Where’s the Money?
Despite the glut of capital that wasn’t invested during the recent recession, investors are slow to put cash into venture capital funds. “Fundraising continues to be challenging,” says Darren Acheson, managing director of Mill City Capital in Minneapolis, a leveraged buyout firm that is currently investing an already-committed fund. He was part of a panel of investors speaking about new business financing at the annual Minnesota Venture and Finance Conference in October, which is organized by the Collaborative.
Investors are reluctant to tie up money for 10 years, as venture capital investment typically requires, and are still feeling the aftereffects of the recession and financial market meltdown. Some U.S. venture capital firms have closed—in 2010, 462 venture capital firms managed $177 billion, down from 1,022 firms managing $220 billion in 2000—and others find it more difficult to raise funds.
It can be particularly difficult for smaller, earlier-stage businesses to get funding. Traditional sources of funding are scarce, and the Small Business Administration has discontinued an investment program. High–net-worth investors are increasingly investing in funds of funds, rather than directly into smaller firms or individual venture capital funds.
Start-up businesses don’t always find it easy to get personal or business loans, because banks often see them as credit risks. That increases their dependence on venture capital funding and on leveraged buyouts, in which firms such as Acheson’s buy a majority position in a new company.
There is money out there for start-ups, but increasingly deals are chasing dollars—not the other way around. Firms need good ideas, big markets, and a clear path to profitability or resale in order to attract venture capital. Even then, they’re likely to find themselves valued at perhaps 1.5 times earning projections by their second round of financing—not the three to five times earnings projections that a company might have seen six or seven years ago.
Venture capital investors are particularly interested in companies that have a health and wellness angle. “Medical devices have been such a strong suit for this region across decades,” observes Michael Gorman, managing director of Split Rock Partners in Eden Prairie.
“In the Twin Cities, the largest number of early- to mid-stage deals by venture capital investors are in medical technology and information technology,” says Vance Opperman, CEO of Key Investment in Minneapolis.
Geographic nearness makes meetings and due diligence easier; it also provides some comfort in numbers. “There’s some safety in investing in whatever everyone else is investing in,” Opperman says. “Ten years ago or more, most entities had larger staffs to do due diligence. That’s been pared and so there’s more of a buddy system.” Proximity helps venture capitalists get a sense of what other investors think about a sector or specific opportunity, which can make them more confident in their decisions.
This geographic concentration has also produced serial entrepreneurs. “These guys tend to stick around and start multiple companies in similar areas with a core group of people,” Opperman says, citing Robert van Tassel as an example. “He’s a famous cardiac surgeon who invented a heart catheter device 20 years ago, and now he’s founded InterValve, his eighth company. [His businesses] are all in and around the heart space, usually involving some kind of minimally invasive technology.”
The medical technology sector is still producing compelling developments, Gorman says. Split Rock invested in a company called Ardian, for instance, which treats high blood pressure with a one-time procedure that reduces nerve sensitivity around the kidneys. It can yield a 30-point drop in blood pressure—much better than the typical 10-point reduction seen from medication. (Medtronic bought Ardian in 2011.)
From an investment perspective, however, “the sector is facing some headwinds from regulator changes and extended time frames and uncertainty,” Gorman says.
U.S. Food and Drug Administration (FDA) rule changes have made medical technology approvals more complicated and less certain. The FDA asks for more information and the rules have gotten fuzzier, says Pete McNerney, a partner in Minneapolis-based Thomas McNerney & Partners, which invests primarily in medical technology and devices, biotechnology, and pharmaceuticals. “When a product is finally approved, then you have to deal with insurance companies, which are asking for more data and studies to justify reimbursement, and convince them to pay for the product,” McNerney says.
The payoffs in medical technology are still appealing, McNerney says, but waiting longer for FDA and payer approval means putting more money into a firm. That reduces an investor’s net profit. What’s more, “you have to wait longer if you invest earlier,” he says, and longer waits are more expensive. His firm is willing to look at companies at all stages of development, but finds that economics dictate that the firm choose more later-stage deals, as well as fewer deals overall. “We’re being forced to allocate more capital to existing deals, and that means we have less capital to put into new deals,” McNerney says.
It’s not a terrible problem for investors, who get their pick of start-ups, but it does hurt early-stage medical technology companies, which compete fiercely for those dollars.
Companies have the best chance of securing investor money when they have a great idea and an obvious market. “We can’t be investing in marginal areas. We need to find significant unmet medical needs,” McNerney says. The most attractive companies might offer new treatments for cardiovascular ills, diabetes, or obesity, he says: “These are diseases that the U.S. health care system spends many, many dollars on, so if you can add value, that’s great.”
Software and the Internet
It’s also a good time for companies that seek investors in new software, Internet-based service, and social media strategies, Gorman says. Cloud computing and its many offshoot needs—storage, security software, and applications—are popular with venture capitalists, as are Android cell phone technology and social media analytics and applications. “Facebook has become the Internet for many users, and there are opportunities for new businesses in that,” Gorman says.
Minnesota has attracted a fair number of computer technology companies, and this segment has produced serial entrepreneurs such as Phil Soran, who began Compellent and sold it to Dell in 2011. Like the medical technology sector, software and computer technology benefit from informal chats and due- diligence partnerships of geographic concentration, creating background perspective about both the industry and its individual players.
For a venture capitalist, software development has the advantage of being less expensive than medical device development. Software doesn’t require regulatory approval, but open-source software and cloud computing have also driven down development costs. Software venture capitalists can determine if a company’s product will be viable with a smaller capital investment. In turn, more investment dollars are available to earlier-stage start-ups.
Nearly every market segment currently suffers from a lack of good exit opportunities—another reason for reluctant venture investors. Initial public offerings (IPOs) have become more complex and expensive, and much less common.
Many firms now find their exits through strategic sales to a competitor or firm in a related business. “Strategic investors have a lot of cash on the balance sheets, and they’re looking to grow. Making acquisitions in portfolio companies can be a good way to do that,” Acheson says.
Such transactions may not be as profitable as they have been in the past (though prices from strategic buyers have always tended lower than those from financial buyers). A seller might realize between four and six times EBITDA (earnings before interest, taxes, depreciation, and amortization, a common valuation metric), not the 15 or 20 times EBITDA they might have pocketed seven or eight years ago, Opperman says.
“Experienced entrepreneurs are doing more to develop firms that they can steer specifically toward an identified potential buyer,” Opperman says. For instance, a medical start-up might choose to develop a product that would interest a specific large medical company, which makes a practice of acquiring smaller firms.
In the leveraged buyout sector, where Acheson’s firm works, many companies find financial buyers. Those with minority venture capital investment sometimes also find that venture capital firms specializing in later-stage companies will take them on.
For firms that don’t find buyers, there’s another option: turn an early-stage company into a more mature business, then run that business. It’s best to make that decision early on, Opperman says, because the choice to sell or run a firm can influence everything from product development to personnel decisions.
“It may affect who you hire and who you keep,” he says. “If you run the company, you’re focusing on the fundamentals of your business and making it more successful, which is different than figuring out what the Death Star buyer needs but doesn’t have. It means that you need to manage the business for the long term. Some people are very good at managing; others are very good at PRing a firm to potential buyers, and those are not always the same people.”
If many start-up owners decide to run their firms instead of selling them, they could fundamentally change the equations for venture capital firms. For now, though, most start-ups seem accept the need to compete for the venture capital dollars they can find.
Disclosure: Vance Opperman is owner and CEO of MSP Communications, which publishes Twin Cities Business.