September 5, 2008

Early-Stage Venture Capital in the Midwest

According to Midwest Venture Partners, early-stage venture capital is investment after angels and seed money, but before expansion / later stage Venture Capital firms. There is a strong need for early-stage venture funding in the Midwest. This region has the raw materials and resources to build successful companies, but lacks this integral round of funding. Additionally, Angels and Seed funds are noting the quality and quantity of the deals coming out of the Midwest. Right now, technology start-up companies are typically able to raise $1-1.5 million from initial investors. To get to the next level and attract national Venture Capital firms and partners, they need $3-5 million. This is causing the best companies in the region to go elsewhere for funding. What is the reason for the gap?

Funds invest their money based on the amount of capital raised. For example, if a fund raises $20 million, it can invest in 10 companies at $2 million per company average. The fund has an accepted period of time to invest the money, usually 3 – 5 years. There are roughly three segments of funding available to start-up companies. Angels or seed funds are small and typically invest early in the business with small amounts of money, in the $500,000 to $2 million range. Once that round has been completed, early-stage venture capital ideally comes in with larger amounts of money, in the $3 million to $5 million range. Finally, after the company has proven their product in the marketplace, and is ready to ramp up, National Venture Capital firms take interest and invest large amounts in the multiple millions.

Historically, it has been shown the early/seed funds outperform investment alternatives. Over the course of 10 years, they return close to 35% compared to the S&P 500 return of 5% in the same timeframe. As a fund becomes larger by attracting more investors, it becomes harder to invest in early-stage businesses. The average investment size has to get bigger forcing the management to look to later in the business cycle, which have larger needs. Early-stage funds are making up a smaller segment on the investment arena as the investors put more money into the successful early stage funds, making them to big to bother with small investments. The management is more than willing to participate in larger funds with higher fees and potential payoffs for them. Why not create more small funds to maximize the return, and make money available to more companies in this critical stage of development? If we are truly interested in growing entrepreneurial firms, this issue has to become a priority.

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