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Seed funds invest in companies at the earliest stages, meeting capital needs at a time when a company is perceived as too risky for bank financing and too small for venture capital. Learn about the components of successful seed capital funds and how incubators can be involved in their creation.

Growing seed funds: For-profit strategies, experienced managers, adequate deal flow (and no politics) make for successful public-private funds

by Justin Boyd

October 2002

Chip Cooper, executive director of Missouri Innovation Center, the University of Missouri-Columbia's technology commercialization office, became frustrated in the mid-1990s that companies spinning out of the university couldn't attract the seed investments they needed to grow. When Cooper looked around the state, he found virtually no sophisticated venture capital focused on early-stage start-ups. In fact, outside Missouri's two urban centers, St. Louis and Kansas City, seed capital was nonexistent. So Cooper began drumming up support for the creation of a statewide seed capital fund that would invest in early-stage start-ups in all parts of Missouri.

By 1998, Cooper and his coalition of technology transfer officials, venture capitalists, politicians, incubator managers and others had drafted legislation that passed as the New Enterprise Creation Act. The act authorized the creation of Prolog Ventures, a seed fund organized in 2001 as a private, limited liability company that would focus on making investments in early-stage companies around the state. The state authorized the fund's managers - professional venture capital investors rigorously evaluated and recruited by Prolog's organizers – to offer up to $20 million in tax credits to private investors who would receive a 50-cent state income tax credit for every dollar invested in the fund. By the time the fund stopped taking investments, it had spent $17 million of the tax credits and raised $34 million from sources including wealthy individuals, Alafi Capital, the Carpenters' Union Pension Trust Fund, the Danforth Foundation, Monsanto Company, Stifel Financial Corp., the University of Missouri, Washington University, and others.

By using tax credits as a stimulus to raise private capital, Prolog's organizers not only enlarged the amount of money available for seed investment, but made wealthy individuals and institutions more involved in seed investing and aware of its importance in the state's economy, Cooper says. The fund has invested in three companies so far, all clients of St. Louis incubators – two from the Center for Emerging Technologies and one from the Nidus Center for Scientific Enterprise.

Although Prolog has not yet invested in companies outside St. Louis, Cooper is not discouraged. "We just needed to have the pros available to us," he says, so that he and others could begin building relationships that he anticipates ultimately will result in investments. Indeed, he is hopeful that Prolog soon will invest in a company at the University of Missouri-Columbia. "We have introduced several university researchers to them and are moving closer to organizing our first Missouri University company with Prolog," he says. Prolog's managers also make regular appearances at the university to lead seminars with Innovation Center entrepreneurs and talk with University of Missouri MBA students, he notes. (As part of its technology commercialization functions, the Innovation Center provides business assistance services, and sometimes space, to companies the university spins out.)

Economic development professionals, including incubator managers, increasingly have the option of steering companies toward state and local seed funds for the early rounds of financing they need to develop their ideas and technologies. These pools of private and/or public capital are focused on investing in emerging companies at the earliest stages and can meet capital needs at a time when a company is perceived as too risky for standard bank financing and too small for traditional venture capital investment.

"The average size of a venture capital fund is between $100 million and $200 million. These funds rarely make an investment as small as $500,000. Even more rare is an investment of less than $500,000," says Dan Loague, executive director of the National Association of Seed and Venture Funds (NASVF). "A venture capital investor would rather put $50 million into one deal with an annual rate of return of 25 percent than put $50 million into 50 deals with an annual rate of return of 50 percent."

Recognizing the need to fill the capital gap that exists between traditional lenders and venture capital firms, proponents of the knowledge-based economy – including representatives of government entities, universities and even incubators – have been working, often in conjunction with private venture capital firms, to create pools of capital focused on making $25,000 to $2 million investments in emerging companies. Although these efforts often focus on technology companies, any company that promises rapid growth and a high rate of return is a candidate for seed fund investment, experts say. All 50 U.S. states are either operating or planning seed capital initiatives in an effort to spur economic growth, and many smaller funds exist across the country, Loague says.

But even though seed funds are gaining in popularity and numbers, not every community has this resource for entrepreneurs. What conditions must exist in a state, region or community for economic development officials to pursue creating this type of investment source? What are the components of a successful public-private seed capital fund? And how do incubators get involved? Answers to these questions vary from region to region, but some generalizations can be made about seed investing to guide incubator managers interested in creating or accessing seed capital to help their clients grow.

Nonprofit goals, for-profit strategies

Despite the fact that many public-private seed funds seek to achieve traditionally nonprofit goals (such as job creation), they often are for-profit entities that base investment decisions on one very important matter: returning a sizeable profit to the fund.

"We have goals in the background, but our view and our clear statement to the city commission when they were considering investing in this fund ... was that the criteria are going to be financial returns," says Ron Sampson, executive director of the Mid-America Commercialization Corp. in Manhattan, Kan., and manager of its affiliated $2 million seed capital fund, Manhattan Holdings. "If we're successful doing that, as an ancillary we're going to do these other things - create jobs and create companies. So you're going to get [jobs and companies], but we're not going to make decisions on anything else but financial criteria."

The reasoning behind this for-profit approach is sound. First, seed fund experts agree that a pragmatic, bottom-line approach is imperative for a fund's long-term survival. "Regardless of how well meaning [fund managers are] in making investments, if there's no return, then sooner or later they deplete the fund and they're out of business," Loague says. "It's always dangerous to invest in a business that doesn't promise an adequate return on investment," he says.

If a fund's long-term goal is economic development, it should commit to being a revolving door of investments and returns so it can support new companies with returns generated by the success of previous investments, not by continual injections of public money, says Craig Greenberg, general manager of Commonwealth Seed Capital LLC, a $10 million, statewide seed fund the Commonwealth of Kentucky created in 2001. Commonwealth Seed Capital is a "fund of funds" that invests in private venture capital firms that commit to investing in Kentucky companies, rather than investing directly in companies itself. (Most seed funds, however, invest directly in companies, according to Loague.)

The second reason to focus on the bottom line versus, say, job creation, is to ensure that a fund isn't throwing away its money on companies that sound great, but are unlikely to succeed. "If you're attracted by the lure of 'it's going to create X number of jobs,' and aren't focused on [a company's] business, its competitive position, its structure, its viability as a commercial operation ... you fund companies that frankly aren't viable and you pay the price," Sampson says.

Fund organizers also must recognize the tension between economic development goals and pure for-profit investing strategies when deciding the parameters to place on the types of investments a fund using public money can make. Most fund organizers and managers agree that putting a timetable on placing investments can force fund managers into bad investment decisions. "You're forced into making decisions you otherwise would not make," Sampson says. But minimal parameters – particularly ones designed to make sure that economic benefits of investments are enjoyed within the city, region or state from which the public money derived – can make sense, provided they're flexible enough that quality fund managers can still find good investments and tolerate working within the rules.

Commonwealth Seed Capital requires venture capital firms receiving its investments to match the state's investment 2:1 and dedicate the total amount to Kentucky companies. So, its first investment – $2 million in the venture capital firm Chrysalis Ventures – required Chrysalis to put up $4 million of its own money, thus dedicating a total of $6 million to investing in Kentucky companies. Commonwealth Seed Capital also set aside $1.5 million to place in a venture capital firm that commits to investing its money outside of the Lexington-Louisville-Northern Kentucky region, Greenberg says, to ensure that the state's initiative won't neglect rural Kentucky.

Although Commonwealth is in the early stages of placing its assets, its presence is already being noticed, says Joseph Fink, director of the Advanced Science and Technology Commercialization Center (ASTeCC), a technology-focused incubator at the University of Kentucky in Lexington. Representatives of Chrysalis Ventures have been to campus to explore potential investments, but have not yet invested in an ASTeCC company, he says.

The for-profit mindset applies to hiring seed fund managers, too. Good seed fund managers perform the same functions as good incubator managers – they provide portfolio companies with guidance and expertise in management, marketing and business plan development, Cooper says.

The intricacies of seed investing take a special set of skills: an understanding of equity investing and expertise in the development of start-up companies. In addition, because so many seed funds involve public entities, managers ideally should have some experience working in a public (that is, political) realm. Many fund organizers say the right people for seed investing come from the private sector and have backgrounds in venture capital investing, although anyone with a sophisticated understanding of starting and running a business could be a candidate. In many cases, a fund is run by a team of two or three managers who each bring a special set of skills to the fund and together possess the necessary expertise to achieve success.

Additionally, seed fund organizers may want to attract a manager who, in turn, can attract investors. "Most venture capital funds make their reputations on the last few deals that they did," says Andrew Maxwell, managing director of the University of Toronto's Exceler@tor, an incubator involved with four seed funds totaling US$20 million. Managers who can't point to a proven track record might not be able to raise money to create new funds, he says.

Organizers who want to attract high-quality managers should be prepared to reward them, Sampson says. "When you get involved in ventures, it goes nights, weekends. They take more than the normal [9 to 5] job requirements." Managers often receive an annual management fee of 2 percent to 3 percent of assets within the fund. This pays their salaries, the fund's administrative costs and a "carry," or percentage of the return, on successful investments. The ability to share in profits is a strong incentive to potential seed fund managers. "The bottom line is, there has to be an opportunity to share in the returns, " Sampson says.

The bare necessities

Not every community's entrepreneurs have a seed capital fund to turn to for investment, and that's because not every community has the elements necessary for a fund to tick. First off, of course, a community must have adequate deal flow. Because seed funds take equity in companies in return for their investments, they reap a return only when companies make an initial public offering (IPO) or are acquired. And that's not very often, according to Loague. Because seed fund managers spread risk by investing in a portfolio of 10 to 15 companies, not every investment is a winner. In a portfolio of 10 companies, for instance, a seed investor might expect the following scenario: one or two deals would lose money completely, three deals would make no money or very little money, three deals would produce a modest return, and only one or two would make an initial public offering (IPO) or be part of a major acquisition. And while the fund waits for its few winners to develop and attract buyers, it must continue to operate, using some of its capital to pay managers, overhead and the expense of nurturing its investments.

The upshot is that many funds cannot survive – without regular injections of new capital – unless they invest only in companies that have the potential to provide a return on investment of 10 to 20 times in three to five years, Loague says. While this does not rule out manufacturing and other types of relatively low-technology companies, high-tech companies often promise the best opportunities for the large returns seed funds pursue.

In addition to a continuous flow of potential investments, a seed fund must have a sufficient base of assets in order to survive its first five years of operation, during which it will assess and make investments but generate few, if any, returns. Assuming a fund follows a traditional model of paying operating costs and annual management fees (generally 2 percent to 3 percent of a fund's total assets) out of its capital pool, some experts believe that $10 million to $15 million is the minimum amount that a freestanding fund must collect in assets to remain viable without further injections of capital.

Having a critical mass of assets also allows a seed fund to follow up its initial investments. This can really help when a fund is seeking external second- and third-round financing for its companies, says Robert Calcaterra, a former manager of seed funds in Arizona and Colorado and executive director of the Nidus Center for Scientific Enterprise, a life science incubator in St. Louis. If a fund can say it's going to increase its own investment in a portfolio company, attracting other investors is much easier, he says: "That makes the risk a lot less for the other venture funds, and really makes them much more willing to step forward." After spreading their investments among 10 or 15 companies, funds smaller than $10 million often can't afford to follow up their initial investments, he notes.

Smaller funds increase their chances of success, however, if they can avoid pulling overhead and management fees from their asset pools and can find qualified volunteers to help with some tasks. As executive director of the Anoka County Economic Development Partnership (ACEDP), a 501(c)(3) in Anoka County, Minn., Roger Jensen created and manages the Anoka-Sherburne County Capital Fund, a $2 million, for-profit seed fund focused on technology start-ups in a two-county area of Minneapolis/St. Paul. The county pays Jensen's salary and the fund's operational costs, so no money is drained from the fund while it waits for returns on its investments. In addition, Jensen has developed a group of about 15 volunteers – corporate executives, former entrepreneurs and professional investors – who evaluate potential investments.

Jensen also organized and manages a for-profit investment club of wealthy individuals with about $2 million in assets. This enables him to marshal resources to provide second-, third- and fourth-round financing for the capital fund's portfolio companies. Sometimes, individual members of the capital fund or the investment club decide to invest in the companies on their own, in addition to their participation through the ACEDP's seed investment entities, Jensen notes. This creates an even larger source of seed funding for emerging companies.

Keep politics out

Public-private seed funds should minimize government involvement in day-to-day investment decisions for two major reasons, experts say. First, state agencies and officials rarely have the expertise to make smart investments. "We considered all sorts of options [and] decided that the state is not a good venture capitalist in general," Greenberg says. "There are professional, qualified and successful venture capitalists out there who are much more qualified to source and execute quality deals than the state."

Second, seed funds managed by state officials or those which the state controls are in danger of squandering public money on investments made on the basis of politics rather than sound financial criteria. That's a recipe for disaster, fund managers say. "If you have public money, suddenly somebody's constituent thinks they have a right to it, and you get political pressures to make investments that don't make any sense," Sampson says. "If you have political pressure as part of the investment process, you're almost doomed to fail."

Many public-private seed funds are operated as private companies, often limited liability companies. Although a university or a state, county or city government can be the only member of an LLC, the company's managers will not be public employees, nor will the company be subject to the same regulations as public entities in business transactions and financial activities. This arrangement can be a prerequisite to attracting good managers, fund organizers say. "[Individuals who are talented enough] to be in this business are not going to get in the position where their reputations and track records can be screwed up by politicians," Cooper says. "If you involve the government beyond a very limited role, you will scare off the very people you need." Managers want the flexibility and speed of operation that comes from being a private entity, Maxwell says, including the ability to sign contracts, own equity, and hire sole suppliers for goods and services.

Being a private company provides other benefits, too. Public entities are subject to Freedom of Information Act and open records laws that require them to make available to the public and media detailed information about their activities. This can be problematic for seed funds that have a vested interest in protecting the confidentiality of their companies, Sampson says. Being a private entity solves this problem.

Organizing seed funds as private companies also protects public entities from political fallout when investments fail, Sampson notes. "We know all these deals are not going to succeed ... (but) direct public money can't tolerate any failures because all the press, all the politics focuses only on the failures," he says. "No matter what else happens, somebody's going to try to get some heads to roll for any failures." Having an independent company making investment decisions creates a buffer between government and investments that can minimize political finger pointing when ventures fail.

Finally, although states or other nonprofit entities shouldn't meddle in seed funds' day-to-day activities or investment decisions, they should maintain some oversight of seed funds that invest public money, experts say. If fund organizers have done a careful search and hired qualified fund managers, having a presence on a fund's board of advisors is an adequate level of oversight, Calcaterra says.

Getting involved

Incubator managers and others can participate in the creation or operation of seed funds in a number of ways, ranging from championing the establishment of a fund, to sitting on a fund's board of directors, to simply staying in contact with fund managers to keep them abreast of potential deals.

In the case of the Exceler@tor at the University of Toronto, employees of the incubator's parent organization, the nonprofit Innovation Foundation, team with private venture capital managers to make investment decisions for the four funds with which the incubator is connected, Maxwell says. The Innovation Foundation, an independently organized company in which the university is the sole shareholder, also was instrumental in the creation of the funds, he notes. "We went to a number of venture capital organizations and said, 'You guys like investing $2 million, $3 million, maybe $5 million in a particular activity,'" he says. "'Why don't you instead invest $5 million in us and we will then manage the actual disbursement of that – we'll break it up into blocks of $250,000 or $500,000 – and put it into a portfolio of start-up companies that come out of the university, and we'll do the due diligence, we'll help with the management of the companies, and we'll spread your risk by being involved in five or six organizations.'"

The Canadian government helped the Innovation Foundation establish three of the funds through a government initiative that provides tax incentives to private investors who put money in venture capital funds that partner with nonprofit seed funds in Canada. The government requires that the money these funds raise be dedicated to investment in some sort of nonprofit "community" – an incubator, group of incubators, city or any other nonprofit entity – and that the funds work with the community to make investment decisions. Three of the four funds the Innovation Foundation works with are these types of funds.

In Missouri, now that Prolog Ventures is up and running, Cooper is satisfied to sit on the fund's advisory board and present potential investments to the fund's managers. "We get access," he says. "When I call, they take the call. When I've got a deal I'd like them to look at, they look at the deal. That's what we needed."

7 steps to a public-private seed fund

1. Champions of the knowledge-based economy begin to communicate the need for early-stage capital in their community and gain the support of community leaders.

2. These champions assess the community's ability to sustain a seed fund: Are there enough investment-worthy companies to provide adequate deal flow and return on investment? Are civic leaders committed and adequate financial resources available to create a fund? Can the community provide or attract quality management for the seed fund? Are there legal constraints to public entities being involved in seed investing that must be overcome?

3. Developers establish the structure of their fund: Will it be geographically focused? Will it concentrate on a specific sector of the economy? What kind of public oversight will it have? How will the fund raise money? Who will manage it? What money will cover the fund's operational costs – the fund's assets or some other source?

4. Developers outline a strategy to navigate the political process. A publicly supported fund may require legislative approval, as was the case with Prolog Ventures (see cover page).

5. Developers identify/recruit fund managers from within their ranks or through research, solicitation of proposals, and/or interviews of professional managers, and establish compensation acceptable to developers and the fund's manager(s).

6. Developers and/or managers raise the fund, either through direct government funding or by using public money as a stimulus to attract private investment.

7. Managers seek out and make investments within the parameters established by the fund's creators.

For further reading

Dan Loague, executive director of the National Association of Seed and Venture Funds (NASVF), suggests the following resources for further reading on topics relative to seed capital:

  • Growing New Businesses With Seed and Venture Capital:
    State Experiences and Options
    , a National Governors Association report. Available at
  • Every Business Needs an Angel: Getting the Money You Need to Make Your Business Grow, by John May and Cal Simmons. Crown Business, 2001. Available at the NBIA Bookstore,
  • Attracting Capital From Angels: How Their Money-and Their Experience-Can Help You Build a Successful Company, by Brian E. Hill and Dee Power. John Wiley & Sons, 2002.
  • The National Association of Seed and Venture Funds Web site,

Keywords: business financing, capital access, in-house loan and equity financing program, partnerships -- organizational/corporate

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