Not sure how it happened, but over the last couple of months people I have never met before reached out to me for my thoughts on developing an entrepreneurial environment in their communities. I am certainly not an expert on the subject, but those calls prompted me to write this simple primer and share some ideas along with what I know/think. It’s not a complete guide (there are many books on the subject), or a fully articulated plan, but here it goes.
I have been an active supporter of entrepreneurship initiatives for the last twenty years, and somewhat of a serial entrepreneur/intrapreneur myself, so I occasionally engage in conversations with community, education, and business leaders on ideas and approaches to developing an entrepreneurial environment. From my experience in places I lived and worked before, influencing policy development through business community engagement, and improving talent development through educational initiatives, are two core components to building a healthy and thriving entrepreneurial ecosystem. But not enough! Of all the actions a community can pursue, from sponsoring incubators and donating space to mentoring groups, to the launching of grand marketing and tax-break initiatives to highlight their attractiveness as a destination, the most important, by far, is the development of an active and perpetual early-stage Venture Capital (VC) transaction deal flow environment. And without the C of VC that deal flow environment remains random and anemic; subject to strokes of luck rather than the result of a strategy. Without the presence of strong local VC firms, or at least individuals actively providing deal flow to VC firms, the husbandry of early stage companies is left to the pursuit of funding by the three F’s (3F=Friends, Family, and Fools), the randomness of loosely structured part-time-managed Angel networks, or the kindness and whims of high net-worth individuals. Even though those sources of money are required, they are still not sufficient.
Fostering a self-sustainable environment requires the focused, active, and continuous searching, finding, screening, seeding, and mentoring of the inventors, researchers, budding entrepreneurs, and corporate refugees pursuing the creation of their own companies. And it is real work that must be based on a clear strategy and requiring dedicated resources, if it is to bear fruit over time. It is a process that needs its own TME (Time, Money, and Effort/Energy) resources as much as the companies it will eventually produce. Some people would immediately point out that is the role of the VC firms. That’s true in a general sense but, unfortunately, because of the structure of most VC funds and the nature of VC’s, that initial ground-laying work is one that is rarely, if ever, funded in smaller communities.
So how can a city or a community overcome that? I certainly don’t have “the answer” so what follows are highlights of a framework I use to discuss the development of potential solutions. As usual, feedback is actively sought and encouraged.
First some basic background, with the hope I do not offend the intelligence of my readers.
First of all, what is an early stage company?
An early stage company is an individual, or a group of individuals, with an idea for a company, sometimes a fully articulated business plan but most often not, and occasionally with some minor amount of capital invested in the development of the idea or basic research. It is not a company with a proven business model, revenues, and a customer base. If a company has reached that stage of its evolution, it can be funded through multiple channels. An early stage startup is an idea for a company looking for direction and funding to find a runway to take off from. Not one on the runway already, in the process of taking off, or early off the ground. The high infant-mortality quotient for start-ups is well established, but what is not clear is that the infant mortality of really early stage startups is even higher, because many of them never even get a chance to find the runway, let alone become an actual start-up with a chance to succeed or fail. The often quoted ratio, and one I have personally experienced in my investments and entrepreneurial pursuits, is that of ten early stage investments at least five will completely flame out and return a loss, two to three may break even, two to three may generate a decent return, and one or two may become the break-outs that provide significant returns to the investors over two to five years. Funding ten early stage companies over three to five years may be enough for a single VC firm but not enough to build a healthy and community-impacting ecosystem.
So what’s a community to do?
Well; it’s a game of numbers and it’s all about the money! Based on my experience, I believe it takes the funding of 25 to 50 early stage companies per year per one million residents for any Metropolitan Statistical Area (MSA) to maintain a constant deal flow, and make a lasting impact on the community. For example, the Tampa/St. Pete/Clearwater MSA with its 2.5 million residents should be incubating 75 to 100 early stage companies per year. Using the anecdotal new-company-mortality-rate data this would generate 20 to 30 self-sustaining companies per year. Out of those, 5 to 15 will achieve a significant return for the investors and become deal flow accelerators themselves, spawning other start-up companies. Of course finding hundreds of legitimate early stage companies per year, getting them funded with seed capital, and getting them to the runway and ready for start-up take-off means looking at and evaluating the feasibility of (again based on anecdotal data and personal experience) 300 to 500 ideas/plans per year. That may appear impossible, but all it takes is awareness, some money, and an active program. Just through my participation on the advisory board of the University of Tampa’s Center for Entrepreneurship I hear at least ten decent ideas each semester that are worth exploring.
But where can the money come from?
Other than the three F’s, and Angel Investors who fund many start-ups and most, if not all, small businesses, there are a few formal sources of capital for early stage companies: Venture Capital Firms, Strategic Investors, Money Managers for High Net-Worth individuals (HNWI), and Regional Development Organizations.
Venture Capital firms – VC’s maintain an active role in the startups they fund and want to “drop in” regularly at companies they invest, so VC firms and VC’s are generally not nomadic in nature. They tend to domicile in large metropolitan areas that provide access to institutional capital for their funds, have large universities and large firms who attract and develop talent and spawn new companies for their deal flow, or are great cities for the VC’s to live after they made their money, etc. Even though some VC firms will fund companies not in their immediate geographic area, they usually require a local connection they trust to co-invest and then represent them on Boards of Directors. In the absence of that connection – and a very frustrating outcome to local business leaders – more often than not, a startup company funded by a remote VC eventually packs up and moves to a place close to the VC like Silicon Valley, Boston, New York, etc. If your community is not blessed with an active VC presence, short of finding someone rich who can make a large investment into a VC fund and demand the establishment and funding of a local office, there is not much else a community can do to directly impact their presence.
Strategic investors – Companies with interest in a specific technology coming out of a local university, the success of a local supplier, or in need of support businesses around one of their facilities occasionally fund start-up activities. But that happens only when they can see a clear reason not to pursue it as an internal project, or a new division of their own, or if some of their executives are HNWI actively involved in the community. They generally invest because they can identify what the new company will do to serve their interests, either by creating new technology, exploring new markets, supporting their operations, or extending the life of a product, rather than for the pure economic return on investment. So a strategic investment in an early stage company that creates a new technology the strategic investor can use, or builds a necessary component required for manufacturing, but breaks even financially as a standalone company returning a minimum gain to its investors, is still a success for them. Just like with the VC firms, your community needs to be the “right place at the right time with the right startup” for that to happen.
Money Managers – Some High-Net-Worth-Individuals make their own investments and fall under the 3F category randomly pursuing investments presented by friends, or focusing in an area they have a personal interest in. Those HNWI who have enough money to drive a community as active investors, generally do it through a professional money manager. Unless the HNWI directs the money manager to invest some of their money in early stage startups, money managers almost never do. High investment risk in any single start-up is a key reason individuals avoid investing in really early stage companies so when money managers try to do it on their own, because most are financial planner or portfolio management types, they look for lower risk investments and require an on-going business and revenue status before investing, which disqualifies most early stage companies. Some HNWI’s get around their own, or their money manager’s, risk aversion by spreading the risk and becoming limited partners in VC funds. Unfortunately for small communities, that money is rarely invested locally because investments are subject to the VC domicile preferences described above. So if a HNWI wants to help a community, and has enough money, or can pool enough money from other HNWI, the best thing they can do is to either create their own fund, or invest it with a VC firm that commits to opening a local office.
Regional Development Organizations – RDO’s come in many shapes such as State Economic Development Authorities, State-funded investment funds, regional innovation centers and a number of other structures. These organizations, well intentioned and sometimes well-funded as they may be, most of the times are mired in bureaucracy, are subject to political whims, and rarely staffed by experienced VC’s or executives who can initiate deals and maintain constant deal flow. The one exception is funds and/or resourced dedicated to funding R&D programs in universities, but they generally don’t step outside their limited role and leave the commercialization of the R&D to other groups. RDO’s are best in a supporting role, once the initial money is invested by someone else.
So what’s community to do to establish an active program?
I believe a VC Scout (VCS) firm may provide an answer. A VC Scout firm is, initially, a group of dedicated people who have enough experience, credentials and drive to do the screening work required to start the process and also act as representatives for multiple VC firms. The VCS firm becomes, in effect, a co-founder of many early stage companies it eventually puts on the run-way for take-off, but once the company is launched, it steps back to a support role. Eventually the VCS firm can develop its own early stage fund by using some of its returns from being a co-founder in many start-ups and consolidating the local angel, HNWI, RDO, and 3F capital into a more organized structure.
This is not as easy as it may sound. First, the team working for the VCS firm needs to have a core set of skills:
- Management and operating experience to screen ideas for feasibility and help shepherd the founders through the initial formation and infrastructure implementation of their companies, as well as a track record that potential investors would respect
- Temperament and personality to coach and steer the founders from concept/idea to a cohesive business model and plan
- Financial, economic, and risk analysis capabilities to help founders understand and build economic and financial models and pitch books that can be presented to VC firms
- Administrative and legal capabilities to deal with the deluge of paperwork required to support multiple companies and negotiating experience in putting funding together for projects
- Access to an extensive network of contacts who can act as sounding boards and provide industry-specific views around each idea and form the early advisory boards of the start-up companies
- Access to local incubators, accelerators, etc. who can provide the support required to get from early stage to a start-up, etc.
Each community has people like that, but from what I have observed and personally experienced, the recruiting of the individuals required to build the VCS firm always falls short. The individuals that fit the profile fall in one of two categories. They have the skills, and could put the effort required into the VCS but are working as executives and managers in companies or are entrepreneurs themselves and are not about to go work for free, or a de minimis salary, betting on compensation from the eventual returns, or they are retired executives who have the skills and can afford to do it on the promise of potential returns, but are not interested in working full time or putting in the effort required. I have seen this pattern play out a half-dozen times in the last ten years and I have come to the conclusion that unless there is enough capital to attract and fund the VCS team initially with really talented people and competitive salaries, it never takes off the ground and the community does not develop with any consistency.
But I also think there are options, and I am convinced, for example, that most communities can leverage existing resources to fund the VCS.
Maybe there is a HNWI who understands the concepts and risk of funding early stage companies, and is actively involved in the community who can either fund the VCS’s operating budget directly, or become a limited partner in a VC fund with the condition of establishing a presence in his/her community. Because a VCS would be subject to the Virtuous Cycle – Good things bring more good things – and the Fly-Wheel effect – It takes tremendous initial effort to get it spinning, but once it starts it take less and less energy to get it going faster and faster – a few small initial successes will attract more and eventually grow to a self-sustaining model.
Or perhaps a local corporation(s), private equity firm(s), or business organizations in the area who has a long-term view and dedication to the local community can fund the operating budget of the VCS for a period of, say, three years and participate in the long term returns from the equity the VCS holds in the start-ups it launches. The key is to fund the operating expenses independent of any VC funds the VCS has access to who would not be interested in management fees higher than the norm (1-2%).
What do you think?