Solving The Series A Crunch

At the recent CATTECH VI conference, we had a couple discussions around the Series A crunch.  It is especially acute in the midwest.  I understand that entrepreneurial ecosystems are entrepreneur lead, but without money to fuel the fire, the entrepreneurs leave.

We talked a bit about failure.  All startups fail and for many in the midwest, failure isn’t a badge of honor but a scarlet letter.  Even the press reporting on Groupon ($GRPN) has been about the travails of the company.  I think Groupon is a success.  How many of us have taken a concept to multibillion dollar IPO in 5 years?

Does government have a role?  Many state governments have set up matching funds that add a little capital to the ecosystem.  In Illinois, some companies have seen their seed convertible debt rounds filled out with a little government money.  The state didn’t allocate hundreds of millions of dollars, but just a small pile and that pile is gone.

It remains to be seen if it will help or not.  The companies that received government money haven’t had the time to succeed or fail.  Someone should keep a scorecard.

Philosophically, I am against government investing money in anything.  Governments don’t invest, they spend and taxpayer dollars should be going to basic things.  But, when the series A crunch is as bad as it is, there are empathetic ears in the halls of government.

Many states have passed an angel tax credit to incent accredited investors to put money into startups. In states like Wisconsin, Minnesota, and Nebraska, angel investment increased with the passing of the tax break.  I think tax policy is an excellent way for governments to provide incentives to break the Series A logjam and try to get capital flowing to startups.

But is this the right tax break to remedy a crunch?

The tax credit does nothing to change the calculus of whether to invest or not.  It’s a “nice to have”.  But, if a company fails you can still write off the loss on your taxes.  Since most fail, that is one benefit to investing, although it’s not one an investor wants to take regularly!

What about 0% taxes on any gains from investing in seed or series A rounds?  That policy exists on a federal level until 2014.  But, it’s had little effect on investing.

The idea behind a 0% tax is that on successful exits, the investors will take some of the capital and plow it back into new startups.  There is no guarantee that they will, but once you are a successful investor, you usually come back for more.

Allen Dines from the University of Wisconsin mentioned that many of the pension and institutional funds from the midwest send their capital to the valley, and then we “bring it back and buy it” in the form of startups.   Sort of a colonialism of capital!

The midwestern mindset is not a venture capital mindset.  It’s a private equity mindset.  Even some “early stage” investors aren’t classic early stage investors like the ones on the coasts.  They want to see a longer track record and a path to profitability.

Ted Fierstein made an excellent point.  A lot of investing is timing.  If you invest too early, the company has to sort itself out.  There is great peril in doing that, and if you invest at that time, there needs to be reserve capital built into the investor equation so another check can be written precisely at the time when product/market fit is discovered, but before it ramps up.

There isn’t anyway to predict when that is going to happen.  That’s why it pays to be earlier rather than later if you want to maximize return.  It’s also why successful angel investing is hard work.  You have to be on the ground networking and working with teams prior to investing.

It’s going to be eons before the “midwestern mindset” changes.  Additionally, many of the people with a lot of capital to invest have a hard time doing it.  Commodity traders for example.  They have to keep a huge pile of cash liquid in case they get a “rainy day”.  They also have to keep money liquid to be on the ready to increase margins when they see an opportunity.

No, some of the money needs to come from established family offices and high net worth individuals that allocate a slice of capital to build the ecosystem.  There are two reasons they should.  First, altruistically, they are building their own community through investment.  It’s just like a donation to a civic organization and they need to think of it in that way.  Second, they have a chance of realizing a nice return on investment and improving their financial condition for the long haul.

But there is one more thing the midwest doesn’t have that Silicon Valley has that would go a long way in improving the Series A climate here.  Silicon Valley has “acquihire”.

Acquihire is where a firm like Google ($GOOG) buys a startup simply for the talent. Investors might have invested in the company at a pre-money valuation of $3M, and Google buys it for $8-$10M.  It’s not just Google, but Apple($APPL), Facebook ($FB) and other large companies acquihire in the valley.  To be clear, that is not a way to make money long term in angel investing, but it’s a part of the ecosystem that is missing in the midwest.   Acquihire also starts to remedy the “failure syndrome” that I highlighted earlier in this post.

Think of it in an alternative way.

A successful commodity trader that position trades will make their big money on 5-7 trades per year.  In between, they have some losers, and they have lots of little trades that net them a little bit of money.  In and out trades, scalping.  They risk a little and make a little.  The market takes them out.  Usually these are momentum type trades.

The acquihire is the momo trade of angel investing.  Midwestern corporations need to begin to step up to the plate and start buying companies at an early stage.  Their business development people need to actively begin to attend midwestern events and start networking with midwestern entrepreneurs and investors.  Corporations need to encourage employees to start to mentor startups.  Beginning the conversation this way will allow big companies to figure out how to interface with startups.

At the same time, founders need to understand early that it’s okay to be bought out for a small amount of money.  There is plenty of time to do an earn out, and then leave to do another startup.  Not every idea they have is a home run and some are better off being integrated into a larger company.

Sometimes the company isn’t a business, it’s a feature or an app.

One of the other challenges midwesterners have is distance.  On the coasts, the ecosystem is compact geographically.  In the midwest, like farms it’s spread far and wide.  Each city has a little something good going on.  When you sum up the parts, it’s very dense.  But, the “transaction costs” of having a physical presence in, and networking through each city are high compared to the coasts.  Just in Illinois, we have things cooking in Champaign, Chicago, a new simulation center in Peoria, and if you drive three hours away you’ll find entrepreneurial ecosystems simmering in Madison, Milwaukie, Indianapolis, and at many Big 10 universities.   Not to mention U Chicago and Notre Dame.  Distance, even with all the virtual ways to connect remains a problem.

The capital crunch in the midwest is a real and present danger.  We have to solve it if we want an entrepreneurial ecosystem to exist here.  But, everyone has to pull on the rope.  No one can do it by themselves.

 

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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