Entrepreneurs strive to overcome seed-financing shortfall

For entrepreneurs seeking seed money, up has become down, black has become white and hot has become cold.

By:
Brad Broberg
Puget Sound Business Journal

In other words, says Ron Howell, "The risk/reward curve has inverted. Early investors aren’t getting paid for taking a risk. Until that changes, it will be difficult for the entrepreneurs and dangerous for investors."

Howell speaks from experience. As president of the Washington Research Foundation (WRF), he likes nothing better than to make early-stage investments in promising young companies. However, in the current climate, he is more gun-shy than gung-ho. "It’s made us more reluctant," he says.

The WRF is a not-for-profit corporation created to license technology developed at the University of Washington, invest in early stage companies, and support research at the UW and other research institutions.

According to Howell, much of the current seed financing shortfall stems from the high-tech boom and bust of several years ago and its ripple effect on the relationship between seed capital and venture capital. Seed capital is generally measured in the tens of thousands of dollars and comes from early-stage — aka angel — investors who have little more to go on than faith in an entrepreneur and the viability of his or her idea.

On the other hand, venture capital is generally measured in the millions and requires a lot more progress by entrepreneurs before investors will participate.

In the past, angels could pretty much count on being rewarded for the increased risk of investing early as long as the company grew enough to attract venture capital. But that was when venture capital investors were more generous with their support.

Now, the hangover from the tech bubble has hardened the VC community — and that translates to a sour environment for early-stage investing, says Howell.

Even when entrepreneurs have all their ducks in a row — appropriate valuation, strong board of directors, attractive market cap — VCs are still wary, which can hang angels out to dry by denying entrepreneurs the funding they need to move their businesses forward, says Howell.

What’s more, when VCs do invest, the terms they demand can gut the stake angel investors assumed they would retain in the company.

"It can look like all you’re doing is taking the risk for someone else’s gain," says Howell.

It doesn’t take a genius to calculate the result. "Seed money," says Howell, "has fallen off the map."

If that’s true, then the Washington Seed Capital Network might be just the organization to put it back — not just in the Puget Sound area but throughout the state.

Created by the Washington Technology Center, the WSCN is forming networks of angel investors in Wenatchee, Yakima, Spokane, Vancouver, Bellingham, the Tri-Cities and the Olympic Peninsula.

According to Nate Silverman, manager of the project, expanding access to seed capital for entrepreneurs statewide is just one benefit of creating new angel investor networks. By connecting those networks to existing networks in the Seattle area, the WSCN will be a conduit for sharing information, expertise and investment opportunities, says Silverman.

Susan Preston shares the belief that the seed capital needs and resources of the state’s outlying communities deserve more attention.

"There’s a lot of wealth in rural communities, but people there don’t always understand (early-stage investing)," says Preston, a corporate finance attorney with Davis Wright Tremaine in Seattle and a champion of angel investing.

The risk for communities without local investment networks is that homegrown entrepreneurs will be forced to leave town to find funding for their businesses.

"You want to keep people like that in your community," says Preston.

The key for entrepreneurs as well as for angels is education, she says. Entrepreneurs must structure their companies so that early-stage investors can clearly see how they will get their money out.

For example, if a company’s market cap is modest, the chances of an initial public offering or acquisition are slim, so an entrepreneur may want to dangle a different carrot such as a limited partnership or buy-back agreement, says Preston.

For angels, the trick is learning "how to make an investment that protects them but doesn’t strangle the company from getting subsequent rounds of funding."

Overall, Preston is optimistic about future seed-capital opportunities.

"The number of nascent angel investors compared to actual investors is something like 7-to-1, so there’s a lot of potential out there," she says.

Evidence that Preston may be right can be found in Spokane, where a a $2 million-plus fund is being created to make early-stage investments in local companies.

"If you can put together the right structure, it’s a good time to invest," says John Pariseau, general manager of Win Partners LLC.

Pariseau’s faith is driven by a strong belief that "innovation is constant," he says. "There are always going to be entrepreneurs working in their garages on their widget, giving it hell, and they don’t say they’re not going to work on their widget because it’s a tough funding environment."

Like all investment vehicles, Win’s goal is to make money, but equally important to its partners is the opportunity to jump-start local businesses and boost the local economy.

"I can’t look investors in the eye and say this is the best possible investment for that slice of capital they have," says Pariseau. "But I can tell them that the money will go to work here locally … and maybe make a little return in the process.

"We’re pretty optimistic," he says. "There are some viable deals out there to look at."