Living in the Midwest—a place where venture capital investors are scarce and generally smaller than their venture center counterparts—presents high impact entrepreneurs with a number of challenges not generally encountered by their peers in places like Silicon Valley. One of those perhaps subtle, but quite important, challenges is this: understanding what smaller regional venture investors are looking for in terms of exit scale/timing and associated risk/reward profile, versus what the entrepreneur might be thinking—and how to bridge and manage any gaps.
If this problem seems a little remote, lets start with the investment landscape as it might appear from the perspective of, for example, a Midwest angel fund, or modest (in terms of the national averages) Midwest venture capital fund. In the first case, when you are sitting on say $5 million of angel capital, here’s what you are likely thinking as you evaluate a seed investment in a startup (lets call it Newco): that your little pool of capital is not enough to sustain Newco through a good exit – at least if you are planning, which if you have any sense at all you are, to spread your small wad of cash across a half-dozen or more portfolio companies. This kind of thinking leads, naturally, to thinking about who might provide the needed downstream capital. In the vast majority of cases–using history, as well as common sense, as a guide – that thinking will lead you to a shortish list of nearby venture funds, few of which have even $50 million of capital and almost none of which have $100 million or more.
So, where does this leave our angel investor, as he or she ponders whether to chance a few hundred thousand dollars on Newco? Most likely, it leaves the angel thinking that the key metrics for judging whether Newco would make a good investment are how much capital—and how much time—it will take Newco to get to an exit; by extension, an exit most likely premised on positive cash flow. In more prosaic terms, she is likely thinking something like this: “Is Newco the kind of deal that, with $2-5 million of risk capital, can get off the venture capital treadmill in several years and bought by a bigger company for around $25-50 million?”
While there are exceptions, the vast majority of really big exits involve deals hatched and nurtured in the major venture capital centers. Certainly, there are a lot more exits measured in the hundreds of millions and billions of dollars on the coasts than there are in flyover country. And–a subtle but important point here, in terms of understanding and managing investor expectations–the majority of those smaller flyover country exits are based on profitability, while the majority of the huge coastal deals are based on growth metrics. Companies that exit based on hyper-growth metrics are almost always cash flow negative in a big way right up until and beyond the exit–which is to say, feeding at the risk capital trough right up to the exit.
So, there are three take home points, here.
First, if you are an entrepreneur in flyover country and want to stay there (and for my own selfish reasons, I hope you do), you must appreciate that your pool of regional investors isn’t (for the most part) looking for the next Facebook–a company that needed several hundred million dollars to get to an exit.
They are instead looking for the next startup that can, with considerably less than $10 million, sell itself to Facebook for say 20x the modest amount of risk capital invested. Thus, your pitch should emphasize getting to cash flow positive (and thus off the risk capital life line) as soon as possible, with as little risk capital as possible (try to stay under $5 million). Build your investment model so that the necessary 10x return is 3-5 years out and based on fundamental P&L metrics, not industry-swallowing growth rates.
Second, if you are a flyover country entrepreneur thinking about pitching to established venture investors in places like Silicon Valley, you must adjust your pitch to reflect that those investors need the same kind of 10x return but must put several times as much capital to work. So instead of showing how a small amount of capital can lead to early cash flow, your investment model for these folks should show how a bigger amount of risk capital can lead to outsized mid-term revenue growth.
A brief digression: There is nothing wrong with an entrepreneur pitching two different investment models to two different types of investors. The tricky part is making sure that the entrepreneur and investors come to a common understanding by the time the investment is made. Which leads to the next point…
Finally—and this might be the most problematic situation for many flyover country entrepreneurs in the coming decade, be prepared to work with your current investors if or as the investment opportunity and model shifts. Historically, it has been very difficult to attract the big venture center investors to the Midwest. But that is changing (for example, NEA recently decided to open an office in Chicago), and I suspect the rate of change will be accelerating.
As that happens, more and more flyover country entrepreneurs will find themselves faced with new opportunities—sometimes mid-stream—to pivot from the flyover country “home run” investment model (and its related risk/reward profile), to the venture center “grand slam” investment model, and its quite different risk/reward profile. Entrepreneurs with a stable of flyover country investors with the home run model in mind will find managing the transition to a grand slam model challenging, indeed.