Category: Funding

Who needs risk capital anyway?

The Pittsburgh Business Times ran an interview this past Friday featuring Kit Needham (subscription required), a former colleague at the Allegheny Conference who is now: running her own consulting firm; working as a senior advisor at CMU’s Project Olympus (described as “bridging the gap between cutting-edge university research/innovation and economy-promoting commercialization for the benefit of our communities”); and serving as educational coordinator for Blue Tree Allied Angels, a network of local angel investors. There is no doubt that she has dedicated countless hours to the entrepreneurial community over the years.

In the article, she discusses her own investment strategy, which seems to be directly at odds with her advocacy for early-stage businesses. To quote Ms. Needham:

“It’s so hard to pick the winners and what I’ve learned is, I can’t pick winners,” said Needham, who also runs her own firm, Needham Consulting, and has worked for the Allegheny Conference on Community Development and what is now BNY Mellon.

“I learned I just didn’t have the time or, really, the commitment to spend the time to do a good job of this,” she said. “I am not keen on relatively illiquid investments.” (Emphasis mine.)

The article goes on to explain how she came to her investment strategy, which she described as a “proven sets of rules to build and preserve client’s wealth.” She broadly outlines her methods and the success she’s had (roughly 4% five-year return vs. S&P’s 0.99%).

For the record, I don’t fault anyone for a low-risk investment strategy that relies on mutual funds and stocks. Everyone has a different risk tolerance, which should be taken into account when pulling together a wealth-building strategy. Diversification is great. We should all aspire to structure our investments in a way that minimizes losses.

BUT, isn’t it concerning that someone so deeply entrenched in the entrepreneurial community can’t find space in her portfolio to directly invest in a local start-up? Sure, I could see where she might be reluctant to invest because of a potential conflict of interest, e.g. there’s an opportunity for personal profit if she provides advice relating to a company in which she’s invested. However, it seems counter-intuitive that someone who’s so directly involved in commercializing technology and guiding the funding of risky ventures admits that she can’t pick winners and isn’t keen on illiquid investments.

The oft-heard complaint in Pittsburgh is that we don’t have enough risk capital. I’ve heard great arguments from the various sides — some believe that VCs and angel investors are too risk-averse and let good companies flounder, others think there aren’t enough good deals worth funding, still others think that there’s plenty of risk capital in the region. Regardless of where you stand on the issue, can entrepreneurs get a fair hearing when someone who can’t handle the risk of a start-up is advising critical early-stage-oriented organizations? Finally, why would she publicly admit that she’s uninterested in risky ventures given her role?

I perceive that getting funded in Pittsburgh can be a challenge. While I’ve had the chance to help successfully pitch to an angel investor, our funding came from a close contact of one of the company’s founders who isn’t involved in the local angel community. As a result, we were fortunate to bypass the standard pitch-your-ass-off process that most start-up companies have to endure. Perhaps I’m over-reacting to a one-off PBT article, but if the folks influencing investment into our regional start-up companies can’t bring themselves to invest in these companies, then I can’t see how the money tree is going to be shake loose new money any time soon.

I’ve noticed that there are two schools of thought in Pittsburgh about the availability of risk capital and the lack of funds going into local start-ups.  The first is that there are some very good deals in Pittsburgh, and there is precious little lower-level risk capital ($500k-$2M), and blame generally falls on the nearly impossible standards set by the local VCs/Angels. The second is that there is plenty of money out there and that money and finds great deals no matter what, inferring that the issue isn’t money, it’s the companies coming out of the region.

As someone who has worked on a project that got an Angel round (and some subsequent cash infusions), I can understand the difficulty in finding that money and, as a result, I’m a bit biased. Looking at the landscape, I believe that there are some very intriguing companies/technologies coming out of our colleges, universities and innovative entrepreneurs, and that should be supported. Obviously, I’m not alone — the Pennsylvania government and local foundations infuse local organizations with capital that is then extended to these companies. However, when those companies have grown out of the alpha stage and to a point where they’re ready to start beta testing in real-world environments, are they the quality deals that attract VC investment? Is Pittsburgh’s risk tolerance unusually low?

My guess is that our VC community isn’t much unlike others around the country. I’d also guess that Pittsburgh has similar state-level resources to other areas and, perhaps a little more. What I don’t think we have is an ecosystem — a critical mass of successful entrepreneurs that have cashed out for several million and immediately feel the responsibility to return the favor to other hungry entrepreneurs.  The cities most often cited as models for the ecosystem — Silicon Valley, Boston, etc. — have earned that reputation honestly, but have taken decades to build that ecosystem. As one local VC said to me, “they weren’t built overnight, and we won’t be either.”

But, I think we’re getting there. There is a lot of energy in this community and, I suspect, additional resources will be devoted to not only supporting these companies, but helping to create that ecosystem that is critically important. I also believe that we need to do a little marketing to the outside world, showing off some of the companies that are making a difference. Would engaging other cities’ communities help facilitate some cash inflow by introducing their financiers to our companies? Would connecting with the diaspora help us to bring some of that money back to Pittsburgh? I think it would.

In the end, almost any money is good money, no matter where it comes from. Would I like to see more low-level risk capital? Of course. But, until we have a critical mass that can support some of these good-to-very-good deals (as opposed to great deals), we’re going to struggle to fund these companies. Should the state take a more active role? How do we get this done in a down economy? And, what are the best way to keep these companies fed in the meantime?

It was reported today (via PopCity) that eighteen Pittsburgh companies raised $78.27 million in venture capital in the third quarter of 2009. This is obviously very good and echoes what my hunch was in my post about the feelings of optimism at AlphaLab’s Demo Day. The more money we can get across the continuum, the better, especially in the very early- to early-stage funding categories.

However, this is only part of the story. If you look at the PricewaterhouseCoopers (my spell check believes this word should be ‘slaughterhouses’, by the way) MoneyTree report (the source of the VC funding data point), you’ll find that a lot of critical investment money isn’t included in their research, including angel investment (see the criteria summary here). Obviously, the report is invaluable in allowing us to track what kind of investment activity is happening across the country, but I feel like there are some gaping holes in really being able to assess how much entrepreneurial funding activity is happening in a given area.

I suppose this is because it is very difficult to track this type of investment. For instance, a business plan project on which I worked will likely be funded within the next three weeks at about $50,000 (obviously a very early-stage investment). The individuals involved aren’t what I would consider part of the “entrepreneurial community” in the region, so no one will know about it. This also goes for another project on which I worked, which secured $500,000 in its first round; there were no trumpets sounded or press releases written, yet the company opened the offices in the heart of Pittsburgh with six new jobs within city limits.

Is the nature of angel investment such that tracking it just doesn’t work? Are angels usually uncomfortable having their investments publicly discussed? Or do many people in the realm simply not care about having this type of investment counted? While there are good arguments to be made that Pittsburgh needs more risk capital than it has available, I believe the picture has to be better than even what the PWC report says.

So, how do we keep better track of this information? How do we make it easier to brag about Pittsburgh’s entrepreneurial community?

Something that seems to scare most entrepreneurs is figuring out how to do pro forma financial projections. It’s scary stuff — you really don’t know what the costs are going to be, what your sales are or how exactly you’re going to have the cash flow to make payroll even before you start. All you know is that you have a product idea, and maybe costs or the right price point. Beyond that, you’re really not sure.

I’m not a finance wizard, but I’ve pulled several pro forma financials together for various businesses. The long and short of it is, every investor/bank wants to see the same stuff — sales, cost of goods sold, expenses, net profit, etc. It’s not altogether difficult, but the process can be very intimidating.

I have some things that I’ve followed along the way below the fold . However, to get you started, I’ve developed a starter template that I’ve used on several projects (albeit with some significant edits) that you’re free to download (FinancialsTemplate.xls – 118kb). This should help get you started, but realize that it’s only a template and I don’t take responsibility for your final version.

Thoughts and tips are below the fold… Continue reading