Building an Entrepreneurial Ecosystem in Sioux Falls Part 2: Making Capital Available to Entrepreneurs
A few weeks back, I highlighted four things that the city of Sioux Falls will need if it wants to become a true entrepreneurial city that regularly spawns job-creating and capital-attracting startups. In short, if we want a stronger social community of entrepreneurs, we need to do a better job of sharing our success stories, we need better educational opportunities and we need to make more early-stage capital available.
Today, I would like to dive a bit deeper into the topic of venture capital. I had previously written a short guide that outlines the options for entrepreneurs that want to raise money in South Dakota and the surrounding region. Now, I would like to review the available risk capital options for private-held companies at varying stages in the business life cycle and try to identify where the need for additional capital is.
The Venture Capital Stack
Companies can raise money to grow their business in many ways. The options that are available to them will vary largely depending on the size of the business, the age of the business, its financials and how much money the company is hoping to raise. Understanding the different segments of venture capital will help us understand what unmet venture capital needs there are in the city of Sioux Falls.
Here are the traditional segments of private equity financing:
- Pre-Seed Stage or Friends, Family and Fools — Before a company has fully formed, developed its products, and attracted its first customer, it will be very difficult to attract the interest of a professional investor. If you need to raise money before having your first customer, you will likely need to rely on your own personal finances or an investment or loan from a friend or family member. In some parts of the country, there are incubator programs that will sometimes invest a very small amount of capital (say $25,000), which can help a company get off the ground.
- Seed Stage — Companies that have started to flesh out their business and have their first few customers and want to raise an initial round of $250,000 or $500,000 of growth capital are seed-stage companies (at least in my part of the country). These are largely funded by individual angel investors and angel groups, such as Falls Angel Fund and The Funding Farm.
- Early V.C. — When a company has developed significant traction and wants to raise $1 million to $5 million in capital, it will need to look to local or regional private equity firms. Locally, Bluestem Capital, Bird Dog Equity Partners, McGowan Capital Group and others fill this role.
- Late V.C. — Companies that are looking to raise $10 million or more will almost certainly need to look outside of the state, perhaps even outside of the region, to find capital.
- Public Markets — When a company becomes very large and wants to raise public capital (often 9 figures or more) or pay off its private investors, it may file an initial public offering (IPO) and be traded on the public markets.
Of course, there are other ways to raise money for your business. You can borrow money from a bank if you can show cash flow to pay off a loan. You can use your own personal financial resources or personal lines of credit. You can try to launch a crowdfunding campaign to get financial support for your business as well.
The Location-Independent Nature of Venture Capital
A while back, there was a thread on the Sioux Falls Area Entrepreneurs group that chided local investors for not investing more in local businesses. An entrepreneur commented that they had to rely on outside capital to fund their business because no local investors were interested in funding their company. What this entrepreneur failed to realize is that almost no private equity investor is going to make an investment simply because they are based in the same city. Private equity investors are not non-profits looking to create local jobs. They are investors looking for a return on their investment commensurate to the amount of risk they are taking. Every angel investor, angel group, or private equity fund has certain criteria they are looking for in a founder and in a business when they invest. If they don’t see what they’re looking for in a deal, they are not going to invest — even if the company is just down the street.
Because venture capital is largely location independent, local angel funds and private equity groups often invest in companies located outside of South Dakota. For example, Falls Angel Fund recently invested in Myriad Mobile out of Fargo. Some might see this as an economic development problem (“Why not invest your dollars in local companies?”), but it’s not. Just as local venture capital dollars are flowing out of the state, venture capital dollars from around the country are flowing into the state. Companies in South Dakota can look to private equity firms based out of Minneapolis, Omaha, Denver, Chicago and California to raise money when they exhaust local sources of venture capital. For example, Docutap raised nearly $12 million from Bessemer capital out of California. The fact that venture capital flows from city-to-city and state-to-state is very much a net positive for companies in South Dakota, because companies can access much larger pools of capital out of state than if they had to rely solely on South Dakota dollars.
Seed-Stage Capital Needs in Sioux Falls
In my opinion, the greatest need for capital in Sioux Falls (and South Dakota) for that matter is for pre-seed and seed-stage companies. I do not see a significant need for post-seed stage capital because companies that hit significant traction can typically raise money regardless of where they are located. I really believe we need more sources of capital that will write the first $25,000, $50,000 or $100,000 check to help get a privately-held company off the ground. The five local angel funds sponsored by the Enterprise Institute, along with The Funding Farm and individual angel investors, are good steps toward providing this type of capital. These sources have invested in many companies located in South Dakota, but they don’t have enough capital to fully fund 100% of the fundable seed-stage companies in the region.
There will always be companies that angel groups turn down because of perceived problems with the business or its founders, but I believe Sioux Falls would probably need to have two more angel groups with similar capitalization levels to Falls Angel Fund in order to cover 100% of the fundable businesses in the city and surrounding communities. I don’t believe having a single larger fund is the answer, because private equity groups sometimes get deals wrong and I believe companies should have opportunities to raise money from different groups. Having multiple funds would also force the funds to compete over deals, leading to entrepreneurs receiving better valuations for their businesses and more competitive terms.
It’s probably not very likely that another Falls Angel Fund will pop up in the next couple of years, because it raised $1.35 million from 31 different local investors. It only came together because of a concerted recruiting strategy from myself and John Henkhaus over the period of several months. The $50,000-at-a-time money may be tapped out in Sioux Falls for now, but that doesn’t mean we can’t have another angel group that funds seed-stage companies. It would probably just need to be capitalized in another way. For example, a larger private equity group could create a $1 million fund specifically for investing in early-stage companies and bring on someone deeply involved in the entrepreneurial community to identify deal flow for this fund.
Pre-Seed Stage Capital Needs in Sioux Falls
This is an area where our community is making progress. The Zeal Center for Entrepreneurship is launching a growth-accelerator program that will provide participating companies $20,000 in seed capital along with free coaching, mentoring and branding services. As best as I can recall, about 15 companies applied to the program. I served on the panel that interviewed the applicants and saw enormous potential among many of the companies that applied. Hopefully, Zeal will be able to systematize their accelerator program and have a new class of seed-stage companies go through its accelerator programs once or twice per year.
Post-Seed Stage Capital Needs in Sioux Falls
It would be much more difficult to create significant new local sources of post-seed stage capital from private equity firms. We would really need a new generation of Steve Kirbys, Gene McGowans and Paul Schocks to start a local venture capital firm to create a significant source of new private equity dollars coming out of Sioux Falls. I personally don’t think this is something that Sioux Falls has a strong immediate need for, since companies that gain significant traction can raise money from outside of the state.
One positive news item in the private equity space is the creation of South Dakota Equity Partners (SDEP), which is a local private equity firm funded partially by the state of South Dakota itself. The fund hopes to raise a total of $30 million and will invest in “earlier stage to more established middle market companies with a goal to diversify its portfolio across industries and investment stages.” SDEP will also focus on “companies seeking to expand existing operations in, or relocate to, South Dakota.” SDEP has not launched yet to the best of my knowledge, but I anticipate that the firm will be able to start writing checks later in 2017 or in early 2018.
Join the Conversation.
I created a discussion group on Facebook called Sioux Falls Area Entrepreneurs. Join the group and have your say in what the city of Sioux Falls needs to do to better foster entrepreneurship and make more capital available to entrepreneurs.