(And just in case you are still wondering about the title, imagine a graph with stock keeping units on the x-axis and number of units sold on the y-axis, with the most popular items closest to the origin. The top line of the graph will look like a ski-slope – a steep black run at first – the most popular 10% of items, say – then a gentler blue run where sales level out but never quite hit zero. This blue run is the long statistical tail.)

None of the long-tail analysis implies that there is no place for physical, high-street stores. But it does mean that each type of outlet has to focus on what it is good at. I suspect that I’m like most of you in still enjoying browsing book and record stores and trying on stuff before I buy it. But Amazon and other online stores have been a liberation. My taste is both – bare with me – catholic and esoteric. That is, I enjoy a wide range of styles but much of what I like you cannot find in the high street. And even if you could, you certainly would not find all of it (Pablo Casals and Kimya Dawson) under the same roof.

The Funding Gap

So how does any of this affect the funding gap, let alone dig us out of the hole created by the sub-prime lending crisis?

The answer is surprisingly simple. The sub-prime crisis exists at a relatively high level of abstraction – one clearing bank (not) lending to another in the capital markets, and the impact this has on liquidity ratios, tier 2 capital and many other forms of black magic in which an actual five pound note is hardly ever seen.

But at a more mundane level – where people really do lend CASH to each other – a thriving market in peer-to-peer lending has begun to emerge.

Take, for instance, a company formed only three years ago this month: Zopa (so called from the negotiating term ‘zone of possible agreement’). Launched in the UK in March 2005 by much of the same team as started Egg, Zopa was funded by some serious venture firms (Benchmark, Wellington) precisely to facilitate peer-to-peer lending on a many-to-one basis (ie, provided you make more than £500 available, your money will be split across several loans). Zopa undertakes automatically authentication and credit checks as part of its facilitation process and charges a 0.5% fee on monies lent.

In a nutshell, suppose you want to borrow £5,000 for your new nursery at home. Your credit score is high (A*) and you want to borrow over 3 years. The current benchmark interest rate is 6.8% and you might find that a total of 10 people contribute funds to your loan.

At the end of 2007, Zopa launched in the US. It also has sites covering Italy and Japan. The US market is already served by other peer-to-peer sites such as Prosper (also backed by Benchmark), which facilitated some $96.4M of loans in 2007 and is already registered with the Securities and Exchange Commission. Some analysts predict that the US P2P lending market could be worth $1bn 2010 and $9bn 2017.

Now, you may say that compared with what conventional banks do already this is small beer. But that is not the point. P2P markets – especially in finance – are like the Heineken advertising slogan: they reach parts that other lenders cannot find. So far bad debts have run at about 0.1%.

And there is room for improvement in the retail lending market. UK banks have a 50% cost income ratio (for every pound they earn, 50p goes on paying staff, keeping branches open and paying out on legal claims: last year UK banks paid out £560m for claims made in respect of unfair fees). Despite such expensive processes, UK banks still wrote off a record £6.8bn in household debt.

But until now, no effective mechanism existed to access the direct lending market. The long tail is changing that.

The Long Tail of Equity Funding

And it doesn’t stop there. It can only be a matter of time before the long tail helps make the highly inefficient small end of the unquoted equity market efficient enough to go through a renaissance.

Consider the following facts:
- Most analysts of the angel market (such as Colin Mason of Strathclyde University and Richard Harrison of Edinburgh) consider that it is more important than the formal venture capital market for both numbers of ventures supported and total capital flows
- The business angel market is notoriously difficult to quantify (it raises questions of definition, many investor guard their privacy, much activity is below the radar) but some recent surveys suggest its size is 8 times that of formal VC market, not least because of the vast increase in personal wealth since 1970s, the impact of tax schemes (such as the EIS, VCTs and ECFs), as well as positive changes in attitudes to business to entrepreneurship

Now think of the following example. The Cambridge Technopole Report - Spring 2008 estimated that the amount of venture funding in Cambridge in 2006 amounted to US$260m. If the ratio of VC to angel funding really is 8x, then the potential angel funding in Cambridge in 2006 would have been…US$260m x 8 = $2080m = £1000m!

Even if it was only a quarter of that amount, it would still go a long way towards filling the funding gap, which has been discussed in the UK since at least the publication of the Macmillan report in 1931.

The Leverage Effect

A little equity funding goes a long way. As real risk capital, it is highly instrumental in levering in other forms of funding, from bank debt to grants and soft loans until the business is generating positive cash flow.

But I speak from bitter personal experience as a former non-executive director of a network of angel networks that informal equity is an inherently inefficient market, with many personal fiefdoms and Old Spanish Customs being ferociously protected to the detriment of the common good. No one hitherto has managed to find a calm and effective platform for putting – and keeping! – investors in touch with entrepreneurs.

Now, having seen the success of Zopa and Prosper in the debt market, I do not believe it can be long before the latent potential of the informal equity market is combined with the efficiency and transparency of P2P lending platforms. This would enable pre-investment referrals by one angle to another, evaluations by industry experts, ongoing investor relations, and even – eventually – a secondary market in unquoted equities.

The technology and the business models behind many other long tail firms will sooner or later reduce the practical barriers – and the ‘shoe leather costs’ in schlepping from one hermetically-sealed investor forum to another – involved in obtaining angel funding. Some moves have already been made in this direction in California (have a look at Fundability), though on both sides of the Atlantic the monstrously complex and expensive – and ineffective - regulatory regime (built for supervising Citicorp or Enron or Northern Wreck) may have to allow for a larger element of caveat emptor before angel markets really take off. Real angels should be allowed to look after themselves, especially once greater transparency is provided through regular investor updates.

And here I must publish my Truth in Advertising Statement: I am a director of a Cambridge start-up which is trying to set up a fully-functioning online angel market.

What Next? Back to the Future

I believe that online markets for debt and equity will supplement not replace current models. Banks will still be required for specialist services such as trade finance and insurance. I suspect that it may take the angel market 5 years to catch up with the debt market. The amounts involved in the equity market may be smaller, but their leverage effect will be significant.

P2P funding does not create money in the way that the banking sector does (by using algorithms to calculate how many times it may safely lend the same deposits out as loans) but it will fill in some gaps which, because of their size or sector or complexity, the mainstream banks do not find they can serve cost effectively.

In some ways, P2P funding is a return to a Victorian past populated by Friendly Societies, Mutual Associations and Building Societies, to say nothing of tontines or Odd Fellows, Elks, Maccabees, Foresters or the Knights of Columbus.

What has changed between now and then is the paradox of globalization. In the nineteenth century, enough business was done locally to justify having regional stock exchanges in cities such as Birmingham or Manchester. In the twentieth, economies of scale consolidated almost all such activity in London. But in the twenty-first, Internet technology and the cost-effectiveness inherent in the long tail has once more made small-scale transactions possible: we can think small AND develop scale at the same time.

Micro funding once again becomes cost-effective, even across borders. I think of this as a Grameen Bank for the developed world, but with lower rates of interest. Soon, even Aunt Ada Doom may forget about her shares in Northern Rock and be tempted to peer for a second time into the woodshed.

13 March 2008

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