Feature: California Dreamin’ – Two Regions Aspire to Attract VCs –

With overproduction pushing almond prices down to a 10-year low, appetite for the candy-coated wedding favorite has surged, says Eric Merz, founder of Almendros Inc. Deep in California’s agriculture-rich San Joaquin Valley, Merz and his partners are looking for ways to capitalize on the sudden demand by aggregating farmland for large-scale almond production.

About 250 miles to the north, in California’s Sacramento Valley, Steve Watkins is shopping his company, Fame Analytics Inc., to venture capitalists. The company, which specializes in lipid metabolite analyses, has close ties to the University of California at Davis, and is one of the first commercialized biotech efforts to emerge from the university’s research labs.

Their strategies may differ, but entrepreneurs like Merz and Watkins are popping up all over California. Planted squarely outside the high-tech corridor of Silicon Valley, they are trying to tap its frustrated financiers and harness the spillover from its flooded tech sector. This new wave of entrepreneurs is also highlighting the state’s potential across a diverse industry base and pointing to the impact of venture investment in economic development.

“We’re shooting for a 5% to 6% return on the farming side, and there’s little risk with properties being bought at low prices,” says Mark Albert, a partner with Almendros. “If we can project cash-flow return based on historical prices and historical yields, then we can minimize any risk.”

Almendros, which provides farm management and nut harvesting services, is in the market hoping to close a seed round of $20 million to $50 million by year-end.

“For individual investors who want to round out their portfolio, the opportunity to invest in this type of real estate is limited,” says Albert. “It’s a way for folks to diversify into this segment, and in the long term bring in REITs.”

A year ago, Watkins founded Fame Analytics with fellow UC Davis graduate Jeremy Ching. After adding three more to their team, creating a scientific advisory board and securing a steady stream of analytics work, the company now is one-third of the way along in closing its first round of venture financing.

“Enthusiasm has been uniformly great, but whether the check’s in the mail, we’ll find out in the next month or so,” Watkins said. The round is expected to total between $750,000 and $1.1 million – enough capital to fund the build-out of a database of metabolites and double the company’s staff.

Tipping the Scales

Last June the nation’s largest public pension fund, California Public Employees Retirement System (CalPERS), created the California Initiative – an effort to put $475 million to work in underserved rural and urban markets through regional VC firms.

Although California start-ups raised nearly $42 billion from private equity investors last year, almost 75% of that total remained in Silicon Valley. In the San Joaquin Valley, home to Merz’s Almendros Inc., only three companies succeeded in getting $29.2 million in venture funding. Around Sacramento, where Watkins’ Fame Analytics is based, 13 start-ups raised $178 million last year, less than 0.4% of the state’s total venture pool.

In its effort to tip the scale away from Silicon Valley, CalPERS named 11 private equity firms to participate in the California Initiative. The biggest pool of capital went to Los Angeles. On the list, however, were two firms dedicated to investment outside California’s urban centers: a $10 million slice to Sacramento’s American River Ventures Fund and a $20 million slice to Redwood City-based Draper Fisher Jurvetson Central, a still-unformed fund aimed at California’s Central Valley.

“There’s been a steady outward migration from the Bay Area, so the management talent is there, but the funding infrastructure isn’t. Part of the reason CalPERS invested in us is to help build companies that haven’t been reached by Silicon Valley investors,” says Corley Phillips, a principal with American River Ventures and a member of the Sierra Angels. “It’s an advantage for us: Less competition for deals mean better prices for LPs.”

To be sure, funneling money into previously untapped markets does not ensure a successful investment strategy. Capital alone will not multiply into returns for LPs, nor will it sustain a business long enough to transform it into a viable entity with long-term growth prospects.

Indeed, dedicated investment capital is a start for underserved regions, but for areas like Sacramento or the Central Valley, an infusion of VC more often than not is a culmination of long-term, grassroots initiatives aimed at creating a solid foundation for investment.

While Sacramento may well be on its way, California’s Central Valley may still be missing some of the components essential for building that foundation.

It Takes A Village…

Localizing VC is Village Ventures’ trademark. Matt Harris and Bo Peabody head the Williamstown, Mass.-based firm. With a family of 12 regional early-stage funds in 11 states and a vigilant eye on 50 to 60 new markets, Village Ventures has institutionalized the process of transforming a community into a ripe source of entrepreneurship.

Before setting up shop in new markets, Village Ventures weighs four issues.

First, it considers whether there is an existing source of VC in the region. Since venture capital is a local business, the presence of local VCs can indicate where deal flow originates, how competitive the environment is and how successful local entrepreneurs have been in attracting larger late-stage investors.

An active angel investor presence is also a positive indicator. “There’s a fair amount of wealthy individuals from which to raise a fund, and people are reasonably educated on where to put money,” Harris says. At the same time, the firm measures the depth of intellectual capital – whether there are universities in the area, whether there are high-tech employers as well as demographic statistics like overall academic achievement. The level of entrepreneurship and the viability of business plans, says Harris, will often mirror the depth of a region’s intellectual capital.

Finally, Village Ventures gauges a region’s quality of life – an issue that often determines the success of a start-up’s recruitment program – and also factors in the cost of living and doing business in a given region.

Using Village Ventures’ metrics, California’s Sacramento region looks ripe for investment initiatives, but the Central Valley, despite Draper Fisher’s efforts, may have difficulty sustaining a venture program.

Of the 13 Sacramento area companies that got funding last year, the largest deal was a $50 million round for Web-based telecommunications service provider NetStream Communications. Other deals – like the $15 million investment in AgraQuest Inc., a developer of environmentally friendly pesticides, or the $6.5 million investment in AgEx.com, an online crop exchange – draw on the region’s agricultural roots.

However, a flurry of new deals is emerging in the application service provider, software, networking and biotechnology arenas. And a new generation of entrepreneurs is emerging from inside Hewlett-Packard Co. and Intel Corp.’s regional engineering and manufacturing facilities in Sacramento and UC Davis’ biotech research hub. Technologies are being spun from the labs and the recent successes of young companies like Web-based student information system provider PowerSchool Inc., recently acquired by Apple Inc., are creating a climate for entrepreneurship.

Some say Sacramento already has cycled through a first generation of technology-based start-ups. Initially funded by VCs and later acquired or sold on the public equity markets, these entrepreneurs, and the engineers and scientists inside Intel, Hewlett-Packard and the university, are populating a second generation of start-ups.

“The region is seeing more and better start-ups developing. There’s a migration of talent into Sacramento that comes out of a culture of start-ups; they’re more seasoned people that have moved in,” says Jon Gregory, CEO of the Golden State Capital Network.

While early-stage funds like Sacramento’s Akers Capital LLC have long invested in their own backyard, the region slowly has been garnering the attention of more Silicon Valley VCs. Regional efforts like Gregory’s Golden State Capital Network and the Silver and Gold Venture Club have sprung up to harness their attention.

“The region’s clear strengths are in having a leading research university in UC Davis,” Gregory says. “And there’s a natural advantage of being close enough that the investment community that can come take the two-hour drive, visit the company, monitor the investment and sit on the board.”

Lacking Attractiveness

California’s Central Valley, and its regional capitol in Modesto, has few of these advantages.

In the last two years, only Insulair Inc., a manufacturer of insulated paper cups, has been able to attract VC into the region. Founded in 1996, the company has raised almost $10 million since last year in four small rounds of venture financing led by Weston Presidio Capital Management.

Indeed, the Central Valley’s strength lies in its manufacturing and agricultural capabilities. In Stanislaus County, the area surrounding Modesto, after the county government and school district, the three largest employers are the Ernest & Julio Gallo Winery, TriValley Growers and Foster Poultry Farms. Agriculture employs 11% of the 160,000-strong workforce while the manufacturing sector employs 19%. Another 21% commute daily into Silicon Valley.

The Central Valley has neither the history of entrepreneurship nor the depth of intellectual capital usually favored by VCs. But, noticing the job creation and growth potential, the region is billing itself as business-friendly, with a low cost of doing business and a high quality of life.

“The California Initiative was approved by the board in an effort to get capital into rural and urban underserved markets – not poor areas, just ones that have not received a lot of capital,” says Brad Pacheco, a spokesman for CalPERS. “In Modesto and Stockton, we see an opportunity to get some smart money into these areas.”

Draper Fisher has not released any details surrounding its planned Central Valley fund. Still, the firm says, VC can be a successful force in any community where both a feeder system and models of success already exist.

Without a sustained effort from around the community to identify and nurture young business like one that’s taken hold in Sacramento, those opportunities might never arise in the Central Valley.

“What the (Sacramento) region is working to do is to bring people together working on the same goals: Attracting initiation and follow-on capital and creating a supportive environment for entrepreneurs to get their businesses up and running,” says Nora Moore Jimenez, director of UC Davis’ UCD Connect program.

The program, itself seeded by the university just over a year ago, links private sector and university resources with budding entrepreneurs though a series of networking events and information seminars. Although UCD Connect does not fund companies directly, its members include investors, law firms and young companies covering the Internet and life sciences space.

Meanwhile, two angel groups – the Sacramento Angels and the Sierra Angels – have formalized their networks to connect entrepreneurs with facilities, advice and capital.

“Five years ago there was no climate for venture capitalists, but it went up with the surge of angels and venture investment two-and-a-half years ago,” says Roger Akers of Akers Capital. “As the market downturn occurred, as in other places, liquidity dried up. But in this area, a lot of angels are realizing it’s better to invest in their own backyard, especially in the technology arena.” Akers’ venture fund invests in underserved markets like Sacramento and Northwestern California, and Akers himself serves on the board of the Golden State Capital Network and teaches at UC Davis’ Graduate School of Management.

Sacramento has created a foundation for venture investment that cannot be recreated in Modesto and the Central Valley – a large research university, large high-tech employers, a depth of intellectual capital, existing capital networks and a wide net of services for budding entrepreneurs. While Watkins’ Fame Analytics will likely close its first round of funding and launch a venture-driven growth curve, Merz and Almendros Inc.’s path will be more tenuous.