The "gap" between angel funding and venture capital

Does a gap really exist between angel funding and venture capital funding? Yes, but the gap also exists between venture capital funding and IPOs. The two gaps are related. When we had a market that accepted, even demanded, early stage IPOs, venture capital firms (VCs) were motivated to invest at the stage before the IPO. Otherwise, they missed the opportunity to invest because most VC funds are not permitted by their investors to invest in publicly held companies (the institutional investors who invest in VC funds can make those investments without the help of VCs).

Now, we do not have a market that supports early stage IPOs largely because there are no securities analysts who will follow small, publicly held companies. Why? Because the securities analysts can't get compensated for promoting these companies within their own organizations. So, VCs aren't very interested in making investments at the early stage of a company's life. In addition, the VCs have so much money to invest that they can't make small investments of, say, $1-3 million because the small investments won't make a difference to a portfolio of $200-500 million. Further, for a $200 million fund, a 10 to 1 gain on a $2 million investment (yielding a $10-20 million gain) produces the same fee to the managing partners as a 2-3 to 1 gain on a $10 million investment. It is a lot easier to invest in companies that make a 2-3 to 1 gain over several years than it is to invest in companies that will make a 10 to 1 gain.

With the non-existence of an early stage IPO market and the growth in the size of the VC funds, a layer of capital is missing for attractive, early stage companies that have made it through the startup stage and are poised to grow if capital were available (second stage companies). What is a company in this stage to do? Can this company obtain bank financing to grow? Yes, but only to marginally grow the accounts receivable or inventory, not to fund more product development or marketing campaigns.

Why doesn't our market system take care of gap between angel funding and VC funding? Primarily because of the unintended consequences of added regulation pertaining to broker dealers and the effects of Sarbanes Oxley (making it very expensive to be a publicly held company). Still, our market should find a way to invest in companies at this stage.

Maybe, investors will wake up and realize that investing in the stock market is only a "market play" and does not result in high growth potential companies receiving capital. Shouldn't investors want to invest directly into companies with high growth potential so that the capital invested causes the high growth? But, the securities laws, mostly written in the 1930's, make it difficult to spread risk among many investors in non-public companies. Instead, the securities laws force the risk of investment in privately held companies to be concentrated among a few investors. This is upside down.

One answer to this is to invest in business development companies, a special animal under the securities and tax laws. A BDC is basically a closed end mutual fund that can raise capital from investors in the same way that a closed end mutual fund raises capital. A BDC is required to invest in non-public companies, usually early stage companies. A BDC is essentially a publicly held VC firm, but with the transparency of a mutual fund. There are a handful of BDCs that invest in early stage companies and quite a few that are essentially finance companies making secured loans to companies who can't borrow from commercial banks. BDCs that focus on making equity investments in early stage companies could fill the gap between angel funding and VC funding. But, it is hard to launch a BDC. I'll write more about why it is hard to get a BDC launched in another blog.