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.

Why do young businesses have to go through hoops to succeed?

In order to succeed, a young business (from startup to high growth mode) must go through many hoops. Why? Should our government (federal, state or local) eliminate some of these hoops? My view is - No. A market driven economy has an "invisible hand" that allocates success among the many young businesses at each stage of their existence. As with any scarce resource, success is hard to come by. Can government pick winners and losers? Hardly.

The "invisible hand" customizes the hoops that each young business has to go through. If the business makes it through these hoops, then more hoops are presented. It's the way our market driven economy disciplines businesses. Each set of hoops is different, but most of the types of hoops can be predicted such as finding a product or service for which demand exists (not just a perceived need), finding a good (although not perfect) mix of people to run the business, obtaining capital (directly or indirectly), staying focused (but on the right things), etc. When a business makes it through the hoops, it deserves to grow and, possibly, thrive. If it doesn't make it through the hoops, it deserves to fail or become part of the living dead.

So, one of the jobs of an entrepreneur is to know the hoops that he or she will have to go through and, then, to acquire the skills and resources to go through the hoops. But, entrepreneurs "don't know what they don't know." So, how can they possibly anticipate the hoops let alone be able to get through the hoops?

Frankly, most entrepreneurs who make it through a set of hoops are lucky. But most of them don't make it through the hoops because they are blindsided by the hoops and, when a hoop that wasn't anticipated is presented, it's too late to change direction or gather more resources to avoid the hoop or overcome the hoop. This is why smart investors want to invest in serial entrepreneurs - they have been through the process and are smart enough to know most of the hoops or to get "just in time" advice,to tackle or avoid a major hoop.

The hoops are the best filters our system has to pick the winners and losers. Government should stay out of the way and not try to eliminate the hoops. Our economic system is much better at determining the necessary hoops than bureaucrats who are just like entrepreneurs. They usually "don't know what they don't know."

The best way entrepreneurs can find out what they don't know is to ask others who have been there. Yet, one of the weaknesses of most entrepreneurs is an unwillingness to seek advice (or listen to advice). The hoops will take care of entrepreneurs who fail to seek advice.

Advanced entrepreneurship and an MBA

I teach Entrepreneurship and Entrepreneurial Finance as an adjunct instructor in the Rollins College MBA program. As a lawyer for 34 years working with entrepreneurial companies, primarily high tech companies, I've been part of the growing pains that these companies go through. I also have an MBA and worked as the CFO for a startup company that went public (before I decided to go to law school).

Having an MBA is incredibly useful when your company has the resources to do things that MBAs are skilled at doing. That is, researching the market, developing a strategy, finding and arranging for the infusion of new capital, managing the supply chain, developing sales channels, etc. all require a minimum amount of resources just to consider these matters. Startups are always severly resource limited and have to be very clever at using other people's money to get to a sustaining level of business.

I've seen only a handful of startups where one of the founders had an MBA. But, the skills taught in an MBA program were not really applicable to the startup. Not until the company reached a level of revenues of $5-10 million did the company have the resources to even consider doing the things a person with an MBA could suggest.

So, my observation is that a person with an MBA usually has a greater impact on an entrepreneruial company at the stage where the company has reached a level where it can obtain resources such as investor capital or bank borrowings to use to grow the business. Companies at this level have the potential of making a much greater impact on the local community than startups because they can grow rapidly with the use of resources that are not generally available to startups.