Sequencing Venture Capital

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Thomas McInerney

Stage 1, Pre-Seed: Friends & Family

It’s no surprise to Mark Epstein that his son, Corey, has developed a knack for building businesses. The elder Epstein started a Denver technology company in the 1980s and later took it public.

So when Corey Epstein approached his father last summer with an idea to start an e-commerce company to sell men’s clothing on the cheap, Epstein didn’t hesitate to pledge money to help the venture.

“When Corey told me he was interested in doing this, I totally supported him going out and making that change,” said Epstein, 59. “As long as he had done the research, I probably would have backed anything he wanted to do.”

Epstein participated in what is commonly referred to as a friends and family investment. These deals are more nebulous than other startup investments because they often happen before a company has even established an office, hired its first employees, or started selling a product or service.

The size of the deal can vary greatly depending on a venture’s startup costs.

Corey Epstein said he wanted to own as much of the business at the beginning as possible. So he put $150,000 of his own money into 20Jeans and then reached out to friends and family for an additional $25,000.

Raising money from loved ones can help a founder make it through a startup’s early stages before tapping more established investors. But it also comes with its own set of problems: namely, the risk of mixing business with family.

Both Epsteins took steps to ensure that a sticky financial situation would not ruin their relationship. Corey Epstein, for instance, made sure he was financing the majority of his company in the early days. And Mark Epstein, now retired, made only a small investment.

“My future doesn’t depend on his success,” said the senior Epstein. “I’m glad I’m in a position where I can help him out and where it won’t negatively impact me if something goes wrong.”

Stage 2, Angels: Early Round Integral to Growth

The surge in startup activity in Los Angeles has created a steady stream of potential deals for the local community of angel investors.

Though angel investments often occur under the radar, the wealthy people behind the deals are integral to the funding ecosystem. Angels help startups – many of them without proven business models – fill the gap between raising money from friends and family and reaching out to institutional investors that will take significant ownership cuts.

Dozens of individuals – both career angels and active tech executives – invest in a startup’s seed and Series A rounds.

These investments can range from $25,000 to $250,000, depending on the angel, and taken together lead to a seed round typically south of $3 million. Some angels like to make a few large investments for a big piece of the equity pie, while others prefer to participate in many smaller deals and take only a 1 percent or 2 percent stake in the company.

Because angels invest their own money in deals, their investing patterns are less rigid than venture capital and private-equity firms.

Jarl Mohn, a longtime television executive-turned-angel investor, started investing by writing only a few million-dollar checks each year. But he soon settled into a habit of writing smaller checks.

“It’s more fun,” said Mohn, the former chief executive of E! Entertainment. “I get to see more opportunities and get in earlier.”

For angels, the decision to invest in a company is largely personal. Though standard criteria include an experienced founding team and a product that stands out from the pack, most angels said they base their decisions on intuition.

For Mohn, it typically takes three phone calls before he’s ready to write a check. Meanwhile, Thomas McInerney, an active L.A. angel, said he’ll often decide to invest in a company while meeting with a founder over a meal. Robert Jadon, also an angel in Los Angeles, said he vets startups by talking to his network of tech entrepreneurs and investors.

“As an angel, I don’t get to see any of the company’s traction because I’m investing too early,” Jadon said. “It’s really a lot more about feel than metrics.”

INVESTOR PROFILE: THOMAS McINERNEY

TITLE: Angel investor

COMPANY: Self-employed

YEARS AS AN INVESTOR: 4

LOCAL INVESTMENTS: Lettuce, an iPad app for small businesses; Zefr, a YouTube monetization platform; Burstly, a mobile advertising tool.

What’s your standard investment size?

My typical investment is $25,000 to $100,000 and my average is $50,000.

What rounds will you participate in?

I’m always in seed and I sometimes do series A. I’ll certainly do my pro rata, which means that in subsequent rounds I’ll invest to keep my ownership the same and prevent it from being diluted.

What is your time line for expecting a return?

The irony is that the best companies take the longest, like Burstly and Zefr. They are taking a long time now, but they have big ambitions. They aren’t just a quick talent acquisition.

What is your benchmark for how many deals you make a year?

If I were smart, I’d have more of a sense. But then again, you don’t know when something great is going to happen. I know how much I have in my personal bank account and I have to watch that. That’s probably the biggest indicator.

Describe a time where you made a mistake or regretted an investment.

The second deal I saw was AirBNB, which I didn’t end up doing because I was just so new at investing. I kick myself every day for that. But it gave me the impetus to be more aggressive as an angel.

Stage 3, Small VC: Most Active in L.A.

In the last year, at least four venture capital firms dedicated to funding at the seed and early A rounds have sprung up in Los Angeles. They have joined a group that has become the most populous and frequent investors in the local tech scene.

New to this cadre of companies – which invest between $100,000 and $1.5 million in each startup – are Karlin Ventures, Tenoneten Ventures, Canyon Creek and Plus Capital. Already established in this funding stage are Baroda Ventures, Siemer Ventures, Anthem Ventures, Double M, DFJ Frontier, CrossCut and others.

In a sense, the sheer number of local companies that participate in these smaller funding rounds reflects the stage in which L.A. tech finds itself. Plenty of startups have come together (perhaps through an accelerator), stabilized their revenue models and are looking for the first infusion of significant money to prove their business model.

“The early stage funding is probably the strongest I’ve seen it in 20 years,” said Paul Bricault, a longtime venture capital investor in Los Angeles. “Hopefully that means more companies will have the capacity to bring in late A or B rounds and eventually exit.”

At this level, companies that pitch themselves to the venture capital community have enterprise values hovering around $30 million.

In most cases, V.C. firms have the option of taking the role of the round’s lead investor or following as part of a financial syndicate. Taking a lead position requires a firm to be the largest investor as well as taking on the responsibility for vetting a business’s bona fides.

The choice of whether to lead or follow is often intrinsic to a firm’s investment strategy. While leading a round gives an investor a larger equity stake in the startup, they risk greater losses should the business go under.

Santa Monica’s Siemer Ventures, which has been among the most active investors locally and has chipped in to startups such as Adly and StyleHaul, prefers a quantitative approach. Among the 24 investments the company made in 2012, few were above $1 million and in none did it take the lead.

A smaller investment does run the risk of having the equity diluted as a company raises bigger money down the road, but as Siemer Managing Partner Eric Manlunas looks at it, “I’d rather have a smaller piece in a bigger pie, than a big piece in a small pie.”

INVESTOR PROFILE: ERIC MANLUNAS

COMPANY: Siemer Ventures

YEARS AT COMPANY: Began investing in 2003. Been at Siemer Venture since firm’s inception in early 2011.

SIZE OF FUND: $30 million

COMPANIES INVESTED IN:

Invested.In, Social Annex, Club W.

What types of companies do you invest in?

We’re in three verticals: Internet software and mobile services, and within those we’re big into ad tech; e-commerce; and digital media.

How do you valuate a company?

There are four elements I look at: How big is the market; how does it fit into it; what is the quality of the team; and what are the financial risks involved. Those are the things we evaluate, but it’s more of an art than science. It’s a function of all those elements and negotiations with the founders.

What’s your time line for expecting a return?

Anywhere from three to seven years. It’s been averaging around that time frame. Our first exit, CloudTrigger (a San Diego cloud software maker), was 14 months. But most are obviously within that three- to seven-year mark. At the rate we’re going, we expect exits to happen on a yearly basis in the next few years.

Are there any concerns you have about the local funding scene?

What we don’t have enough of is the bigger firms who can do follow-on beyond series A. But there is plenty of money from up north and ultimately the good companies that are proving metrics will get money and the mediocre ones struggling to prove their concept will struggle.

Stage 4, Midsized VC: Local Leads for A and B Rounds Not Easy to Find

Firms in Los Angeles willing to write out seven- or eight-figure checks for tech companies are becoming a rare breed.

Only three local venture capitalists actively participate in late A or B rounds here: GRP Partners in Century City, and Santa Monica’s Greycroft Ventures and Rustic Canyon Partners. As recently as the mid-2000s, that list was considerably larger.

A startup looking for an A or B round has already acquired customers, is probably producing revenue and needs more capital to begin competing with some of the entrenched competitors.

Ironically, as the local scene continues to pop out companies looking to raise money, the number of venture capital funds that can lead an A or B round has shrunk.

Firms such as Palomar Ventures, Steamboat Ventures and Clearstone Venture Partners, once stalwarts of the midstage investment scene, have either spent down their funds or are only looking outside the area to invest.

During the heady days before the first tech bubble, venture capital firms were forming nationwide. The bubble’s burst, however, led to a silent vow by many investors to be more cautious. And they were already wary of Los Angeles.

“A lot of the institutional money still doesn’t believe in L.A.,” said Mark Suster, a partner at GRP. “That’s starting to change, but they don’t believe in L.A. because returns have not been historically great.”

In a startup economy, where less money is floating around to help bring companies to the next level, many promising businesses aren’t afforded the chance to scale and succeed. For most businesses, it is a make-or-break stage.

Venture capitalists are routinely looking at startups whose values are nearing $100 million range, perhaps even higher. As such, firms that lead a round in this stage invest up to $10 million.

The gap between the many funds that contribute in seed rounds and the few that come into the picture later on is responsible, in part, for an investment falloff known as the “Series A crunch.”

It’s unclear whether this phenomenon is the result of an overheated seed-round market, signs of a healthy financial ecosystem or perhaps both.

No matter the cause, one fix locally might just be having more venture capital firms raise bigger funds and invest at higher levels.

“I would love to see more venture capital firms in L.A., which surprises people because it seems like competition,” said Rustic Canyon’s David Travers. “But GRP and Greycroft are not our competition. Our competition is people thinking ‘Just go to (Silicon Valley) to get funding.’”

INVESTOR PROFILE: DANA SETTLE

COMPANY: Greycroft Partners

POSITION: Founding Partner

YEARS AT COMPANY: Seven

SIZE OF CURRENT FUND $175 million

INVESTED IN: AwesomenessTV; Adly; Epoxy.

DEALS PER YEAR: 25

What is your standard investment size?

$500,000 to $5 million.

What rounds will you lead?

We will do what makes sense for the entrepreneur. We don’t have to lead, but are happy to lead if it makes sense. And we won’t fund a company without fellow investors.

How do you determine a company’s value?

We have a broad and deep net of people that we tap into. We’re surrounded by companies and place them into our ecosystem and get feedback on how acute the problem that they’re solving is.

What are the most important criteria you look for in a company?

The No. 1 pattern is successful repeat entrepreneur teams doing it again in the same space with the next iteration. We look at teams working together again even if it’s in a slightly different area.

What is your time line for expecting a return?

Our fund life is 10 years and we hope to see (an exit) in three to five years. But we can be patient.

Stage 5, Private Equity: Investors Wait, Looking for Positive Cash Flow

Los Angeles is home to dozens of deep-pocketed private-equity firms that invest tens or even hundreds of millions of dollars at a time. Just don’t look for many of them in Silicon Beach.

Private-equity firms take risks and bet on up-and-comers, sure, but unlike venture capital firms, they tend to avoid investing in businesses that aren’t profitable or that have relatively short histories.

Ryan Wald, a managing director at Westwood’s Gores Group LLC, one of the region’s biggest private-equity groups and a longtime investor in tech companies, said Gores isn’t invested in Silicon Beach companies because they’re too small, too young and too risky. The firm typically invests in more mature companies that have had at least a few years of positive cash flow.

“Venture capital guys are going to have a lot more misses than we are,” Wald said. “We have more of an eye toward downside protection.”

What’s more, Gores and other large private- equity firms that perform leveraged buyouts – deals secured by the assets being purchased – aren’t interested in buying young companies that lack the equity to secure a loan. There’s more interest in tech companies from firms willing to take minority positions in a company and to invest with little or no leverage, but there’s still not much, especially locally.

Kayne Partners, part of Century City private- equity firm Kayne Anderson Capital Advisors LP, invests in tech firms, but few local ones.

“Historically, Los Angeles has not been a particularly fertile location for Kayne Partners when it comes to technology investments,” said Doyl Burkett, a partner at the firm.

Like Gores, Kayne typically invests in companies that are cash-flow positive and that have $10 million or more in annual revenue. But both firms expect there will be many more local companies meeting those criteria over the next few years. And that will likely mean more private-equity dollars flowing toward Silicon Beach.

“Today, it’s not a place for us to play, but I do think, ultimately, it will be,” Wald said. “If these businesses have good cash-flow profiles and there’s a decent level of predictability, I expect we will start to look at them.”

INVESTOR PROFILE:: DOYL BURKETT

COMPANY: Kayne Anderson Capital Advisors LP

POSITION: Partner

YEARS AT COMPANY: Four

YEARS IN PRIVATE EQUITY: 15

SIZE OF CURRENT FUND: $100 million,

two-year fund.

What types of companies do you invest in?

We invest in businesses that are solving large, well-established problems by utilizing current or next-generation technologies. Most of our companies are not capital intensive and have a meaningful portion of revenue that is recurring in nature.

What is your average investment size?

Most of our investments are $10 million to $15 million. We often like to take a staged approach with our investments. We may start with a $7 million investment and then invest additional growth capital over time.

What size of company do you typically invest in?

Revenues when we first invest are normally between $10 million and $50 million.

How big a stake do you typically take in a company?

We focus on minority deals and usually take a 10 percent to 40 percent stake in our portfolio companies.

How do you evaluate a company? Please walk us through that process.

Generally speaking, we start with the standard analyses: comparable public companies, comparable transactions and discounted cash flow. Then we expand our process to consider recurring revenue models, long-term contracts, and strong track records of growth and profitability.

What is your time line for expecting a return?

Three to seven years.

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