Where the Money Is

Cover Story

Grassroots venture capital

Recent years have left venture capitalists awash in cash. Are start-ups getting more of it?

Water, water, everywhere, / nor any drop to drink." In Coleridge's 202-year-old couplet, you've got the metaphorical equivalent of today's conflicted take on seed funding and venture capital.

Impression one: The institutional venture-capital market is so flooded with money that anyone with half a good idea can find funding everywhere. Mohanbir Sawhney, professor of electronic commerce and technology at Northwestern University's Kellogg Graduate School of Management, in Evanston, Ill., has put it this way: "How do you start a company? Go to Menlo Park and find the nearest tree. Shake the tree. Venture capitalists will fall out of the tree. Say, 'E-commerce and Internet,' and they'll give you $3 million." Despite last spring's market fluctuations, venture capitalists still have record sums to invest.

Impression two: There will be no drinking from that cash pool; venture capitalists never provide seed money. Indeed -- goes this line of thinking -- the swollen reservoir of available VC cash makes the likelihood of getting even a meager $2 million virtually impossible, let alone typical seed amounts of $250,000 to $500,000. With funds so flush, VCs have had to invest ever-larger allotments in each start-up, because they have only a limited number of partners who can sit on the boards of companies in their portfolios.

The truth, when it comes to seed funding for start-ups, lies somewhere in the middle. And no matter how the venture capitalists distribute the riches from their 500 or so funds, their role in the early-stage-equity market is changing the way that even informal angel investors do business.

Thanks to the raging bull market of the late 1990s, "venture capitalists have more money to invest now than at any other time in history," says Kirk Walden, national director of VC research for PricewaterhouseCoopers (PWC). And PWC's Money Tree Survey has the numbers to prove it. In 1999, VCs invested in companies -- from the seed stage to the fourth round and beyond -- a total of $36 billion, up from $14 billion in 1998. Moreover, the number of companies receiving seed funding from VCs (and, yes, VCs have consistently provided seed funding to start-ups) has been steadily rising. The Money Tree Survey reports that 343 companies received a total of $966 million in seed money from VCs in 1999, compared with 145 that received a total of $269 million in 1995 -- a whopping 137% increase in companies invested in.

Who are the venture capitalists making those investments? Some are small funds dedicated to seed financing, such as Murphree Venture Partners, in Houston, and the Ben Franklin Technology Partners, a quasi-public, quasi-private firm in Philadelphia. Others are big houses like Sprout Group, based in New York City, which do a handful of seed deals a year, primarily with referrals from their portfolio companies. Still others are small funds that act primarily as a source of deal flow for large funds. For example, Timberline Venture Partners, in Vancouver, Wash., is an affiliate of Draper Fisher Jurvetson, in Redwood City, Calif.; and AV Labs, in Austin, is a feeder firm for Austin Ventures.

But before you get too excited about the VCs' largesse, consider this: Not only is the number of companies that get early money very small, but the percentage of start-ups getting that seed money has remained essentially the same over time. Every year since 1995, just 9% of the companies funded by VCs have been at the seed stage, with the exception of 1996, when the percentage rose to 11%. So far, this year appears to be following the same trend. PWC's Walden projects that there will be about 350 to 400 companies -- again about 9% -- receiving a total of $1 billion to $1.1 billion in seed money from VCs. And typically, 90% to 95% of the seed-stage investments, Walden says, are in technology start-ups.

So where should embryonic companies -- in both the tech and the nontech sectors -- -go for sustenance? The traditional -- and still the most viable -- source is angel investors, wealthy individuals (many of whom are cashed-out entrepreneurs) who are looking for companies to fund and to mentor. There are currently about 2.5 million angels in the United States, 400,000 of which are active. Together they pump between $30 billion and $40 billion into about 50,000 ventures annually -- and about 80% of that money goes to start-ups at the seed stage. Which means that, all told, venture capitalists are responsible for less than 1% of the seed deals completed every year.

Still, the VCs' contribution is significant -- not because of the quantity of their investments but because of the quality. And increasingly, angels are operating more like traditional VC firms. That change has come about in three ways. First, the angels went from investing individually to pooling their money and investing through formalized networks -- groups ranging from the well-known Band of Angels, in Silicon Valley, to the Nashua Breakfast Club, in Nashua, N.H., and from the CommonAngels, in Boston, to the Capital Network, in Austin. Then, rather than following a strict sequential order for their investments (that is, the angels providing the seed money, and the VCs kicking in for later rounds), the angels started piggybacking onto VC deals, with the entrepreneurs sometimes bringing the parties together in a round that would raise $1 million to $3 million. And most recently, angels have begun establishing small limited-partnership funds fed by individual investors, such as the San Francisco-based Venture Strategy Group, which closed its first, $25-million vehicle last year. Angels are also teaming up with VCs to contribute to traditional VC funds or to participate in arrangements like those designed by Venture Investment Management Co. (VIMAC), in Boston.

VIMAC is something of an anomaly because it provides a structured way for angels and VCs to invest seed and other capital side-by-side, on a deal-by-deal basis. It has a classic, $200-million VC fund made up mostly of money from institutions -- pension funds, life-insurance companies, banks, and so on. It also has a network of about 250 angels. Every time the fund makes an investment in a venture, the angels can invest in the venture, too. Those that do may end up sitting on a company's board in place of a VIMAC partner -- and they get compensated from the firm's earnings in the bargain. That's how VIMAC handles the common VC problem of not having enough partners to go around when disbursements are small and numerous.

Although VIMAC typically invests $1 million to $3 million (with 75% of the money coming from the fund, and 25% from the angels) in companies that have at least a prototype and a business plan, it provides sums as low as $500,000 as well. Indeed, almost a third of its portfolio companies were brought into the fold at the seed stage, or, as director of investments Neal Hill says, "when you have two guys in a basement with an idea." VIMAC likes to follow up its initial funding with subsequent rounds that it shares with other VCs, and over the long term, it invests an average of $6 million to $7 million in each of the companies it has sponsored. "The advantage to the entrepreneur is the access to funding that goes beyond just the angel seed round," says Hill, "and our continuous commitment to managing the company to the end of its life."