Privacy a Key Concern (and Opportunity) for Venture Capital Firms

Venture capitalists (good ones, at least) focus heavily on changing market dynamics to help mitigate the tremendously high risk of investing in pre-seed, seed and early stage companies. As online privacy becomes an increasingly prominent concern, Internet companies and the VCs that back them should develop a solid understanding of the changing legal and regulatory privacy landscape in order to develop products and services that are sustainable long term. Yet despite widespread public concern about online privacy and potential government restrictions, Internet tracking companies continue to secure new investments from VC firms.

If this doesn’t surprise you, consider the relatively hostile regulatory and legal environment that Internet tracking companies currently face. The Wall Street Journal's year-long What They Know investigation into online tracking has exposed a fast-growing network of hundreds of companies that collect highly personal details about Internet users. The FTC called for a "do-not-track" system in December. Several privacy bills affecting the collection and use of personal data were introduced in the House already this year. Privacy lawsuits against online behavioral tracking companies abound. 

A number of the FTC’s recent privacy-related enforcement actions give businesses a reason to be increasingly wary of Internet tracking practices. For example, in 2009 the FTC filed a complaint against Sears because the company failed to adequately disclose to consumers the scope of the data Sears collected using tracking software. Additionally, some heavy-hitters in the Internet market are calling for stronger consumer privacy protections given the spotlight on Internet privacy concerns. Mozilla added a do-not-track tool to an upcoming version of its Firefox Web browser. Microsoft recently followed suit - its upcoming Web browser, Internet Explorer 9, will also include an anti-tracking tool that will let users create their own custom lists of companies to block from tracking them. For companies implementing anti-tracking mechanisms, consumer backlash against online tracking appears to trump the concerns voiced by Internet advertisers and tracking companies that such tools will negatively impact their businesses.

In some ways, the VC market has been quite reactive to the changing privacy landscape. The surging demand for online privacy protections spells market opportunity. Numerous start-ups offering privacy protection products and services have emerged in response growing concerns regarding the collection and use of personal data, and consumers seem receptive. For example, within two weeks after software engineer Brian Kennish launched “Facebook Disconnect” – free software that prevented Facebook widgets from inadvertently transmitting users’ personal data - 50,000 people had installed it. Given his initial success, Mr. Kennish launched a new piece of software - “Disconnect” - which blocks a wider array of widgets on Facebook, Twitter and Digg, and prevents search engines from providing personalized search results based on tracking user behavior. Mr. Kennish’s success didn’t go unnoticed in the investment world – he has received three acquisition offers and four unsolicited investment offers. Last June, SafetyWeb received $8 million in VC financing. TRUSTe got $12 million. ReputationDefender raised $15 million even though the company wasn’t actively looking for new cash. The jump in privacy-related investments underscores how online privacy protection is increasingly viewed as a real business, attracting prominent investors such as Bessemer Venture Partners, Accel Partners, Kleiner Perkins Caufield & Byers.

While some VCs are moving to Privacyville, VC investment in Internet tracking isn’t slowing down. VCs as a group have invested $4.7 billion in 356 online-ad firms since 2007 and continue to pour money into Internet tracking companies. To be sure, these VCs aren’t ignoring privacy litigation and potential regulation when making investment decisions – companies endorsing tracking techniques with greater privacy implications may be considered less attractive to fund. For example, First Round Capital, which ranks among the VC firms most heavily invested in Internet tracking, has declined investments in companies that marry online data with offline databases to develop richer portraits of Internet users.

The FTC recently encouraged companies to take a "privacy by design" approach, integrating consumer privacy protections into their regular business operations and at every stage of product development. A company that addresses privacy issues during business development, rather than after, will be in a better position to secure VC funding. It may be too difficult for a company to reverse course in order to address privacy concerns that were overlooked during the development of its products or services. This could lead to an insurmountable hurdle in the road toward funding if VCs perceive the privacy concerns as too great a risk.

As a result, companies – particularly those in the field of Internet advertising and tracking - should conduct thorough privacy due diligence. The same goes for VCs looking to add these companies to their portfolios. VCs that fail to evaluate the current and future privacy landscape while conducting due diligence may unsuspectingly invest in superficially attractive but ultimately non-viable ventures. Companies and VCs alike should have intimate knowledge of the privacy concerns raised by consumers and businesses, understand the implications of privacy laws and pending legislation, and be aware of privacy-related enforcement actions and litigation.

The near-collapse of the global financial system in late 2008 demonstrated how capital markets can place too much faith in technology stocks and reinforce an unhealthy obsession with short-term financial performance. The comparatively small number of companies that have been able to innovate repeatedly over long periods of time tend to have strong relationships with their customers. The more our lives are lived online, the greater the privacy implications of online tracking become. Internet tracking companies that fail to tailor their products and services to address growing privacy concerns may be unable to sustain relationships with consumers that will prove necessary for their survival. If long-term innovation is the goal, perhaps VCs will become more reactive to the tumultuous privacy landscape when making investment decisions. It’s quite possible that greater VC reactivity will mean increased investment hesitancy.  To disprove hesitancy, companies are well-advised to seek guidance while developing their business plans to adequately anticipate and address growing privacy concerns.