Wednesday, June 23, 2010
How I See It
It's time for innovation in financing innovative startups
By Andrew Updegrove, partner at Gesmer Updegrove LLP
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All across New England, a new wave of innovation is evident: proponents of “lean” bootstrapping are meeting to compare notes; incubators of all types are springing up while the granddaddy of them all, the Cambridge Innovation Center, expands dramatically in size.
Meanwhile, entrepreneurs are developing and rushing products onto new mobile platforms and into the cloud. It seems like innovation is everywhere.
It’s everywhere except, of course, in startup financing. Compare a venture capitalist’s term sheet from 1980 to one drafted today and you will be hard pressed to find a meaningful difference. To the extent that the VC investing model has evolved, it has done so by becoming more narrowly selective. Back in 1980 (or even 1990), many funds would look at almost anything innovative with high growth potential. But now? VCs complain about too much money chasing too few deals, but the real issue isn’t any scarcity of quality business plans. The problem is how small the eye of the needle has become that those plans must squeeze through.
Angel investors have become more selective in their interests and more rigid in their deal terms as well. Most now invest only through groups that use VC-style term sheets and criteria.
The sad reality is that while dramatically more money now flows into emerging companies, the percentage of companies eligible to access these funds has greatly decreased. All that money is clumped into much larger funds and angel groups, all seeking the home run opportunities that, coincidentally, carry the highest risk. Meanwhile, the far greater number of companies able to hit doubles and triples with much less chance of a washout goes largely unfunded.
Now, that is strange, because normally when an unserved niche appears in the marketplace, savvy observers move in to exploit it. Not so with finance, though. Investors are willing to fund the innovation of others, but the founders of the funds they entrust their money to don’t seem to be very creative at all.
This lack of vision is bad for investors and entrepreneurs alike. Over the last 25 years, the failure rate of minimally capitalized companies we have represented has been very low. But the frequency with which these same clients have achieved exits in the $10 million to $100 million range five to ten years after formation has been very high. Had financing been available, most of these companies would have taken it, and their investors would have profited quite handsomely.
Today, the opportunities for non-VC profile investing are greater than ever because costs and time of development are way down for so many types of products and services.
It’s not particularly difficult to design new investment models that fit well with market realities like these. Years ago, I designed a variety of term sheets which attracted funding in exchange for royalty rights in already developed, high-margin software products. Investors could assess factors such as competition, sales strategy and customer reaction at the time of investment rather than guessing what the marketplace might be like years in the future when the product was finally ready for launch. They also began to receive a return on their investment, and a reduction in their risk, within six months.
The moral is that there’s more than one way to structure a deal that will work for both sides of the money equation. Investors and their financing models should adapt to address current opportunities, rather than letting some of the best, and lowest risk, deals pass them by.
Andrew Updegrove is a regular contributor to Mass High Tech. He can be reached at andrew.updegrove@gesmer.com.
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