Engineering Capital Flow: Thoughts on Wisconsin & Beyond

Late last month there was a formal announcement of a new $30 million information technology venture capital fund in the state of Wisconsin called 4490 Ventures. The fund is the creation of the State of Wisconsin Investment Board (SWIB) and the Wisconsin Alumni Research Foundation (WARF). The fund will be seed stage, investing $0.5 to 2M per company. The news is exciting for the community – who wouldn’t want an influx of $30M of fresh capital? But with opportunity comes questions.

By that afternoon, Michael Koeris, co-founder of Sample6 Technologies, a synthetic biology company located in Boston, had raised the issue with me on Twitter:

Sad that Wisconsin Launches $30M seed fund 4 IT, not LifeSci even though that’s what they made $$$ with… @scientre http://feedly.com/k/WEa2WG

I looked back at my replies to summarize them for this post. They do a decent job reflecting my thoughts even though they were off the cuff. I did emphasize the following:

  • Not clear what criteria lead to sector specific fund. Good WI investment opptys across spectrum of tech biotech & adv manuf
  • State of Wisconsin Investment Board (SWIB) has made sector specific VC investment plays http://ht.ly/jg5pS  But in existing VC firms
  • Wisconsin Alumni Research Foundation (WARF) has equity in at least 30 cos, lists successful exits across sectors http://ht.ly/jg5E3
  • Good history of bio/med tech in WI: Epic, Ultravisual, DNA Star, Geometrics, Forte Research, Nimblegen incl software
  • Also good tech companies: ScheduleSoft, Murfie, Raven Software, Networked Insights, Shoutlet. Many newer 2 PerBlue, Mobile Igniter
  • I am enthused by idea of using tech to solve bio problems. Is that tech? Biotech? If good idea/plan/ppl, fund it.
  • Brief ovrvw current Madison Health Tech/IT scene http://ht.ly/jgabW  & how we share talent http://ht.ly/jgaeg  Off soapbox cc @mkoeris

As luck would have it, I had the chance to talk to a couple of tech folks about the fund at the Spring Tech Kickoff the same evening. A couple of the conversations got lively and the most interesting part to me was the discussion of the impact that the choice of fund manager will make. Across industries, I hear from people about barriers to investment capital that go beyond the capital – due diligence requirements, timelines, risk tolerance, etc. Finding a fund manager who can deploy this capital effectively in the Madison environment will be one of the single greatest determiners of the impact of this fund on the community.

So again, what is the profile (e.g. past experience, skill set) of an effective fund manager for a $30M IT-focused fund in an “emerging cluster” such as Madison, Wisconsin? I figure I have to at least start the ball rolling but I would love to hear your thoughts on this question.

My two cents on a finding a fund manager:

  • Enough operational experience to help management identify the key drivers that will catalyze growth of their business
  • Strong relationships with coastal venture firms would allow the person to help portfolio companies build credibility and strong syndicates in subsequent rounds.

Another question that arises is whether a traditional early stage venture fund model is most appropriate choice 1) in general and 2) in a place like Madison. Venture capital has been under scrutiny lately from institutions that range from large pension funds such as California Public Employees’ Retirement System (CalPERS) to the entrepreneurial minded Kauffman Foundation. While twenty year returns were very strong (28.8%), VC returns over the last decade has been a challenge (6.1%; data from Cambridge Associates). The challenging math has been a recent topic of discussion between tech (Fred Wilson of Union Square Ventures and Jo Tango of Kepha Partners) and biotech VCs (Bruce Booth of Atlas Venture and Bijan Salehizadeh of NaviMed Capital) alike.

Just this week, Wilson posted about the 1 in 3 success rate of early stage VC – and more interestingly, what happens to the other investments. Wilson estimates “at least 50% of the outcomes are not a win for the VC or the entrepreneur” and describes two main scenarios: slog it out and hit the wall. Of particular note in the description of companies that slog it out:

there is no way a company can operate for two or three decades without being able to sustain itself. VCs do not keep pouring money into these businesses, maybe they do that for the first five years, but not after that. These “slog it out” companies turn into real companies eventually but just not companies that have the growth trajectories or strategic profiles that make them great acquisitions.

Tango followed up on Wilson’s post with some additional data from Cambridge Associates showing 63% of IT & digital media start ups in the 2001 to 2011 period did not return capital. Returns from 3-5x were found in 8% of companies and 7% returned 5x+. How do you move the needle on returns to LPs with these numbers?

The challenges the VC community is facing are not unique to the tech sector but there are differences that strike me as relevant to fund strategy. As Booth and Salehizadeh pointed out in a Nature Biotechnology paper, one of the differences between tech and biotech is that outliers (100x) are possible (albeit unlikely) in tech; they do not exist in biotech. In a more recent post, Booth provides much more color on the issue in the post Biotech Venture Capital Math Problem – a great read about the fundamentals of the impact of cash in and cash out on VC returns. While I can’t capture the whole post here, the themes that stuck with me on providing good return to investors are: ownership stake and holding time.

Tech (and biotech) in Madison has created good returns for investors as well as good employment opportunities. (Milwaukee tech has a good history as well.) However, the companies tend to be grown over longer stretches of time with a mixture of equity and revenue, in large part because of the lack of large equity capital sources in the state. Looking at Wisconsin VC investments over the last eight years, I found four companies with large (at least a $4M round) VC investments, representing $75M of total capital (including angel and corporate dollars). There are likely less than a dozen smaller companies with VC dollars, with the majority coming from an early stage New York based firm, Great Oaks Venture Capital.

What does all this information mean when structuring a venture fund in Madison? With pressure on the traditional model and a history of WI tech companies building value with blended revenue and investment streams, perhaps the fund should have the flexibility to invest in companies with a clear path to revenue and profitability – in search of higher success rates (>3 of ten) with less ambitious multiples (no 100x+ outliers). This strategy may require structural considerations in setting up the fund and should certainly involve consideration of alternative corporate structures for the investments.

Booth has written about a couple of alternative liquidity models in biotech, which include an LLC holding company. In this scenario, a passive parent company is established with subsidiaries that include a management corporation and a C corporation for different drug targets. A similar structure in tech could allow companies to capture value from products that would otherwise require too high of a barrier to achieve significant distribution. Are there tech-specific models that would allow investors to capture value from the slog it out companies, shifting the needle on overall returns?

There are some interesting things happening in Madison’s tech and I hope 4490 Ventures gets a structure and a leader that can add fuel to the fire.

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