19 Nov Seed-Stage Venture Financing
The Wisconsin Technology Network has received from NorthStar Economics an advance copy of its 60-page report, which contains a primer for Wisconsin companies seeking information about risk capital available in the state. David Ward and his team have agreed to exclusively excerpt their report in four-installments on WTN. Today’s forth and final installment is:
Seed-Stage Venture Financing
Seed-Stage Financings are often comparatively modest capital amounts provided to an inventor/entrepreneur to finance the early development of a new product or service concept. These early financings may involve product development and market research or building a management team and developing a business plan.
How are “seed-stage” investments used by early companies?
A genuine seed-stage company has not yet usually established commercial operations, and may be a company involved in continued research and product development. These early companies are typically quite difficult business opportunities to finance – often requiring capital for pre-startup R& D, product development and testing, and/or designing specialized equipment. An initial seed investment round made by a professional lead VC firm typically range from $250,000 to $1 million.
As their early-stage portfolio companies grow, costs can quickly add up. Seed-stage VC funds will typically participate in later investment rounds with other equity players to finance the business expansion costs of raw materials, components, sales and distribution capabilities, inventory of partially and fully completed products, expansion hiring and training, trade shows, demos and samples, and marketing efforts.
The American Seed Capital Marketplace
Seed capital has always been considered a part of the American venture capital industry, focusing on its earliest ventures. In the venture industry’s early years, all venture investing was seed capital, supporting the launch of high-risk, technology-based concepts such as computer networks (e.g., Wang) and, later, personal computers (e.g., Apple) . Over time, venture investors discovered they could apply the techniques of private seed investing to more mature companies, particularly well-established businesses that are positioned to grow rapidly.
These mature companies have been able to profitably use very large amounts of money, making it practical for investors to assemble much larger VC investment funds.
If angel financing is not available locally (and/or friends and family become tapped out), a high-potential technology business opportunity should consider approaching a seed-stage investing venture capital fund directly. The company may raise more money faster, including making the second and later rounds of financing much easier.
Patient Investors Using Syndications
Only a small percentage of professionally managed venture capital firms specialize in early “seed” capital investments. Those venture firms that do, however, normally have nurtured networks with other venture funds that will participate in syndications of these “deals.” The other participating venture firms can be involved in early and later financing rounds as individual portfolio companies grow requiring more capital.
A lead investor venture capital fund that is respected will typically take the local responsibility for choosing the deal, packaging the investment for syndication, and for the ongoing monitoring of the selected seed-stage investment.
Seed-stage venture firms typically realize significant capital leverage into their invested deals, especially as later rounds provide follow-on financing for expanding portfolio businesses. For example, a leading seed investor firm in Boulder, Colorado had invested $12. 5 million into 54 businesses from 1983 to 1997, but the firm had also obtained syndications of more than $222 million capital for its portfolio companies, often supplied to its Rocky Mountain companies through major venture capital funds on the coasts.
Genuine seed venture capital funds are quite patient equity investors. These seed venture firms’ deals often take six to eight years to successfully exit.
How did an immense venture industry grow from the family fortune investors in the 1920-30s, American Research & Development in the 1940-50s, and the SBIC movement in the 1950-60s?
Well, it was not a straight trajectory. For instance, the U.S. venture capital industry all but shut down between 1970 and 1977.
The 1970-1977 timeframe was the post-Vietnam War, oil embargo, stagflation, and stagnant stock market period that achieved double-digit inflation and interest rates simultaneously. Yet within two decades the United States and Western Europe were able to assemble immense venture capital industries and robust entrepreneurial economic growth on both continents.
Actions undertaken in 1978 initiated American venture capital resurgence. “Five monumental legislative initiatives were enacted that dramatically altered the genetic code of American venture capital.”¹
These key legislative changes included the 1979 ERISA “Prudent Man” Rule change that now permits venture capital investments by pension funds; the 1980 Small Business Investment Incentive Act that keeps VC firms from violating SEC investment advisor regulations; the 1980 ERISA “Safe Harbor” Regulation declaring that VC fund managers are not considered fiduciaries of pension fund assets; and two major changes to capital gains tax rates, namely:
The 1978 Revenue Act reduced the prevailing capital gains tax rate from 49.5% to 28%, resulting in a ten-fold increase in capital commitments for venture capital funds during the following year.
The 1981 Economic Recovery Tax Act lowered further the capital gains tax rate paid by individuals from 28% to 20%, causing a twofold increase in commitments to venture funds in 1981.
Singularly and collectively, these five pieces of legislation completely revamped the venture capital industry in the United States, both immediately and up to the present.
What are venture capitalist’s current business sectors of investing interest?
The hot business investment sectors of just a few years ago, such as genetic engineering and computer hardware companies that now have a longer payout horizon, are no longer the favored investment targets. Since 2001, the most active VC industry sectors have been computer software, telecommunications, biotech, and medical devices & equipment.
Venture capitalists operate in niches where traditional, low-cost financing is not available and an investor will exit the company and the industry before the industry tops out.
Venture firms can afford to take substantial risks because of the large upside of the few successful investments. Conventional venture capitalists’ net returns are accumulated from a minority of their investments. Most of the returns come from 10% of the portfolio.
End Note: This excerpt has been published with the permission of NorthStar Economics. Dr. David J. Ward, PhD is President of NorthStar Economics and co-author of the report. He completed a thirty-one year career in the University of Wisconsin System in July 2000. Ward held teaching positions at the University of Wisconsin – Green Bay and the University of Wisconsin – Oshkosh. James Patterson is a senior associate with NorthStar Economics. He served as the principal investigator and co-author of the. The 2003 NorthStar Guide to Growth and Venture Capital for Wisconsin companies that is now available for online purchase online at www.northstareconomics.com for $25 plus shipping and handling.
NorthStar Guide to Growth and Venture Capital Why Wisconsin Lags Behind the U.S. and Minnesota 10/28/03
Angel Investing in Wisconsin 11/02/03
Community Development Venture Capital 11/10/03
Growing Venture Capital in Wisconsin 10/16/03