by Bridget Lair
Business analysts love to talk about venture capital and equity investment, but the reality is, few start-ups benefit from VC or angel investments. The Kauffman Firm Survey, a longitudinal study tracking approximately 5,000 businesses annually, reports only 2 percent of start-up firms receive VC or angel investments, while 84 percent bootstrap and 14 percent finance their businesses with loans or grants.
Many states and community development organizations, including incubators, are starting seed funds to mitigate the financial gap between bootstrapping a business and the first round of outside investment. Seed funds are pools of private and/or public capital that invest in emerging companies at the earliest stages. These funds 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. According to Jim Jaffe, president and CEO of the National Association of Seed and Venture Funds in Philadelphia, the average fund size of NASVF members who invest in early-stage companies is $10 million to $25 million, and the average investment is $250,000 to $500,000.
Given the high upfront costs of establishing a fund, potential risk of investing in start-up companies and low percentage of incubator clients receiving equity investment, why do some incubators start or manage seed investment funds? When incubators effectively manage the risks and possess the expertise to select investments and help companies succeed, the rewards can warrant a little risk. Managing investment funds can help incubators address the dearth of available seed capital for start-ups and diversify their revenues. Here, NBIA profiles incubation programs managing for-profit and nonprofit pre-seed investment funds.
Curtis Nelson, president and CEO of the Entrepreneurial Development Center in Cedar Rapids, Iowa, and manager of the Iowa Seed Fund, says providing early-stage capital can help foster larger-scale economic development. "We started the fund to provide advanced funding for entrepreneurs and also so that we could work with other funds to pull together larger investments," Nelson says.
The Iowa Seed Fund is open to anyone in the state; however, to date, Nelson says they have not invested in anyone who is not an EDC client. Founded in 2003, EDC is a nonprofit accelerator that provides business assistance services to entrepreneurs throughout Iowa. "Every incubator or accelerator out there has heard a company say, 'All I need is money and I can be successful.' But you need the other pieces. Money is an important piece, but without market, strategy and business planning, they will fail," he says.
Nelson says incubators and accelerators are in a unique position to foster seed-stage companies through mentoring and investment. "Early-stage money fails because of lack of due diligence – 67 percent of seed-stage money is lost because the company is not receiving the business advising necessary to succeed," Nelson says. "At the seed stage, that advising is critical. It's not just having money – it's how it's spent, how it grows within the company."
In 2007, Nelson organized a for-profit, limited liability company to manage a $1.25 million Qualified Community Seed Fund, as defined by the Iowa legislature. The majority of the ISF's initial funding came from banks in the form of Community Reinvestment Act investment credits. "We went to financial institutions and said, 'If you would like to increase commercial lending, we need to build more companies that you can work with,'" Nelson says. "From an investment side, it just made sense for banks to build that customer base."
Nelson then followed a natural progression to recruit angel investors to participate in the fund. A QCSF provides for an investment tax credit equal to 20 percent of an individual's equity investment in a qualified business or community-based seed capital fund. "Angels are already making investments in start-up companies – investing through the Iowa Seed Fund provides more oversight, due diligence and strong portfolio management," he says.
Nelson says establishing the ISF required more than 1.5 years and many meetings with legal experts to ensure they met proper staffing and management requirements. "The difficulty is not managing the fund, rather setting it up – how you set it up – how it's structured," he says. "There are multiple contracts between the organizations [ISF and the EDC] defining who does what and when. We have an independent investment panel comprising four venture capital investors from the community that makes investment decisions."
According to Jaffe, an average seed fund takes 2 percent of the money under management to cover administrative fees. For example, a $5 million fund would have income of $100,000 a year, enough to cover operating expenses and one full-time staff person. However, the ISF is sustainable at $1.25 million because the accelerator covers much of the overhead cost. "The accelerator is already providing the businesses advising, due diligence and follow-up with the companies – the only real fund expenses are legal and audit," Nelson says.
EDC employs six full-time and four contract staff who sometimes work with fund portfolio companies. Specific arrangements between EDC and the fund provide for such support in exchange for 100 percent of the annual fund management fee and a portion of future realized earnings.
Fund management fees and investment returns can increase an incubator's revenue, allowing higher management and staff salaries. "There needs to be some return, some incentive to keep top talent interested," Nelson says. "Our purpose is to gain equity in the exit. With revolving loan funds, there is no money in it for the accelerator; it doesn't produce the same value."
ISF usually invests about $100,000 per company, and company valuation determines the percent of equity purchased. Since 2007, ISF has invested in seven companies, and so far, none has exited. There is no set exit date for venture investments, but in general, Nelson says funds look for exits between five to seven years, on average.
A large part of ISF's progress can be attributed to careful selection, follow-up counseling and due diligence that surpasses most venture capital investment firms. "The difference for us as an accelerator is that we work with companies," Nelson says. "We can tell them, 'You need these eight specific things to be eligible for an investment; you only have three.' We can work with that company to help them get the other five so they meet all the criteria. Other investment companies will simply say, 'You don't meet the criteria,' and that's the end of it."
Nelson says the services provided at the accelerator are strongly linked to services provided by the seed fund. "The accelerator is invested [in terms of time and commitment] to help all our businesses succeed. The staff is helping the client – that investment [of time and advice] is making the client's business a success. If you are already making that work, running the fund is not as arduous – it's not much additional work," he says.
Building on an already robust entrepreneurial ecosystem that includes the SmartZone incubator network and linkages between higher education, industry and small business, the state of Michigan initiated a pre-seed capital fund to supply start-up capital and facilitate entrepreneur development. "Many roadblocks were apparent and uniform – such as when clients need to raise several hundred thousand dollars. Private equity is not robust, and we were losing entrepreneurs to other states," says Skip Simms, senior vice president of the SPARK Business Accelerator and manager of the Michigan Pre-Seed Capital Fund in Ann Arbor, Mich.
The MPSCF is a nonprofit, evergreen fund, funded by the Michigan Strategic Fund, administered through the Michigan Economic Development Corp. and managed by the SPARK Business Accelerator. The co-investment fund requires a 1:1 match from the entrepreneur, through a grant or private investment. Investments range from $50,000 to $250,000, with most at the $250,000 level.
Benefits of the seed fund transcend financial incentives. "This is not a return-oriented fund – it is an economic development tool intended to help a company get an adequate launch," Simms says. "The fund helps to foster an entrepreneurial culture and helps that culture and attitude to grow. Entrepreneurs need to be in a community where they can grow with support or they will find a different community to grow in."
The MPSCF, launched in 2007, now has $25 million under management. Simms emphasizes the fund is an investment in Michigan's entrepreneurs. "There must be an identified need for capital. There is risk, but there is also potential for high returns," he says. "Returns from the fund are diverse, including some capital gains, some dividends and some interest." To date, the MPSCF has had $1.5 million (9 percent) returned.
In the fifth year of investment, Simms says the program has yet to meet market need. "There is some pent-up demand for revenue – we have more demand and more applications than ever. On average, we make 12 investments annually," he says. MPSCF has made 65 investments in 62 companies over four years. So far, five companies exited and returned the capital plus.
SPARK delegates much of the responsibility of managing the fund to the SmartZone incubator network and co-investors. "SmartZone members do the due diligence [for incubator clients and others], and SPARK doesn't need to negotiate terms because it is a co-investment fund," Simms says. SPARK uses the same terms as the third-party investor, who also provides much of the mentoring and monitoring. Companies report summaries and activities annually, so SPARK can monitor growth and success.
A 14-member volunteer investor board made up of Michigan venture capital and angel investors makes all investment decisions. Simms personally appoints board members, often based on a referral from a SmartZone manager or other industry peer, and monitors the board's activity.
Using an online platform, SPARK's virtual investment board allows members to review applicants' business plans, presentations and performance plans from their home or office. Simms says the convenience of online evaluations facilitates the process and helps SPARK attract and retain strong board members. "They need to commit a few hours to each application, so the virtual aspect saves them time," he says.
Simms says he was skeptical of the investment match model, but now believes the match is a critical component for the program's success. "It forces the entrepreneurs to learn how to find real money – find potential investment and gain that experience. It prepares clients for future VC commitments," he says.
Return on investment for Michigan's pre-seed program is measured in dollars and cents, but other financial and economic development variables are factored into the state's measure of success. "The state is happy with the results: business success, hiring of highly skilled and compensated employees, and return of capital," Simms says. "The program hits all the state's goals for the fund."
Benefits of a for-profit seed investment fund:
Benefits of a nonprofit seed investment fund:
Costs of a seed investment fund (for-profit or nonprofit):
Jim Jaffe, president and CEO, National Association of Seed and Venture Funds, Philadelphia
Curtis Nelson, president and CEO, Entrepreneurial Development Center, and manager, Iowa Seed Fund, Cedar Rapids, Iowa
Keywords: Funding sources/Fundraising – incubator, economic development, for-profit incubators, venture capital, In-house loan and equity financing program, Angel investors/network, capital access, partnerships–organizational/corporate
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