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."

So, overall, is it worthwhile for nascent companies to try to tap the VC market for their initial outside infusion of cash? Experts say yes, but with a qualifier. According to Jeffrey E. Sohl, director of the Center for Venture Research at the University of New Hampshire's Whittemore School of Business and Economics, in Durham, N.H., entrepreneurs would be wise to put most of their energy into seeking out angels and those VCs that specialize in seed funding. To best judge the latter, Sohl offers some guidelines. "Find out not what their intention is but what their behavior is," Sohl says. "Find out how many seed deals they've actually done in the past, and talk to entrepreneurs they've funded to find out what they're like. That would be the best indication of whether they're true seed investors."

Thea Singer is an associate editor at Inc.


How I Got VC Money: Greg Hinote

CEO: Greg Hinote
Company: The School Co., in Nashville
Business: Helps educational institutions unlock equity assets in existing buildings through sale-leaseback transactions or refinancing
Founded: 1998
Number of employees: 7
1999 revenues: $0
Stage of financing: Seed
Venture-capital firm: Cahill-Warnock & Co.
Amount: $2 million, broken into distributions of $500,000 every six months, contingent on the company's meeting predetermined milestones
Equity taken by VC: Between 20% and 30%
Ace in the hole: VC acted as cofounder

"Our funding has a different look from that of most VC transactions. For starters, it's real seed money as opposed to first-stage money. It was intended to finance a research-and-development period in which we'd look at sale-leaseback and other equity opportunities throughout the education industry. Second, we're a nontech company. And third, our VC, David Warnock of Cahill-Warnock, in Baltimore, is a cofounder of the business.

"I met David through a friend of mine who has a lot of institutional-investment experience. David came to Nashville in the summer of 1998 to visit a company whose board he sits on, and the three of us had lunch. We were talking about the School Co.'s predecessor, a builder-developer of educational facilities, in which I was an investor, and what an impediment to growth real estate capital is for the education industry. As an institutional investor in a lot of education operators, David knows firsthand about how inefficient it is to tie up your capital in bricks and mortar. So we began brainstorming about how we could help educational institutions roll those real estate assets off their balance sheets. David called me the next day and said: 'Wow. I think this is a great idea. Do you think there's a viable business here? I could put up some seed capital, and you could put together three or four people and really look at this market.'

"Of course, before we actually pulled the trigger on the first half million, David and I completed a business plan together by phone, E-mail, and visits. That took about three months. I talked with operators to figure out pricing and to see if our concept would be marketable to equity investors on the real estate side. I agreed to run the company on a daily basis and also to put some of my own money into the effort -- not because we needed more cash but as a sign of management's commitment. David's role would be to serve on the board. By early November of 1998, we had our first $500,000 installment.

"Today we have a couple hundred million dollars' worth of real estate transactions in the pipeline, and we're in the capital markets raising money to fund at least $50 million of that. There's no question about it: we're one of the lucky ones. We're especially lucky when you consider that as a general rule, it's tough to get operating-company VC-type returns on a real estate transaction." --From an interview with Thea Singer


How I Got VC Money: Brian Brittsan

President: Brian Brittsan
Company: Water Management Services Inc., in San Diego
Business: Designs and installs water-conserving upgrades in buildings
Founded: 1996
Number of employees: 20
1999 revenues: $2 million
Stage of financing: First
Venture-capital firms: N th Power Technologies, Early Stage Enterprises, the Calvert Group (a mutual-fund firm)
Amount: $2.6 million
Equity taken by VCs: 30.76% total
Ace in the hole: Structured company with an eye toward attracting VC money; had revenues before seeking financing

"From the beginning, my founding partner, Wade Smith, and I had a strategy for the company that called for establishing the 'right' profile of our management team and board and making sure that our image and business model were appropriate for both VC funding and a future initial public offering.

"Less than three weeks after incorporating, we pulled together a trio of high-net-worth individuals who gave us investment advice and legal counsel in exchange for equity. Not only did those advisers help us put together a business plan, navigate the capital markets, and attract to our board Wall Street-savvy folks like the senior financial analyst for General Motors; they also allowed us to delay payment of our early legal expenses -- close to $100,000.

"Next we rounded out our management team. At the same time, we enlisted a broker to put together a private placement for us. We decided not to pursue venture capital at that point, because we wanted a very small placement in order to limit the dilution of the company. The broker raised some $700,000 from seven accredited investors and in return took a commission of about 8%. As I see it, an Achilles' heel in the financing process is that owners whose core skills are not in financing pull themselves out of the operations of the business to do something that they're not very good at, and everything unravels. We chose instead to put our financing in the hands of others so that we could continue to add value to the business.

"We did that, in part, by forming a strategic partnership with a plumbing subcontractor, who invested $250,000 in us. And we brought in sales: some $84,000 in our first year and about $1.9 million in our second. Having revenues was a critical component to our financing; investors like to see their money going for business-development initiatives rather than to crack your monthly nut. Because it's very difficult for VCs to get their arms around the upside of a service-only company, we were also very conscious about developing a technology to act as an enabler for our service business: an Internet-based water-meter-reading system for tenants of apartment buildings.

"Finally, in late 1997, we felt ready to plunge into the capital markets. We hired an investment banker with a focus on the energy industry -- Boston-based EnCapital -- for a monthly retainer plus commission. All told, we must have talked to 50 VCs -- it was like a dog-and-pony show. Yet even with EnCapital advocating for us, it took nearly two years to close a deal. Why? Partly because most VCs have a minimum amount they want to invest and we were looking for only $2 million, again to limit dilution of our holdings while we went about building value.

"Ironically, at the end of the day, the VCs that invested in us were all brought to the table by in-house management. Still, I'm not sorry that we hired EnCapital, because of its contribution in recasting our business plan, determining our valuation, and advising us in how to negotiate." --From an interview with Thea Singer


How I Got VC Money: Ed Jaeger

CEO: Ed Jaeger
Company: Ironclad Performance Wear Corp., in Santa Monica, Calif.
Business: Manufactures and distributes protective gloves for the construction and automotive industries
Founded: 1999
Number of employees: 7
1999 revenues: $300,000
Stage of financing: Seed
Venture-capital firm: Colorado Venture Management Equity Funds
Amount: $680,000
Equity taken by VC: 23%
Ace in the hole: Used a financial-services broker who was friends with a partner at CVM Equity Funds

"I decided to use a broker to find capital, because I didn't know any venture capitalists or angel investors myself. The broker, Ken Greenberg, who works out of the Denver office of J.W. Genesis Capital Markets Inc., had been an acquaintance of mine for years. In the spring of 1999, I held a money-raising session in Venice Beach for some seven friends and family, and Ken, who happened to be in town, came too. When he saw my business plan, he told me he wanted to follow the company. The meeting generated Ironclad's first $25,000 and allowed me and my four partners to incorporate.

"True to his word, Ken got back in touch in the fall and agreed, for a 6% commission, to work for us. In November he sent our business plan to 20 or 30 funding sources. Most of the VCs he contacted were interested primarily in new dot-coms, but CVM Equity Funds, which is based in Boulder, was different. Not only was CVM looking to set a trend in the nontech sector; Ken also had a personal connection there, he knew Gary Bloomer, the son of the firm's general partner.

"Several weeks after Ken had sent our materials to Gary, we attended our first trade show, in Denver. I invited Ken to the show as my guest, to let him see how big the industry was. It was there that our company really came to life. Our booth was approached not only by retail outlets that wanted to buy from us direct but also by individual reps and rep groups -- folks that handle big names like Stanley and Owens Corning. We immediately started taking orders -- tens of thousands of dollars' worth of them -- and hiring reps.

"Ken was amazed. The first call he made the next day was to CVM Equity Funds to say what a bang-up job we'd done. Within two weeks Gary Bloomer was flying to our new, 1,100-square-foot office in Santa Monica to begin the due-diligence process. Ironclad at that point was valued at $2 million.

"All was not a bed of roses, however. At the 11th hour -- we'd already gotten a term sheet -- the Ironclad partner that CVM Equity Funds had determined should serve as our CEO started pressuring me for more stock in the company. I didn't want to give him more -- he already had a tremendous amount. I suggested that he call Gary to see if his request was appropriate. 'I just gave you guys the litmus test,' Gary said after receiving the call. 'And you failed.' Gary had perceived not only the culture clash that existed between some of us but also that we couldn't settle our own conflicts. He knew that we wouldn't be able to work together well enough to triple or quintuple CVM's money in a short period of time and refused to invest in us if that founder stayed.

"On April Fools' Day, three weeks after that founder left Ironclad, CVM Equity Funds sent us a check for $680,000. You know when you've hooked up with the right VC; it's like finding the right woman after you've been dating around." --From an interview with Thea Singer


Technology rules
Which companies VCs funded in the first quarter of 2000

93% of the companies that VCs invested in were technology-related companies
54% of the technology companies funded were Internet-related companies
39% of the technology companies funded were non-Internet-related companies
7% of the companies that VCs invested in were non-technology-related companies

Where the nontech money goes
VC dollars invested in nontechnology deals in 1999
Last year there was more than $3 billion in VC money invested in non-technology-related companies. Here are the industries it went to:

15% Retailing/distribution
29% Health-care services
19.2% Business services
10.3% Industrial
8.8% Financial services
7.2% Consumer services
6.5% Publishing/broadcasting
4.1% Pharmaceuticals

The picture last year
Technology-related deals versus overall deals in 1999
Total deals: 4,013

84% Technology-related deals: 3,370
16% Non-technology-related deals: 643

Source: PricewaterhouseCoopers Money Tree Survey.
Note: Numbers may not add to 100% because of rounding.


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