Feature Article

 

Seed Capital

Where To Get the Cash To Germinate Your Business

 

By Lisa Ann Thomson

 

Let's be honest. If you ask five smart financial types what "seed capital" is, you'll get five smart answers. They'll agree it's not traditional venture capital or a commercial bank loan. They'll agree it's money you get earlier rather than later in your business' lifecycle. They'll also agree that the Utah financial landscape doesn't have enough of it.

But exactly what it is and when entrepreneurs will need it can be a little hard to pin down.

To some, it is the very first money: your money, your parents' money or your neighbor's money. To others it is the first investment from someone you don't already know: i.e., an angel investor. Still to others, it is the first institutional money from an official fund; i.e., an actual seed fund.

Then you have the question of timing. If the seed capital came from your savings account or your dentist, you are likely in the earliest of early stages — probably just an idea you are trying to get from napkin to drawing board. If the seed money came from an angel investor or a seed fund, your company most likely already has something to show for itself — a prototype, a beta launch or a customer.

Next, you have the question of how much money you can expect at a seed stage. Again, the answers vary. It could be the first $20,000 to test your concept or the first $500,000 to launch your product.

And finally, you have the big question: Where do entrepreneurs get this kind of cash? The truth is, in Utah, there aren't many places. But there are a few, and there are people calling for more. Here's a look at Utah's seed capital landscape.

 

The Seed Gap

If you're a budding entrepreneur, the starting point is almost unanimous: the first money has to come from your own pocket or a pocket close to you.

"If you are truly just looking to get started, I would look in your own bank account and among your family and friends," says Bryce T. Roberts, managing general partner of O'Reilly AlphaTech Ventures, a seed fund based in San Francisco. "I would be looking at what kind of sacrifices I am willing to make; I'd be polling my personal networks to see if there were a couple thousand dollars, a couple hundred thousand dollars to work as a catalyst for me to get things off the ground."

But many companies are finding the next step is a little more tricky. T. Craig Bott, president and CEO of Grow Utah Ventures, calls it the "seed gap." Young companies often find themselves in a tight spot when their own resources run out and they need more capital to move to the next level. But usually they don't need millions, and therein lies the gap.

"It's small amounts of funding to move a technology or a concept or an idea to the next stage of the value chain," says Brian Cummings, director of the University of Utah's Technology Commercialization Office.

The Ewing Marion Kauffman Foundation has identified a capital gap at $500,000 to $2 million on an aggregate national level. But for Utah, Bott estimates the gap to be a little lower, ranging from about $50,000 to $500,000.

"That's significant," Bott says, "because the trend is that a significant portion of businesses can be successful with a relatively small amount of money — meaning the $50,000 to $500,000 can be the last money that business needs to be successful."

The reason for the gap is simple: risk. Investing in a seed stage company is extremely high risk. You are talking about investing in a concept or idea, at the least, or in a beta product with a customer or two at most. "The profile is more risk, more potential return because you get in early," says Jeremy Neilson of the Utah Fund of Funds.

 

Bridging the Gap

With the gap comes opportunities for investors, and that means hope for entrepreneurs. One major trend seen across the country is an uptake in angel investor groups. In Utah alone, where there was once just one major angel group in Utah County, there are now angel groups from Logan to St. George, with more in the works.

According to the Kauffman Foundation, these angel groups are key to bridging the capital gap. "Angel groups are starting to figure out how to put their capital together to fit into that gap," says Marianne Hudson, executive director of Kauffman's Angel Capital Education Foundation. Hudson points to Kauffman data that indicates in 2005 (the most recent numbers available) the average round investment from angel groups was $266,000 — square in the middle of the seed gap.

Another emerging resource in Utah is seed funds. A seed fund is much like a traditional venture capital fund except that it focuses solely on seed-stage investments. Utah currently has only one: a just-announced seed fund sponsored through the University of Utah's Office of Technology Venture Development.

The fund is managed by the school's Student Venture Fund, and specifically targets the earliest of early stage companies. "We look at it as funding to develop either a concept or a technology. We look at it in its earliest sense," says Cummings, who has championed the creation of the fund.

The fund will make investments of $50,000 to $200,000, with the purpose of helping a technology develop to the point of becoming interesting to a venture capitalist. As part of that, venture capitalists are invited to the table from the onset. "We have venture capitalists who would do the follow-on funding involved right from the get-go," Cummings says. "They see the technologies and are there to do the next round of funding."

The university's seed fund is designed to capitalize on the research and technologies coming out of the major research universities in the state, but it is also open to the community at large. The hope is to model what's happening at other schools around the country.

"You see it around Stanford and MIT. There are huge capital networks built around the universities. That's what we're trying to do here," Cummings says.

While the University of Utah's seed fund is the first of its kind in Utah, seed funds are not uncommon in other areas. O'Reilly AlphaTech Ventures is based in San Francisco, but managing partner Roberts says he is open to doing deals in Utah. O'Reilly AlphaTech Ventures' typical initial investments range from $100,000 to $1 million, but it also keeps another $3 to $4 million in reserve capital for that investment.

Roberts acknowledges that the competition is fierce for attracting seed money from outside Utah. "There's a huge curve that you've got to overcome before you'll be interesting to someone in Silicon Valley. You've got to have a real story about ‘why Utah.' The idea, the state of the company, and the entrepreneurs have to be pretty compelling," he says.

Locally, traditional venture capitalists are also dipping their toes into seed capital. The Utah Fund of Funds has worked with several VCs who have set aside capital for seed investments. Neilson points to vSpring Capital as an example. vSpring will invest as little as $250,000 of seed capital, although its typical investments range from $2 to $3 million.

Grow Utah Ventures is another example of a local fund committed to bridging the gap. Grow Utah Ventures is a fund established by a small group of investors in Northern Utah with the goal to invest in 100 young Utah companies. They've invested in about 50 so far, averaging about $250,000 per investment.

"When we put Grow Utah Ventures together about three and a half years ago, we analyzed where our money would be best used," says Bott. "We didn't have much in Utah for the seed stage, so we said, ‘Count us in on that level,' and that's exactly where we play."

Another local player is InnoVentures. InnoVentures specializes in the earliest of early stage companies, but it is not a pure equity player. Rather, InnoVentures specializes in a type of venture debt. It lends money with traditional interest and repayment terms, and it also takes warrants in the company. InnoVentures typically lends between $100,000 and $500,000.

"Most venture funds don't reach down into that area, and if we were doing only equity investments, we probably wouldn't be able to either," points out Damon Kirchmeier, managing director of InnoVentures. "But this hybrid model we've come up with — debt to early stage companies with warrants — allows us to do a lot of deals in small amounts."

 

Moving Forward

Even with these sources of funding, Utah needs much more, says Bott.

"There are two weaknesses in the Utah story," Bott says. "One, there's not enough money. Even though we've made progress, we pale in comparison to other regions — even the Western states. And two, in Utah, we are not really focusing on pre-revenue companies. If you look at seed capital in the rest of the country, they are willing to come in at the proof-of-concept stage, before any sales."

And the reason for that? "Our conservative nature," says Bott. "We want that young entrepreneur to prove he's got a product that sells before we give him seed capital. That puts a huge burden on the individual, his family and friends, to get his business all the way to the stage where he's developed something and it's selling before he gets capital. That's too big a gap for an individual or family and friends to carry."

So we're back to the seed gap — the difference between founders, family, friends and big institutions like VCs and banks. We've got to get more seed money, and we've got to get Utah's seed investors more willing to invest at the seed stage.

"The difference for Utah companies would be huge," says Neilson. "It would allow more companies to get started, grow and reach venture stage; it would allow companies to test their concepts quicker; and it would add needed expertise and advice to the companies."

 

Launch - Mar/Apr 2007