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January 1, 2000

Technology Viewpoint: Ventures in Cyberspace

By Clay H. Womack

The Internet has revolutionized retail investing. Now it is about to do the same thing for the venture capital industry. The forces at work are similar, but the effects may be even more far-reaching.

The Internet has changed the operation of the capital markets, bringing more competition and lower costs. Through financial web portals such as Yahoo!, the Motley Fool and others, individual investors can identify and evaluate investment decisions, using research tools that historically were available only to institutions. The result has been an enormous inflow of capital from individual investors, who operate independently of full-service brokers and other sources for investment advice.

Radical changes are proceeding in the financial services industry. Brokerage commission costs are dropping rapidly. Service rather than stock picking ability is becoming the key differentiator in retail brokerage.

As retail commissions begin to approach the level of underlying costs, wirehouses are dependent on attaining economies of scale. Soon, large brokerages will survive only on retail order execution, with advice and order handling becoming insignificant. Hence the race by wire houses to invest in electronic communications networks and market making firms over the past six months.

Early-Stage Investment

While the retail investor is rapidly gaining parity with the institutional investor in the brokerage business, there is still a domain that remains largely closed to individual investor participation. Early-stage investment opportunities, to a large extent, still remain the private playground of institutional investors. Through their participation in private equity funds that are closed to most individual investors, institutions are able to earn outsized returns of several thousand or even a million times their initial investment through today's hot post-IPO market.

The extraordinary first-day trading performances of today's hottest Internet companies have begun to whet the appetite of individual investors for participation in early-stage investment opportunities.

The Internet is servicing this appetite. It has the ability to be the catalyst for one-to-many communications. Recently, early-stage equity opportunities that traditionally were available only to institutional investors have become electronically accessible to any qualified investor building a personal portfolio.

Today, an individual investor needs only to point-and-click on the right URL to see the prospectuses of investment opportunities in companies that may become tomorrow's industry leaders. This is the next stage in the unstoppable disintermediation of middlemen and the reintermediation of capital to companies through the Internet, thanks to a new breed of content aggregators. (The middlemen, in contrast, merely provide distribution services but fail to add lasting value.)

Eyeing Incursion

Traditional firms within the securities industry are warily eyeing this latest incursion of the Internet into their business models. Of course, like the large wire houses facing the exploding growth of free information and electronic trading, the traditional investment banks clearly have the most to lose from the growing market for private capital on the Internet.

Quality companies with an affinity base of customers may eventually be able to attract capital on their own terms. That will eliminate the need for the expensive, traditional distribution services they currently provide.

A few traditional investment banks are moving to market their private equity deals through strategic partnerships with the new online early-stage investment networks.

These banks become the brand name content providers for the up-and-coming Yahoos! of the private equity arena and offer a sense of reassurance to their investors. But many other firms are taking a wait-and-see approach. That's a dangerous strategy in the Internet era.

Whichever strategy turns out to be best, the Internet is again turning the securities industry upside down, driving the adoption of new business models for a new, more accessible and democratic capital market.