I first met Gerry Hays when I was an undergrad at Indiana University in his Entrepreneurial Finance course. But Gerry didn’t just give me the standard Venture Capital 101—he also helped me package and sell my first business. I’d have to say he knows more about Indiana Venture Capital and funding startups than just about anybody I know. In fact, the last time we grabbed drinks, we had one of the most enlightening conversations about raising capital in the Midwest. That’s why I asked if he’d write this post.
He nailed it. . .
Enter Gerry Hays on Indiana Venture Capital:
Over the past decade, I’ve seen unbelievably positive change in the Indy startup community. There are more successful startups today than there have been at any other point in Indy’s history. Angie’s List just had an IPO. ExactTarget is also an undisputable home-run story. Aprimo recently reached a big exit and returned capital that can be re-invested into new opportunities. Groups such as Verge are injecting the youth and energy that’s so sorely needed in the community. And the Orr Fellowship is breeding a new crop of entrepreneurs every year.
However, one aspect of the community that has not changed is the struggle Indy startups face raising venture capital. While sub-$500,000 seed and Angel deals are achievable (funded mainly by early-stage funds, Angels, and family and friends of the founders), it is significantly more difficult to raise expansion capital. Try and raise $2,000,000 – $3,000,000 in a true Series A round from an Indy venture fund, and the odds get long. Very long. As a point of reference, the local funds don’t show up on the Cap Table of either Angie’s List or Exact Target.
Why is this the case?
We have both a funding and process challenge
For starters, it doesn’t help that Indiana’s share of venture capital dollars relative to the total amount of capital in the marketplace is only one half of one percent (PricewaterhouseCoopers/National Venture Capital Association MoneyTree™ Report). There just aren’t that many places you can go to in Indy to raise a traditional Series A round…something that is unfortunately unlikely to change in the foreseeable future.
However, one of the principal reasons deals don’t get done is due to the “reactionary” process of the traditional Venture Capital mode.
By way of background, I’ve raised my share of risk and debt capital over the past decade as a serial entrepreneur in Indy: first as founder of HomeYeah.com (1999-2003), next as a Co-Founder of the Charley Biggs Food Company (2004-Present), and most recently as one of three co-founders with Apparel Media (2009 – Present). I’ve been involved with multiple investor engagements – in Indy as well as in New York, San Francisco, and Chicago – and I’ve become an active investor and advisor in early stage deals. Lastly, through my position at the IU Kelley School of Business, I’ve had the opportunity to engage in conversation with several venture capitalists regarding how they work with founders. It’s through these experiences that I suggest a new way for the local venture funds
The vetting process fails both the entrepreneur and the venture funds
Before I go any further, though, I want to emphatically state that this post is not about which deals are deserving of funding. Those are business decisions each fund makes on behalf of its limited partners. What I take issue with is the process by which investment decisions are made.
In the traditional use case, a founder is connected to a fund via a reliable referral. If the assigned partner does not have interest in the idea or space, the fund passes. If the partner wants a meeting, the founders go in and with their startup pitch. The partner then presents the opportunity at a weekly partners meeting, where the fund votes whether to pursue or pass. If the fund passes, it passes pretty much for life. Straightforward, right?
The problem I have with this model is that not only is it fraught with multiple trapdoors for the startup, but it trains the venture funds to look at deals in a compressed time space with limited information. In this type of situation, unless there is domain expertise in the room, it’s inevitable that there will be more questions than answers…and when that happens, the easy solution is simply to “Pass.”
The “big fish” that got away from the local venture funds
ExactTarget is the poster child for this argument. Here’s what some of the local venture funds knew definitively about the ExactTarget deal when they were presented with an opportunity to invest very early in the company’s lifecycle:
The founders are smart and talented. Scott Dorsey had a successful senior-level business-to-business sales career before getting an MBA at Northwestern University. He spent two years at Divine Inter-ventures before starting ExactTarget. Chris Baggott, as Co-Founder, had proven that database emailing produced sales for his own dry cleaning business, as well as the other drycleaners around the country that used his method. Lastly, the founders had already launched their SAAS product in the marketplace and were generating sales when other well-funded dotcoms were “pre-revenue.”
With all of this in hand, how was it possible that the Indiana-based funds passed on making an investment?
I’ll tell you why: The traditional vetting model. When there are more questions than answers, funds simply pass and move onto the next potential opportunity. But who lost in the deal? Not ExactTarget. The funds and the Indy startup community lost. How much wealth did the limited partners of those passing funds miss out on? Could the funds have used ExactTarget as use case to launch new funds from those same limited partners? Quite possibly.
To the savvy investor goes the spoils
Fast forward a few months and Scott and Chris get a meeting with Bob Compton. Bob saw the same things the funds saw and probably had the same unanswered questions. But did Bob simply pass? No. Did he invest out of the gate? No. Instead, he provided the founders with a list of businesses to call on with their product. Within a 30-60 day period, they closed nearly all of the sales, if not all of them. Bob then gave them a second list of businesses to call on. Again, they had a closing rate of nearly 100%. The open and ongoing vetting process Bob utilized provided him with enough information to conclude that Scott and Chris were onto something big. This led to the game changing investment that set ExactTarget off to the races. Now how smart is that?
ExactTarget’s story is a great example of just how much more success Indy startups might find if the venture capital process was approached a bit differently.
It pays to get your hands dirty along with the founders
I suppose the counter argument will be that Scale Computing raised a significant amount of capital out of Indy. My answer to that is Jeff Ready is as bankable as they come. He’s a third time entrepreneur with two successful harvests. Unfortunately, 3-point layups don’t come very often.
So, based on what I’ve learned from some really strong VCs around the Country, here are seven practices I’d suggest to our local venture community:
- Maintain dialogues with the savvy early stage investors to get updates on what’s happening within their portfolios (i.e. Gravity Ventures, Sproutbox, DeveloperTown, etc.) as well as Sophisticated Angels focused on later stage projects (HALO);
- Take meetings with any founder that has raised seed capital or invested personal capital and is building something other than a lifestyle business. Be clear that you want to start what may be a very long conversation that may or may not end in funding. In the interim, strategize with the founder(s) on how to make the idea or business more compelling to customers and investors;
- Ask the founder(s) to provide monthly or quarterly updates to help gauge their progress. In fact, launch a website that allows founders to enter in key metrics so you can visually chart the growth of every company within your start-up funnel. Of course, you’d have to provide useful feedback and encouragement in return;
- Hold quarterly open forums at your fund’s headquarters where, for a 4-5 hour period, Indy founders could snag 10-15 minutes and share what they are doing. Provide advice and referrals if it would help;
- View the investment decision as a 12, 18, 24 month fluid process in which a decision comes at the appropriate time with the appropriate information in hand;
- Attend the Verge startup events religiously so to stay on top of everything that is going on in the startup community; and
- For early stage deals that include a compelling idea and talented team, push to make small investments alongside the other early stage funds to get a toe in the water and a seat at the table for future capital needs.
In summary, knowing that only a few companies will rise to the level of a true Series A opportunity, build a huge funnel of companies that will call you first when those few opportunities materialize. When they do arise, you’ll know the person on the other end of the phone and have a repository of information on a company that you’ve been in touch with continually over several months or years.
And at that point, you’ll have more answers than questions. Everybody wins.
What has been your experience funding startups? Have you raised a round in the Midwest or on the Coasts?
Gerry Hays, a resident of Carmel, IN, is a serial entrepreneur, investor, husband and father of 3. In addition, he is a Practicing Professor of Entrepreneurial Finance at the IU Kelley School of Business – Bloomington. Feel free to contact him at email@example.com or firstname.lastname@example.org.