Plugging the funding gap.

If there is a "capital gap" facing emerging companies, Frank Pirri can probably describe it. Pirri is chief executive at ProFind Inc., a Chicago-area high-tech company whose software helps businesses sort through the blizzard of resumes from job applicants and pinpoint the best candidate for a particular job.

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As businesses learn about its product's potential for speeding up the hiring process, ProFind's software is becoming a hot commodity. Since ProFind inked a four-year deal with US Cellular in January 2005, Pirri says, the telecommunications company has already hired 1,000 employees using ProFind technology. In addition, ProFind now has 35 clients, among them Banco Popular, the largest bank in Puerto Rico (which has Chicago branches), and Playboy Enterprises.

Yet, says Pirri, the entire enterprise was nearly still-born. Although ProFind had snagged $1.3 million in "angel" investments--money from wealthy individuals who frequently are organized into investment pools--by early 2005 and could boast a dozen customers and $300,000 in revenues, it was stymied: venture capitalists were balking.

"In 2004 and early 2005," Pirri says, "we participated in three different venture-capital summit conferences." Such conferences are a kind of audition, he explains, "where you pay a modest fee of $500 to $1,500 and get 10 minutes to make a presentation in front of a group of venture capitalists." But there were no takers, he adds, "because of our youth as a company and because we didn't have enough brand-name clients to gain attention."

Eventually, ProFind got lucky. Pirri and his management team began working with Innovation Advisors, a boutique investment bank with offices in Boston, Chicago and New York that, among other things, assists technology companies in raising capital. Under its tutelage, and for an undisclosed fee, ProFind won $4.5 million in venture capital investments from Cincinnati-based River City Capital Funds and Velocity Equity Partners in Boston.

Pirri's experience is not unusual. A chorus of industry participants--including entrepreneurs, angel investors, industry analysts, investment bankers and the venture capital firms themselves--assert that, in the post-seed, post-bootstrapping phase of a company's development cycle, budding technology and life-sciences companies increasingly face a "capital gap."

For a variety of reasons, these sources say, the paucity of venture funding at this critical stage--known as Series A financing, where investors typically put up roughly $500,000 to $5 million--threatens to snuff out promising enterprises just as they begin to make progress. Without this crucial infusion of capital, says Tony Grover, managing director at RPM Ventures, a VC firm based in Ann Arbor, Mich., that focuses on early-stage investing, "Companies can end up in no-man's-land."

There are naysayers, of course. Don Dixon, managing director and founder of Trident Capital, which has just raised $400 million in its sixth fund since 1993, calls any talk of a capital gap an exaggeration. "When I hear about the 'capital gap,'" says Dixon, whose Palo Alto, Calif., fund regularly invests in Series A deals, "I think it's only happening because people don't have an interesting proposition. There's more than enough money to reward good entrepreneurs with good ideas."

Indeed, one of the abiding ironies of the current environment is that venture capital funds are increasingly flush. VC funds raised $11.2 billion for future investments during the second quarter, according to Thomson Financial and the National Venture Capital Association (NVCA), the largest amount in five years; that brought the total to $18 billion so far this year, up 41 percent over 2005 levels. New Enterprise Associates raised an eye-popping $2.5 billion--the largest venture capital fund ever.

But, according to figures compiled jointly by PricewaterhouseCoopers and NVCA and analyzed for Financial Executive by Innovation Advisors, "there has been a dramatic shift in the venture market from early-stage investments to late-stage investments," notes Doug Brockway, managing director at IA.

During this year's first half, early-stage transactions represented only about 30 percent of all venture deals; the remainder comprised later-stage transactions. A decade ago, at the end of 1995, there was roughly a 50-50 split between the two. Early-stage investments, moreover, account for just 16 percent of money invested today, compared with 37 percent in 1995.

"Many VC firms will say that they invest across the board, including early-stage capital," says Kirk Walden, a former industry analyst at PricewaterhouseCoopers who is now an independent consultant in Austin, Texas. "They want to be seen as benevolent and promoting the American Way. But, the truth is that a smaller proportion of actual deals are made in the early stage than 10 years ago."

Later-stage deals have historically soaked up more money per deal than early-stage investments, and the gap is widening there as well. The average early-stage transaction remains in the $3 million-$4 million range, about where it was 10 years ago, notes the analysis by Innovation Advisors. The average investment in late-stage transactions, however, is up to $9-$10 million, nearly a 50 percent jump from the $5 million-$6 million seen a decade ago.

Economic forces account for much of the growing disparity. Walden cites a recent instance of early-stage investing as an example of how even profitable deals are unproductive to big venture funds. Here, an Austin-based venture capitalist was able to make a $4 million, early-stage investment in an entrepreneurial company that, four years later, was acquired by a global high-tech conglomerate for $10 million. "That's a $6 million profit," Walden notes, "and it was a successful outcome, but it's not even a blip on [the VC's] internal rate of return. It doesn't generate the returns that later-stage investments can produce."

Investing greater sums at a later stage not only means a bigger payoff, but it arrives sooner--typically, two years for a later-stage company, compared with four years for an early-stage investment. In addition, it takes a lot more effort for a $100-million fund to keep an eye on 30-50 investments of $1 million-$5 million, rather than 10 larger investments.

And, by their very nature, fledgling companies present a lot more uncertainty than more established ones. David Cremin, general partner at DFJ Frontier, a Santa Barbara, Calif.-based venture capital firm that specializes in post-seed investments, says: "If you are pre-revenue and pre-product, you aren't getting funding unless you go to the small handful of seed-stage venture capitalists and angels who will do that sort of deal. And there aren't many of us."

A lackluster market for initial public offerings (IPOs) isn't helping, either. It means that venture capitalists already have their hands full "struggling with companies that are hanging around like a kid in his fifth year of college," says John Taylor, director of research at NVCA. That makes it hard to contemplate investing in the next generation. "The lead time for an IPO is six years out," he adds, "and investors are trying to size where the market will be ahead of time. So they hope for a good situation--but they plan for a mediocre one."

To bridge the capital gap, entrepreneurs are employing a number of strategies. In a few rare cases, companies are going public immediately after the bootstrapping phase--a strategy that is fraught with risk, yet can pay off handsomely. "If the company has the right stuff," says Chester Paulson, chief executive of Portland, Ore.-based Paulson Capital, "they can make that leap."

Boutique Firms Do Introductions

Like ProFind's Pirri, entrepreneurs are hiring well-connected boutique investment banks to scour the countryside and find venture capitalists to match up with an entrepreneur. "One of the reasons you'd hire somebody like us is to get introduced," says Innovation Advisors' Brockway. "We know what themes are relevant to what VC firms. We can help craft a message and business model which put together near-term and long-term revenue projections and show the financial impact of an investment."

But, caution clearly is important. Although ProFind got positive results with Innovation Advisors, "four or five investment banking companies wanted to represent us, but their fee structure made them less attractive," says Pirri.

An increasingly common strategy is to round up a gaggle of angel investors. Many of these wealthy individuals are coalescing into such groups as Band of Angels on the West Coast and Common Angels in Boston to pool their resources and, in effect, substitute for venture capitalists. "Roughly 40 percent of angel deals in recent years have been migrating to the post-seed stages because of inefficiencies in the market," says Jeffrey Sohl, director of the Center for Venture Research at the University of New Hampshire.

Ian Sobieski, executive director at Band of Angels, says that there are now 110 angel groups "coming together to share knowledge about opportunities, pool money and enhance their negotiating position. It's always safer to be in a herd."

A case in point is Band of Angels' investment in Chackshu Research Inc., a Los Gatos, Calif., life sciences company that has developed an eye-drop formula to clear cataracts and prevent surgery. The eye-drop therapy means that cataract treatment would not only be far less expensive but much less invasive than "slicing open your eyes," notes Sobieski. He says that Band of Angels made an initial investment of $1 million in early 2005. More recently, he says, it ponied up another half-million dollars when it joined in a $15 million round with two venture capital firms. "The company now has enough money to finance clinical trials," he says.

Another strategy, particularly for entrepreneurs with close ties to state university laboratories and campus research centers, is looking for government help. Rhode Island is one of several states that have taxpayer-funded, high-tech funds to promote entrepreneurship and create jobs. The Providence-based Slater Technology Fund, for instance, gets $3 million annually in appropriations from the state assembly. Slater uses that to shepherd along high-tech companies in the Ocean State.

Thorne Sparkman, managing director at Slater, contends that the state-backed fund is more efficient than depending on angel investors. "More angels have gotten involved in the last 10 years," he says. "But it's still hard to raise more than $600,000 or $700,000 relying on angels who are putting up $50,000 to $100,000 each.

"Angels are almost always past entrepreneurs themselves," he adds. "Many are risk-takers who are investing largely for recreational reasons, and they're fiercely independent. So getting 12 of them going in the same direction is like herding cats."

He says Slater has invested in 16 companies since 2000 and that the "sweet spot" investment is typically $250,000 at first. "But, we go up to $500,000 with other investors. I would say we're almost always alone at first," Sparkman adds, "but never alone with the second investment."

One of its best prospects is Advanced Image Enhancement, a Providence-based medical technology company that is transforming to civilian purposes the U.S. Navy's use of imaging technology to spot tiny, undersea mines on a computer screen. The hope is that the same technology can magnify medical images to locate early-stage breast cancer.

To help get the company off the ground, Slater has invested $130,000 so far in seed money, about one-third of which was equity and the rest convertible debt, Sparkman says; its last investment tranche of $30,000 was made in partnership with Cherrystone Angel Group. Michael Duarte, chief executive at the digital imaging company, says: "Because of Slater, we've weathered the storm. It's been an important partner in the evolution of our company."

Finally, however, there are the hardy few--those stalwart venture capital firms that specialize in early-stage investments. "There is a capital gap, and we're there filling it--but we're very unusual," says RPM's Grover. He says the firm finds its investments by "walking the halls" of universities and developing contacts with top researchers and professors. Grover adds that his firm also maintains close ties to angel groups throughout the Midwest and co-invests with them.

Unlike later-stage investing, early-stage companies need more of a hands-on board, greater involvement and expertise. RPM, which specializes in finding companies developing the latest in automotive technology and chemical processes--key industries in the U.S. heartland--plays an important role in linking up its portfolio companies with heavy manufacturers.

"You have to roll up your sleeves and work pretty hard when you're an early-stage investor," Grover says. "Board members have to be there to help with strategy development. And if the CEO needs help with operational issues, you have to be an adviser and sounding board as well."

Paul Sweeney ([e-mail]) is a freelance writer in Austin, Texas, and a frequent contributor to Financial Executive.

RELATED ARTICLE: takeaways

* Experts say that in the post-seed, post-bootstrapping phase of a company's development cycle, many enterprises face a "capital gap."

* While VC funds are flush with cash, there has been a dramatic shift in the venture market in the past decade from early-stage investments to late-stage ones.

* Later-stage investments tend to pay off bigger, and sooner, than the early-stage variety, and it's harder to manage a host of small investments.

* "Angel" investors, special advisors, boutique investment banks and even state government funds are helping plug these funding gaps.