A ready-made venture capital syndicate?

Bo Peabody and Matt Harris founded Village Ventures in January 2000.  Bo and Matt had become friends while attending Williams College in the mountains of northwest Massachusetts.  While still a student, Bo started Tripod, Inc. – an online community – that was sold to Lycos for $64 million in 1998.  After graduating in 1994, Matt went to work for Bain & Company and its venture capital affiliate, Bain Capital.  He returned to Williamstown in 1997 to co-found The Berkshires Capital Investors.

Harris and Peabody’s early experience yielded a couple of lessons.  First of all, talent is increasingly mobile, and places such as Williamstown are talent magnets.  Second, it is possible to create highly profitable businesses and make profitable investments in such places.  We would add two other observations: (1) Given the relative scarcity of employment options in a place like Williamstown, opportunity cost is low.  The combination of low opportunity cost and a lifestyle attractive to mobile talent creates an environment conducive to the formation of promising startups.  (2) Tripod is a classic example of a promising startup (i.e., an inexperienced entrepreneur pursuing a highly uncertain market started it on a shoestring).

However, all is not well in the economic hinterlands.  Per the Village Ventures web site, startups in emerging domestic markets face the following constraints:

·           Limited availability of capital, which arrests company growth at pivotal stages

·           Difficulty building meaningful working relationships with world-class partners and service organizations

·           Scarcity of networking opportunities

·           Lack of an extensive peer community

Furthermore, they note that venture capital is a notoriously local affair, and the cost of running a fund sized to the local market is often prohibitive.  So, Bo and Matt set out to create an innovative structure to allow the cost-effective delivery of venture capital to a national network of “emerging technology markets.”

Here’s how it works.  Village Ventures has identified 30 communities that exhibit high levels of human capital, low levels of venture capital, moderate cost of living, and a high quality of life.  A corporation rather than a limited partnership, Village Ventures has raised $100 million of equity capital from large venture capital and money management firms including Bain Capital, Highland Capital Partners, Sandler Capital Management, and Janus Capital Corporation.  Rather than trying to invest directly in targeted markets, Village Ventures has chosen to facilitate the creation of a network of affiliate funds in places such as Boise (Highway 12 Ventures), Tucson (Solstice Capital), and Charlottesville (Tall Oaks Capital).  Typically, Village Ventures will help the local general partners raise a $20 million fund.  In turn, Village Ventures will create a side fund of, say, $10 million, with the right, but not the obligation, to invest in the local affiliate’s deals.  Village Ventures’ shareholders, in turn, provide follow-on investment capacity.  Finally, Village Ventures offers its affiliates legal, fundraising, and back office services.  Taken together, the Village Ventures model has a number of potential advantages:

·           It lowers the barriers to entry for affiliate funds.  Village Ventures’ service offerings can take some of the cost out of launching and running a fund, which helps to decrease the requisite fund size.  More importantly, Village Ventures can help validate a local fund.  General partners having deep venture capital experience don’t typically launch small funds.  Not surprisingly, prospective limited partners are wary of investing in a blind pool administered by unproven managers.  The reflected glow from the principals of Village Ventures – and its investor group – can tip the scales.

·           One consequence of small local funds is that they are better matched to local conditions.  As we discussed at some length in our previous issues, the environments found in emerging markets are conducive to the creation of promising startups characterized by high levels of irreducible uncertainty.  Risk has to be mitigated through optimal parochialism – it is essential that investors are “close” to the entrepreneurs in a social sense, which is strongly related to proximity.  A small local fund can invest earlier with less reliance upon contracts.  This, in turn, can help resolve risk more quickly and accelerate the opportunity to bring in follow-on investors.

·           Village Ventures is a connector to follow-on investors.  One serious shortcoming of a small fund is that it doesn’t have sufficient resources to make follow-on investments in growing portfolio companies.  Consequently, small funds need big brothers.  However, effective syndication is predicated upon mutual trust, which is a function of reciprocity.  Highway 12 Ventures in Boise, for example, would be hard pressed to create its own syndication network in the near term.  As an affiliate of Village Ventures, however, it can tap into three potential pools of follow-on capital.  First of all, Village Ventures has capital in reserve with which to make investments.  Second, Village Ventures’ investors have presumably engaged in the relationship in order to tap validated deal flow.  Third, as a corporation with an unlimited life, Village Ventures has signaled to the broader world that it has the staying power to develop reciprocal relationships over time.  For example, if one were a VC in Silicon Valley, one may be wary of investing a lot of time getting to know and trust the folks at Highway 12. After all, Highway 12’s first fund will begin to wind down in a few short years, and there is no guarantee that they will be successful raising a second fund.  However, for the Silicon Valley VC, there is a greater chance that an investment in getting to know the people at Village Ventures may pay off someday in the form of quality deal flow.

·           The Village Ventures model shrinks the world for entrepreneurs.  Through its network of affiliate fund managers and regional fund managers, Village Ventures is creating a web of personal relationships that not only increases the funding opportunities available to entrepreneurs in emerging markets, it shrinks the effective distance between the entrepreneurs and other key resources – advisors, employees, investment banks, etc.  The individual entrepreneur doesn’t have to cultivate all these relationships on his own.  Rather, he can tap into the network simply by knowing the local affiliate.

It’s a clever model.  Will it work?  We think so, but the jury is still out.  The current environment for venture capital is pretty grim, which has inhibited the launch of new affiliate funds.  Furthermore, the depressed IPO and M&A markets have meant that few venture-backed companies are seeing liquidity events, which means that the performance of Village Ventures’ portfolio remains uncertain.

As enthusiastic as we are about the Village Ventures model, its Silicon Valley-style venture capital product addresses a secondary financing gap – that between angel money and venture capital.  Promising startups face a more immediate gap – that between friends and family money and angel funding.  If the latter isn’t addressed successfully, Village Ventures may find that it’s qualified deal flow is insufficient, notwithstanding the potential of the emerging markets it targets.

To read a recent article on Village Ventures in Red Herring magazine, click here.

Can community development venture capital help fill the void?

Community capital organizations are nonprofits that make loans to, and invest in, local businesses.  Frequently, they target underserved borrowers such as women and minorities.  Funding comes from banks motivated by their obligations under the Community Reinvestment Act as well as foundations.  Historically, assets came in the form of “stretch senior” loans done in collaboration with local banks.

Leading social entrepreneurs within the community capital world have spearheaded the “double bottom line” approach, which emphasizes the concurrent goals of economic profit and social benefit.  Not surprisingly, forward thinking community capital providers began to adopt the tools and techniques of venture capital over the last decade.  Equity and quasi-equity (e.g., participating debt) investments offer a better structural fit with growing companies than senior debt as well as the chance of significant upside to the investor.  As a consequence, the community development venture capital (CDVC) industry has emerged.  Per the Community Development Venture Capital Association website:

·           CDVC funds provide the equity capital that is vital to the success and growth of small businesses.  The primary source of risk capital for most small businesses is personal savings and loans from friends and family, which tend to be lacking in low-income communities.  Traditional venture capital firms provide financing for only a tiny portion of businesses nationally, and venture capital is almost completely absent from low-income urban and rural areas.

·           CDVC funds target companies that are highly competitive and likely to expand rapidly, offering the promise of both substantial financial and social returns in the form of good jobs with decent wages.  This sector of small, competitive businesses can form the backbone of a successful local economy.

It would appear that the social entrepreneurs that are leading the CDVC industry have clearly targeted the gap between friends and family and angel investors.  We believe that there is real potential that the growing number of CDVC funds can play an important role in bridging the gap and accelerating the emergence of a larger number of promising startups.  There are a number of challenges, however:

·           The double bottom line is a pretty fuzzy concept.  When is it okay to forego economic profit in order to increase social returns?  And, how can social returns be measured?  These are important questions, because measurement can impact incentives, behavior, and accountability.

·           Community capital – surprise – has a local focus.  That’s good news when it comes to optimal parochialism.  It can be bad news if it inhibits the collaboration and syndication that helps yield lower costs and portfolio diversification.

·           The CDVC culture seems to emphasize job creation over wealth creation.  Those aren’t necessarily contradictory objectives.  However, communities don’t become less poor (i.e. richer) just by being employed, they need companies that create wealth.

·           Individual CDVC funds are small.  Consequently, the nonprofit parent most often subsidizes the operating costs of the fund.  That leaves little in the way of budget for the cultivation of entrepreneurial capacity that takes so much of the for-profit VC’s time.

·           The CDVC industry is new and small.  In 1999, there was only $300 million under management by CDVC funds nationwide.

Nevertheless, because they have a vested interest in the success and failure of their portfolio companies, community capital organizations have the potential to become important hubs that provide validated connections among entrepreneurs, angels, and venture capitalists.  That will only happen if the cultural distance (which often borders on mutual suspicion) between the nonprofit community capital world and the for profit venture capital world is reduced.  We at Pioneer Entrepreneurs aim to help in that process.

To read on article in Inc. magazine on CDVC, click here.