Filling the VC void: Small funds meet big need for startups

Originally posted in crainsdetroit.com on September 11, 2011

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Adrian Fortino counts himself lucky he didn’t have to scrounge for money from family and friends to launch Shepherd Intelligent Systems LLC in Ann Arbor. And so far he hasn’t had to deal with the third traditional “F” source of funds for a startup company: fools.

On the contrary, Fortino speaks highly of the advice he has received from the principals of Huron River Ventures — who, with a syndicate of other investors, closed on an agreement with his company three weeks ago to provide $1.25 million in exchange for an equity stake.

The commitment “means the world to us,” said Fortino, 34, who with partner Jahan Khanna co-founded a business that allows cellphone users to time their arrival at bus stations to meet the bus.

That sort of funding can mean the world to perhaps two dozen other startup companies in Michigan as well.

The recently capitalized Huron River in Ann Arbor and Michigan Accelerator Fund I in Grand Rapids invest in Michigan companies only, providing cash commitments that they say can reach $1.5 million — the no man’s land between the “three F’s” and the more established venture funds that usually consider deals in the tens of millions of dollars.

If all goes according to plan, Huron River and Michigan Accelerator each will raise about $15 million by the end of 2012 to invest in startups over the next few years. But both funds have sufficient capital now to make a difference for companies such as Shepherd.

The duo hope to spawn more small VC firms in Michigan as they themselves mature into midsize funds.

“It’s the most important type of funding that we need in Michigan,” Fortino said. “We have all kinds of good companies out there that are looking for growth capital money right now.”

Huron River and Michigan Accelerator fill a need for startups that have proved their business concepts using money from investors who know the company founders personally but that now need additional capital to compete in bigger leagues or tackle the next milestone.

For instance, Fortino said, Shepherd will use its first “tranche” — VC-speak for drawing some funds from the overall commitment — to market its proprietary software aggressively to university bus systems, limousine services, taxicab companies and shuttle service companies across the country.

The farm club system
Huron River and Michigan Accelerator “are tiny funds, but tiny funds can be very important to a state like Michigan,” said Erik Gordon, a professor of entrepreneurial studies at the University of Michigan and associate director of the Zell-Lurie Institute at the university’s Stephen M. Ross School of Business. “There’s a real need for relatively small amounts of money going to early-stage companies to help them develop their idea to the point they can attract bigger money.”

Adrian Fortino counts himself lucky he didn’t have to scrounge for money from family and friends to launch Shepherd Intelligent Systems LLC in Ann Arbor. And so far he hasn’t had to deal with the third traditional “F” source of funds for a startup company: fools.

On the contrary, Fortino speaks highly of the advice he has received from the principals of Huron River Ventures — who, with a syndicate of other investors, closed on an agreement with his company three weeks ago to provide $1.25 million in exchange for an equity stake.

The commitment “means the world to us,” said Fortino, 34, who with partner Jahan Khanna co-founded a business that allows cellphone users to time their arrival at bus stations to meet the bus.

That sort of funding can mean the world to perhaps two dozen other startup companies in Michigan as well.

The recently capitalized Huron River in Ann Arbor and Michigan Accelerator Fund I in Grand Rapids invest in Michigan companies only, providing cash commitments that they say can reach $1.5 million — the no man’s land between the “three F’s” and the more established venture funds that usually consider deals in the tens of millions of dollars.

If all goes according to plan, Huron River and Michigan Accelerator each will raise about $15 million by the end of 2012 to invest in startups over the next few years. But both funds have sufficient capital now to make a difference for companies such as Shepherd.

The duo hope to spawn more small VC firms in Michigan as they themselves mature into midsize funds.

“It’s the most important type of funding that we need in Michigan,” Fortino said. “We have all kinds of good companies out there that are looking for growth capital money right now.”

Huron River and Michigan Accelerator fill a need for startups that have proved their business concepts using money from investors who know the company founders personally but that now need additional capital to compete in bigger leagues or tackle the next milestone.

For instance, Fortino said, Shepherd will use its first “tranche” — VC-speak for drawing some funds from the overall commitment — to market its proprietary software aggressively to university bus systems, limousine services, taxicab companies and shuttle service companies across the country.

To some extent, Gordon, 58, oversees his own tiny fiefdom as adviser to the university’s Wolverine Venture Fund, a $5.5 million fund that serves as a laboratory for MBA students learning to be tomorrow’s venture capitalists.

But where Wolverine Venture can invest in a startup regardless of its location, Huron River and Michigan Accelerator can invest only in Michigan companies because of a patron investor: the Michigan Economic Development Corp.

The MEDC has committed $6 million to each fund, with some stipulations that essentially try to foster job creation in the state, Gordon said.

Michigan is far from unique in using taxpayer money for venture capital. Florida and Maryland are just two examples of states that Gordon said are active in venture funding.

A venture capital firm won’t all of a sudden “move here or just spring up,” Gordon said. “The typical way it works is a venture capitalist or group of venture capitalists start with a very small fund, and they create a track record.”

At the same time, when first-time entrepreneurs need startup capital, they need to understand they are entering a VC farm club system.

“You can’t start with, “Well, I’ve got this great idea from the University of Michigan laboratories or Michigan State lab or Grand Valley lab, and you just give me $20 million and I will get going on it,” Gordon said. “A startup needs to crawl before it can run the marathon of the business world.”

Definitions in the venture capital industry are somewhat loose at the first stage, but pre-seed money usually comes from those who are well-acquainted with company founders, and seed money usually comes from high-net-worth in-dividuals who serve as angel investors. In both cases, the investors put up their own money.

After founders have reached proof-of-concept with the initial funding, they usually seek early-stage VC funds such as Huron River and Michigan Accelerator, which are managed by professionals who handle money from other investors.

“Hopefully, the company needs more money yet: It’s at a stage where they have a more advanced story to tell,” Gordon said. “Now they will need between $2 million and $5 million, and someone like Huron River will get together with a bigger VC firm to syndicate the next round of funding.”

Fortino said he has gotten much more than just cash from Huron River and another VC firm, RPM Ventures in Ann Arbor, which started in 2000 as Waypoint Ventures and has invested in more than 20 companies. Huron River and RPM share offices in Ann Arbor and collaborate closely on opportunities.

“My partner and I were introduced to one another by RPM,” Fortino said. “Jahan was a math graduate student working on the Magic Bus system — the precursor to our system — and he knew there was something there, but he needed help on the business side.” Khanna, 24, is chief technology officer of Shepherd, and Fortino is CEO.

Early VC firms have relationships with larger funds that become essential as a startup needs more capital, Gordon said.

“A fund like Huron River will use its credibility and connections to syndicate the next deal,” he said.

That syndication can occur at an early stage, said Tim Streit, a managing director of Huron River. The fund’s first investment was in Ambiq Micro Inc. late last year as part of a $2.4 million syndication that included investments from Draper Fisher Jurvetson and Cisco Inc. Ambiq Micro is a UM spinoff that claims to have created the world’s most energy-efficient microcontrollers, which operate for long periods on very small batteries.

Ambiq Micro was based in Michigan when it received its funding. The company has since moved its headquarters to Austin, Texas, because that city is home to a number of computer companies. But several Ambiq principals still live in Michigan.

Streit, 33, said his fund usually expects to take an equity stake of one-third to one-half of the value of the company, either by itself or as part of a syndicate. One of the most difficult tasks that all the parties face during negotiations is to determine a reasonable value for the company before the cash investment.

Dale Grogan, who manages Michigan Accelerator along with his partner, John Kerschen, said his fund expects to take similar equity stakes in the companies it backs.

That scale of investment provides enough capital for the startup to grow and keep the entrepreneurs motivated to persevere, but also gives the VC investors a significant say in how the company is run.

“I don’t look at it as if I am losing a slice of the pie,” said Fortino, who would not disclose the percentage stake sold. “I look at it as I may have a smaller slice, but they will help create a much, much bigger pie. On an absolute basis, I’m going to have a much greater overall equity in the venture.”

With its investment, Huron River was given a seat on Shepherd’s board that will be filled by the fund’s other managing director, Ryan Waddington, 40.

The law of averages
Like other small firms trying to establish themselves, Huron River and Michigan Accelerator have to break into the VC industry by taking on deals that are too small for more established funds to consider.

“If you’re a midsized venture capital fund managing $400 million to $500 million, you can’t make investments of $250,000,” Gordon said. “You’d have to make hundreds of investments that size just to deploy your fund.”

Michigan Accelerator already has assessed at least 150 deals since January, Grogan said, ranging from ideas that don’t stand a chance to well-developed business plans “that almost immediately they have everyone circling around them.”

For instance, Michigan Accelerator has made two investments in Metabolic Solutions Development Co. in Kalamazoo (featured in the Aug. 8 issue of Crain’s Michigan Business) in what was considered a later and more mature round of financing. Grogan said the Met—abolic Solutions investment isn’t typical for Michigan Accelerator, but he is elated to have been part of the syndicate — a result of relationships in the West Michigan monied community.

Waddington said he and Streit probably have reviewed more than 250 proposals during the past two years.

Both funds say they see good deal flow — the term assigned to proposals being brought to them for investment. Out of the raft of proposals, each fund aims to select three to four deals a year for investment.

The funds apply standard averages in the industry for failure and success rates. Probably one-third of the deals will be entire losses, the second third may preserve the initial investment with a loss or gain of perhaps 20 percent, and the last third will provide a return of at least five times the original investments. The funds typically hold their equity stakes more than five years before selling.

Even in a case of the failures, the state gets something for its investment, said Gordon, the UM professor who oversees the Wol-verine Venture Fund.

“The investment may turn out to be zero for the funds, but the return for the state of Michigan will not be zero,” he said. “About five (of 10 investments) may be worth nothing — it’ll be a great idea, but when you scale it up, it will fail. But the people who launched the companies have learned a lot along the way, and they may go on to create other companies in Michigan that succeed.”

Staying with what you know
Starting with a $6 million commitment from the Michigan Strategic Economic Investment & Commercialization Board, Huron River has attracted an additional $3 million toward its goal of managing a fund that it hopes will top $15 million by the end of next year.

Both Shepherd and Ambiq Micro are sweet spots for Huron River, which looks to invest in technology companies that conserve or extend energy and natural resources. But Waddington said the fund’s emphasis on clean technology with a positive environmental impact doesn’t include development of alternative-energy devices such as photovoltaic cells, wind turbines and battery storage. Commercialization of those technologies takes investments of hundreds of millions of dollars and years of work.

To be successful, a fledgling fund such as Huron River must select a few companies that are highly efficient with capital and can bring a moneymaking product to market in a few years.

Waddington cut his teeth on assessing energy technology while he worked in the late 1990s in the corporate business development office of DTE Energy Co., where he was involved in about 19 venture capital transactions. He also did stints as director of venture services with NEXTEnergy, a Detroit-based nonprofit that channels federal grants to energy companies and incubates emerging clean-tech companies, and as a director of ZBI Ventures, the venture capital group within New York City-based Ziff Bros. Investments.

“The energy industry is very capital-intensive and very slow-moving,” Waddington said. “For us to be successful, we need to be very capital-efficient and have a relatively short cycle time — yet still have technology that has a positive environmental impact. As it turns out, companies like Shepherd are a very good fit for us.”

Streit said he owes some of his venture capital connections to stints at Hongkong and Shanghai Banking Corp. in Chicago and JPMorgan Chase & Co. in New York City. He holds a bachelor’s degree in mechanical engineering from UM and an MBA from the University of Chicago.

One of Huron River’s strategies is to commercialize research being done at UM, Michigan State University and other state institutions. Last month, Huron River and other organizations sponsored a five-day course in Grand Rapids that drew 21 researchers from 10 Michigan universities to instruct them on how to build businesses from their ideas.

The fund’s investment advisory committee consists of Marc Weiser and Tony Grover from RPM Ventures, Jim Adox from Venture Investors and Peter Mills from @Ventures.

Starting with a $6 million commitment from the state, Michigan Accelerator has reached its initial goal of $10 million and hopes to reach perhaps $15 million, Grogan said.

Michigan Accelerator has a close relationship with Grand Valley State University and Hopen Life Science Ventures, a Grand Rapids-based venture capital firm that recently launched its second fund with a target of amassing $50 million by the beginning of next year for investment in early to midstage life science businesses involving pharmaceuticals, medical devices and diagnostics.

Besides life sciences, Michigan Accelerator looks to invest in homeland security, information technology, advanced manufacturing, agriculture and biofuels, and possibly alternative energy, “although we don’t claim expertise in that space,” Grogan said.

Grogan said he gained some of his experience in finance as president of Leapfrog Smart Products Inc., a Florida company that developed and marketed smart cards — wallet-size plastic cards with embedded integrated circuits for identification and authentication.

About three years ago, Grogan joined Kerschen at The Charter Group, originally a business brokerage in Grand Rapids that evolved into an adviser on mergers and acquisitions with a subsidiary, Charter Capital Partners, that invests in businesses and forms syndicates. Charter has been involved in investments in Alliant Health Care Products in Richland, Intervention Insights in Grand Rapids and Grand River Aseptic Manufacturing in Grand Rapids. Kerschen, 44, is managing director of The Charter Group.

The investment review board of Michigan Accelerator is Kerschen; Mark Olesnavage, chairman of Hopen; Mahendra Ramsinghani, who is managing director of the First Step Fund in Detroit; and serial entrepreneur Craig Hall in Grand Rapids. Hall also advises Huron River on day-to-day activities.

The hope is that the state will continue backing first-round venture funds such as Huron River and Michigan Accelerator.

“We have a lot of smart people in Michigan,” Gordon said. “We have lots of engineering people, we have lots of life science people — we are a state that is rich in potential new companies. To make that happen, we have to be rich in sort of a venture capital ecology.

“The reason that these little guys, even though they’re little, are important is they become the big guys.”

Matthew Gryczan: (616) 916-8158, mgryczan@crain.com