Financing in Purgatory An emerging class of investors is beginning to fill the nether regions of start-up financing – the murky –

When Hans Severiens, a retired venture capitalist and angel investor, established San Francisco’s Band of Angels in late 1994, he believed he was embarking on a part-time project.

He soon realized, however, that running an investment club like the Band, now regarded as the industry’s premier angel network, was an expensive, full-time endeavor – which included mailing a monthly newsletter, traveling on due diligence trips and organizing monthly club meetings. To cope with all of the responsibilities, Mr. Severiens began charging fees to Band members and hired an office staff.

“You have to make a basic decision: Do you want to be a dilettante, or do you want to be a professional?” he says, noting that he gets calls all the time from investors hoping to copy the Band’s success in other markets. “It’s not a simple thing if you want to do it right.”

Pre-venture capital investing has long been – like the venture industry itself originally was – an informal process. But as VC vehicles and average deal sizes grow larger, so too does the seed capital requirement angels and other pre-VC investors must be able to finance. As a result, individual investors have devised a slew of ways to put their money to work, including more formalized investment clubs and small venture funds that cater to individual investor limited partners – all of which can often bridge the gap between angel money and a traditional institutional round of venture capital.

Spreading Their Wings

According to Venture Economics Information Services, a data company affiliated with Venture Capital Journal, limited partners invested a record $24.34 billion in venture capital funds in 1998 (VCJ, March, page 44). The figure, 90% of which comes from institutional investors, represents the latest coordinate on a hyperbolic rise that began in 1991. Clearly, the impressive returns generated by the runaway bull market in the 1990’s have spurred institutions’ support of the growth of the VC industry.

And clearly, entrepreneurs and high-level executives – the very individuals who comprise the angel investor class – have benefited from venture capital’s growth. VCs invested a record $16.02 billion in 2,692 companies last year (VCJ, March, page 39). Coupled with a booming economy, the abundant availability of capital has fueled a number of initial public offerings and sales, leaving many cashed-out entrepreneurs looking for new projects to sink their money into.

Professor Jeffrey Sohl of the Center for Venture Research at the University of New Hampshire – the organization where the term “business angel” was coined around 1980 – says that research conducted in the past 18 months indicates conservative estimates of as much as $20 billion of available angel money. While the figure is not completely reliable, considering angels are reluctant to disclose their personal finances, it is certainly noteworthy.

When angels have invested in groups in the past, it has usually been through angel clubs, such as Mr. Severiens’ Band of Angels. These clubs screen entrepreneurs before a monthly meeting at which investors get to hear a quick business pitch. Interested investors can attend a smaller, second luncheon before deciding whether to commit.

The Band, one of the few angel organizations to keep figures on its investment activities, has invested $45 million in 86 companies over the last four years. The internal rate of return on those investments is about 29.6%, Mr. Severiens says.

In light of the organization’s success, however, it is misleading to refer to Band of Angels as a “club,” Mr. Severiens emphasizes. Running the Band is hard work, and the organization’s ranks grow each year. What began in 1995 with about a dozen investors pooling their money has evolved into a network of more than 10 times that size.

That growth is indicative of the angel investor class as a whole. UNH’s estimate of $20 billion of angel money – which, Prof. Sohl explains, does not include start-up financing from entrepreneurs’ friends and families – is rapidly swelling as the market frenzy for Internet stocks creates more IPOs, more mergers and acquisitions and, thus, more cashed-out entrepreneurs.

While the creation of new wealth has baptized more angels than ever before, it also has spawned a savvier class of individual investor. And as the average VC deal size approaches $6 million, angels are not always content to simply invest a few thousand dollars in a start-up in a familiar industry. Accordingly, these individual investors have found more sophisticated, “institutional” ways to put their money to work.

Institutional Angels

Joanna Rees Gallanter, founder and managing director of Venture Strategy Group in San Francisco, was working as a merchant banker in 1995 when she began to sense an opportunity for seed-stage investing. Venture vehicles, she noticed, were getting larger and increasingly focused on later-stage investing, in part due to an influx of fund managers with investment banking backgrounds who were more comfortable with more mature investments.

Ms. Gallanter believed a pre-venture fund that coupled investors with entrepreneurial know-how with emerging technology companies could fill the emerging early-stage financing void. She launched Venture Strategy Group in July 1996, first concentrating on strategic consulting and traditional private placements for technology companies reliant on a strong brand or “the nexus of brand and technology,” she explains.

In March, the firm closed its first fund, Venture Strategy Partners, a $25 million vehicle primarily raised among executive officers and individual investors who can provide a specific set of entrepreneurial and management skills to start-up companies (story page 18). The vehicle, whose limited partners must invest a minimum of $100,000, will finance deals ranging from $500,000 to $2.5 million, primarily on the West Coast.

What does Venture Strategy Group bring that angel investors cannot? “They’re getting an institutional investor that’s highly focused,” Ms. Gallanter says, noting that individual angels have been known to lose interest in some of their ventures. “They’re getting the resources of a strategic partner.”

VIMAC Corp. in Boston has a similar strategy to Venture Strategy Group. The firm’s origins go back to 1982, when a group of individual Swiss investors set up an angel club to scout deals in New England. The Swiss hired a professional staff to head the effort, and when the angels happily left with some good returns by the early 1990s, VIMAC began offering its services to other individual investors in the area.

VIMAC, which concentrates two-thirds of its deals in information technology and the remainder in medical devices, offers two ways for angels to invest. In “sole purpose limited partnerships,” the firm screens deals that average between $600,000 and $700,000 and brings them to the firm’s pool of angels. The individual investors can choose which deals they like and invest a minimum of $25,000 into a limited partnership set up solely for the specific deal. VIMAC also offers Vintage Trust, a more traditional venture fund that invests in all of the sole purpose limited partnership companies.

The firm fills an early-stage void that larger VCs cannot reach, investing from less than $1 million to about $2 million per round. “There’s so few VC funds that can play in the small deals that we play in,” says VIMAC Director of Investments Neal Hill. “We rarely see any of the big VC funds in those spaces.”

Eric Spitz, CEO of VIMAC portfolio company Trakus Inc., learned that firsthand. The two-year-old company, which is developing a technology to provide objective analysis for commentators of sporting events such as hockey and football games, is currently beta-testing its product. Trakus had little trouble raising several rounds of money from friends and family, but when it came time to raise a larger institutional round, there were not many takers. “We were pre-product in an unproven market,” Mr. Spitz says. “We found it difficult to raise VC money.”

Trakus soon found VIMAC, however, which was able to help the company raise a $2.2 million round in 1998. What was the difference between VIMAC and Trakus’ earlier, individual investors? “They’re definitely professional investors,” says Mr. Spitz, noting the firm’s skill in structuring and syndicating the deal.

And when Trakus raises its next $8 million to $10 million round later this year, VIMAC will be there to help. “Our role is to get companies ready for the larger VC funds in later rounds of financing,” VIMAC’s Mr. Hill says.

Heavenly Cooperation

While some VCs lament that angel clubs and intermediary firms like Venture Strategy Group and VIMAC now compete for early-stage deals, that is typically not the case in reality. More often than not, individual investors and VCs see the inherent value in their complementary relationships.

While Venture Strategy Group’s investors are primarily individuals, several venture firms, such as Brentwood Venture Capital, JW Childs Associates and Catterton Partners, as well as individual partners from Benchmark Venture Partners and US Venture Partners have invested in the fund as L.P.s. These firms see Venture Strategy as a sort of “farm league” for their much larger vehicles.

“[Venture Strategy] is going to see a flow of deals that are frankly below our radar screen,” says Michael Chu, a general partner at Greenwich, Conn.-based Catterton. “We have to be very sensitive about deal size.”

Catterton, which makes investments ranging from early-stage to leveraged buyouts in consumer-oriented businesses, recently began marketing its fourth fund, targeted at $350 million, more than twice its prior vehicle’s size (story page 20). Catterton’s general partnership – not any of its funds – invested in Venture Strategy to get in on the ground floor of seed-stage deals that the firm could not touch with its much larger vehicle, Mr. Chu explains.

While VIMAC does not have any formal arrangements with traditional venture capitalists, the firm does routinely discuss deal flow and pass on more mature investments to larger firms.

“We’re delighted to have any new entrant to join us in [the seed-stage] part of the market,” says Gordon Baty, a general partner of Zero Stage Capital in Boston.

Zero Stage closed its sixth fund in October on $125 million, 150% larger than its previous effort. The firm still does some fairly small deals, but Mr. Baty concedes that it has become more difficult with the larger vehicle. “There’s more [deals] … than we can fund ourselves,” he says. “We’re always happy to work with VIMAC.”

And as the vibrant economy continues to churn out successful start-up businesses, new angels will continue to join the fold. Depending on their interest level or their tolerance for risk, this growing class of investors will continue to find new ways to pool their money and invest in bigger deals. Mr. Severiens’ Band of Angels, the poster child for individual investing on a group basis, is helping to put together a small VC fund in which it will invest as a limited partner.

“Clearly, there’s a lot of wealth being created,” says UNH’s Prof. Sohl. “The [angel] market is certainly getting larger.”

And – when one considers the variety of ways angel investors are creeping into later rounds of financing – decidedly more devilish.