Community Development Venture Capital: Best Practices & Case Studies

Kelly Williams, CDVCA

The Importance of Private Individual Investors: Funders for Early-Stage Companies

The primary source of capital for early-stage companies has always been individual Investors. Jeffrey Sohl, a professor at the University of New Hampshire's Center for Venture Research, estimates that in 2002 approximately 200,000 private individuals invested $15 billion into 36,000 entrepreneurial ventures.[1] Most important, these investors step in to fund businesses seeking capital at a critical stage, generally in amounts over $100,000, considered the point at which money from an entrepreneur's friends and family is exhausted, and up to $2.0 million, when institutional equity financing becomes a possibility. Professor Sohl reports that 47% of all investments by angel investors are in businesses at the seed- and start-up stages, and 33% are early-stage.

The economic downturn over the past three years has reduced both the number of individual investors and the total amount invested. In 2000, the number of investors was estimated to have peaked along with the stock market at about 400,000. Nevertheless there are significantly more individual investors today than in the years prior to 1999, and the number of organizations dedicated to offering angel investors services and investment opportunities, or "portals," grew from 10 in 1996 to more than 170 in 2002. Between 1998 and 2002, the number of portals is estimated to have grown by 60%.

The amount of money invested by the nation's angel investors in small businesses each year dwarfs that of the traditional venture capital industry. In 2002, the roughly 1,400 traditional venture capital funds in the United States invested $21.0 billion in approximately 2,500 portfolio companies, of which only 2.3% were "seed-" and 2.4% "early-stage." Indeed, since 1995, the percentage of all venture capital dollars directed at seed- and early-stage companies has never exceeded 5%.4 Further, the average investment by a traditional provider of venture capital far exceeds the needs of a start-up and most early-stage businesses at the height of the economic bubble in 2000, the average investment by a traditional venture capital firm was $16.4 million, and as recently as the first half of 2002, the average deal size was $7.4 million.

In addition, traditional providers of risk capital always have concentrated their investment activities in a handful of metropolitan areas-Silicon Valley, Boston, New York City, and Austin, Texas-and have strong preferences for high technology, biotechnology, and other sectors, where there are opportunities for very large returns. Between 1991 and 2000, 65.2% of all venture capital investment dollars went to companies located in just five states-California, Massachusetts, New York, Texas, and Colorado.

The effect of this concentration is that in dozens of states, literally millions of companies, many of which are potentially attractive venture capital deals, are left with little or no access to venture capital. Between 1991 and 2000, the 25 states in the bottom half of the rankings received only 3.5% of all venture capital investments - despite having 20.0% of the country's total number of establishments.[2]

CDVC Funds and Angel Investors: Both Working to Fill a Capital Gap

CDVCA's 2001 Annual Survey of its member CDVC funds revealed that the average investment in a portfolio company by a fund was between $250,000 and $400,000, in either a seed- or early-stage company. Professor Sohl's research shows that in 2001 "start-up," "seed-" and "early-stage" are the most popular kinds of investments by a typical angel investor. The average investment by an individual investor was $806,042 and the medium was $450,000.

Co-investing is also a common preference of both CDVC funds and angels: according to Professor Sohl, 84% of traditional angel investors preferred co-investing to going it alone in a deal. 92% of CDVCA's respondents said they hope to do more co-investing in the future or maintain the same level of co-investing, in large part because reaching out to local angel investors and other co-investors enables a CDVC fund to leverage its own capital to achieve its social mission.

Angels: Value-Added Investors

Again, since angel investors are typically "hands on" types and may have been entrepreneurs themselves, they often bring with them particular industry expertise and valuable contacts that can provide a needed boost to a fledgling enterprise. In fact, entrepreneurs often state that the value of an angel's expertise exceeds the money put into the company. "This free assistance and advice from an investor who, quite often, is a seasoned veteran of the business world is priceless for young entrepreneurs starting out and would not normally be affordable by other means," writes former Harvard Business School Professor Robert Robinson.

The following are case studies of three companies in which a capable angel investor has made a significant contribution of time and experience in addition to a sizeable financial investment. In each case, a person of substantial wealth has chosen to make an investment in a local company with the promise of a strong social return on investment. The case studies are meant to illustrate the necessity of all of these factors-capital, business expertise and a willingness to be actively involved - to the success of this kind of investment activity as well as the substantial impact private individual investors can have on businesses that align with the goals of CDVC funds: namely, to bring wealth, entrepreneurial capacity and good jobs for low-income people to underserved communities.

Case Study: Bioverse, Inc.

Bioverse, Inc. markets and sells proprietary, environmentally sound fresh water management programs to control mosquitoes and algae in lakes and ponds without harmful chemicals. The company is headquartered in Bloomington, Minnesota, a suburb of Minneapolis, with a manufacturing facility in Pipestone, MN, three hours south of Minneapolis, which formulates and blends the microorganisms that comprise its products.

The company was founded in 1995 by Michael VanErdewyk, who was the national sales manager for an engineering firm specializing in the construction of wastewater treatment plants. The company has three patents issued, with a fourth pending, and eight registered trademarks. Revenue in 2002 was $872,000, and the company anticipates that 2003 sales will reach $2,500,000. The success of Bioverse and its bright prospects are, in part, due to the active participation of an angel investor, Dr. Conrad Schmidt, a veterinarian and businessman from Worthington, Minnesota, which is located near Bioverse's manufacturing facility.

Throughout the initial two years of research, development and introduction of its first products, the company was funded by Mr. VanErdewyk's own savings, as well as his friends and family. When the time came to increase inventory and working capital to support increased sales, Mr. VanErdewyk approached local individual investors and Prairie Capital, LLC, a regional area investor fund (also called a "RAIN fund"), based in Worthington, Minnesota, which is affiliated with the Minnesota Investment Network Corporation ("MIN-Corp."), a CDVCA member fund.

At the time, Dr. Schmidt was Prairie Capital's chairman and although the fund initially declined to make an investment in Bioverse, Dr. Schmidt was impressed by Mr. VanErdewyk's technical expertise and business acumen as well as the company's safe and sound technology, which he understood and appreciated as a veterinarian. Dr. Schmidt was a co-founder and President of Oxford Veterinary Laboratories, an animal health laboratory acquired by the Upjohn Company, which specialized in animal health, including the feeding of microorganisms to livestock to aide digestion. He is also a former acting economic development director for Worthington, and he was well aware of the need for additional manufacturing jobs in the region.

"We wanted Bioverse to give us a plan on how to extend beyond being a conservative, local industry," explains Dr. Schmidt, "We asked them to come back to us after thinking bigger, and we wanted to see ideas about possible exits, such as potential suitors, if they reached $15 to $20 million in revenues." Bioverse reworked its business plan along these lines and after a few months Prairie Capital made its first investment. Since then, the fund has made a second investment and several Prairie Capital members have made additional, individual investments in the company, including Dr. Schmidt, who is now on the board of directors.

Based on his years of experience at Oxford and as a veterinarian, Dr. Schmidt encouraged the company to search for additional agricultural applications for its technology. To this end, Bioverse is currently developing a number of new products, including a highly concentrated bacteria formulation for pork, dairy and poultry producers for application to manure pits and lagoons, and an odor control product for use in agricultural ponds and confinement barns, which is safe and natural and does not corrode metal, concrete, fiberglass or plastics.

Mr. VanErdewyk also credits Dr. Schmidt with introducing Bioverse to new customers for its products, including a former Oxford Veterinary Laboratories animal health products distributor that has purchased Bioverse's stock tank water cleaner and mosquito control product. "There has been a direct impact on sales," says Mr. VanErdewyk.

Today, Bioverse has four permanent employees at its Pipestone manufacturing facility. The company expects to create a minimum of five full-time jobs per year and to add part-time employees as needed. It is also planning to double the current size of its physical plant. Bioverse products can be found in various retailers, including mass marketers such as PETsMART and Lowe's.

Case Study: Sealtech Company, LLC

Sealtech Company manufactures and markets innovative plastic film products to industrial customers. Sealtech utilizes a state-of-the-art 100% solids extrusion technology that is high volume, yet energy efficient and virtually emissions-free, providing an environmentally sound alternative to competitors' solvent-based products as well as a safer workplace for employees. The company is located in Parsippany, New Jersey, close to some of New York City's more affluent suburbs, but also in proximity to some of its most distressed neighborhoods, from which Sealtech draws workers for its manufacturing process.

The company was founded in September 2000, and began initial manufacturing operations in the late summer and fall of 2001. Manny Ratafia, a founder of several technology-based companies, who also ran an extruded plastics development laboratory, is an active angel investor always on the lookout for new opportunities, and over the years has developed an extensive network of contacts. Mr. Ratafia ran across Sealtech on three different occasions over a period of several months, while the company's founder, Tim Peck, was searching for capital to start the business: first, a promoter of a private angel group in New York City showed him the business plan, then Mr. Ratafia met the founder a few months later at Venture Association New Jersey, an exposition of venture capital opportunities in New Jersey, and finally, the company was exhibiting at the Angel Venture Fair in Philadelphia, which Mr. Ratafia attended.

Initially, Mr. Ratafia had doubts about the composition of the original management team and the limited scope of the marketing opportunities described in the business plan. In spite of these early concerns, he decided to invest. "Because of my background in innovative plastic products, I immediately saw the potential for other market areas that Tim wasn't familiar with," said Mr. Ratafia, "and I thought I could add value." While the company's low-emissions technology and job creation possibilities held strong appeal for Mr. Ratafia, he explains that he weighs these factors only after having decided that the company has the potential for strong financial returns.

Seed capital for the company came from the Sustainable Jobs Fund, Mr. Ratafia, the founder, and other investors. The Sustainable Jobs Fund, a CDVCA member, is a $17 million community development venture capital fund with offices in Durham, North Carolina and Philadelphia, Pennsylvania, which seeks to finance sustainable enterprises that create quality jobs for low-income citizens in the Eastern United States. Mr. Ratafia and a representative of the Sustainable Jobs Fund are each directors of the company. For Mr. Ratafia, an investment in a company is usually contingent upon an agreement that he will have a permanent seat on the board of directors.

During the summer and fall of 2001, the company's machinery was installed, samples were made and marketing efforts began. During this time, Mr. Ratafia regularly traveled from his home in Woodbridge, Connecticut to Parsippany(a two-hour drive each way), and continued his networking in the plastics industry in order to assist in the search for a chief executive officer and a chief operating officer and to scout joint venture and marketing opportunities for the company.

Larry Waddell, Managing Director of the Sustainable Jobs Fund and a Sealtech director, says that Mr. Ratafia's knowledge of plastic films, polymers and chemistry has been invaluable to the company during its start-up. "He is also a very modest guy and great to work with," said Mr. Waddell, adding that Mr. Ratafia holds Master's degrees in Mechanical Engineering from MIT and in Engineering and Applied Physics from Harvard, and an MBA from Dartmouth. Mr. Waddell also emphasizes the value of Mr. Ratafia's tireless networking: Mr. Ratafia regularly visits the websites of Sealtech's competitors and searches for potential customers by following up on leads generated by his hundreds of contacts in relevant industries built up over the last two years. Mr. Ratafia estimates that he receives almost 300 personal e-mails every day, and he sends about 100 per day. He attends industry- or entrepreneurship-related events once or twice a month. "He just likes doing this anyway," reports Mr. Waddell.

Through his networking efforts, Mr. Ratafia identified every candidate that was considered for the positions of CEO and COO. His contacts in the pharmaceutical and chemical industries helped Mr. Ratafia find Joe Bruno, Sealtech's new CEO, who recently moved to New Jersey from Sarasota, Florida, where he was senior vice president of a company that manufactured plastic films and tapes; there, Mr. Bruno managed a staff of 150 with a $400 million annual budget.

For his part, Mr. Ratafia says that co-investing with Sustainable Jobs Fund has been a great experience and that in the future he will look favorably on investment opportunities in which a professional investor such as a community development venture capital fund is involved. Two advantages that he cites are Sustainable Jobs Fund's staff, which is able to quickly turn out expert financial analysis of an issue, and the fund's established relationship with a good law firm. "I tend to do these things a little more intuitively," Mr. Ratafia says. "They have extra people to make sure it's exactly right."

After an additional round of financing completed earlier this year, Sustainable Jobs Fund and Mr. Ratafia now each own about 30% of the company and expect that Sealtech will have a bright future. With Mr. Bruno onboard, the company has stepped up its marketing and will become cash flow positive before the end of 2003. Sealtech currently has 11 full-time employees, including 6.5 people employed in the manufacturing process, who earn between $13.00 and $23.00 per hour.

Case Study: Taction

Taction is a 24-hour, 7-day a week, 365-day per year customer call center and e-commerce service provider located in Waldoboro, Maine, a rural community with a large low-income population. Taction's approximately 130 employees take incoming calls to provide customer service for companies such as Atkins Nutritional, CHANEL and Samsonite, deliver customer support and product advocacy, receive and process orders for merchandise, and also respond to e-Mail and e-Chat, Taction's terms for carefully managed customer contact via the Internet. Taction's agents utilize a sophisticated telephone and data distribution system designed to allow them to respond in the most efficient and highest quality manner, and each agent has received hours of training to ensure that communication skills are among the highest in the industry. Taction has become an industry leader by being one of the first call centers to expand to a full service contact center by offering integrated e-commerce services. The e-commerce customer service staff has been carefully selected and trained to handle the extra demands of providing written responses to customer inquiries.

Robert Flory is a private investor who lives in Damariscotta, Maine, a coastal town near Waldoboro. He and his brother, a CPA, are partners in Flory Investments, Inc., which seeks opportunities in companies with revenues between $500,000 and $5,000,000. The brothers are especially interested in investing in companies in which they feel they can provide valuable technical assistance in addition to a capital infusion.

Mr. Flory became acquainted with Taction in 1999 after he had been recruited to become a Director of Maine Investment Exchange, a non-profit business forum that presents investment opportunities in Maine businesses to accredited investors. At the time, Steve White, Taction's founder and CEO, was seeking additional capital to expand the business. In 1995, Coastal Enterprises, Inc. ("CEI"), a community development corporation in Portland, Maine, had financed the renovation of Taction's 1904 building, and CEI Ventures, Inc., the venture capital subsidiary of CEI, had made an equity investment in the business in 1999.

Mr. Flory is a former entrepreneur and a trained educational psychologist who taught at Duquesne University in Pittsburgh for several years and also worked as an organizational analyst before moving to Maine in 1994. In November 1999, Mr. Flory and his brother met with Mr. White and CEI Ventures to begin the due diligence process. Mr. Flory recalls that their first impression was that they liked the business concept and the strong community development aspect of the company, but they had several concerns. Pooling their expertise as organizational analyst and CPA, they thought that Taction's cost management needed improvement, that its services were underpriced, that stronger management needed to be recruited and, especially, that the company's predictions about its growth rate were too high given the need for an educated workforce in such a distressed community.

Mr. Flory presented a term sheet that called for the creation of a new three-year strategic plan for the company, the hiring of a Chief Operating Officer, and detailed and frequent financial and management reporting to Mr. Flory and the other shareholders. "The underlying message here was one of both accountability as well as leadership," says Mr. Flory.

Mr. White agreed that a Chief Operating Officer was necessary but he had no experience in conducting such a search, so immediately after closing the investment, Mr. Flory designed and initiated a methodical recruitment process. These efforts resulted in the hiring of Hank Berg, a Maine native who had been working in New Hampshire for twenty years with an MBA and degrees in electrical engineering and computer science, who previously served as a vice president at a Lockheed Martin venture. Mr. Berg reports that since becoming COO and, more recently, President, he has utilized this same search process for recruitment of additional officers.

Part of the appeal of Taction, Mr. Berg reports, is the strong socially responsible aspect of the business. "For many people here, this is their first professional job," he says. "And they are learning skills that can be applied to a lifetime of employment opportunities." Taction invests considerable resources in training its workforce, drawn from the local community. To do this, it has embarked on a novel partnership with the public sector whereby the company seeks grant funding from various sources to provide basic professional skills, communication skills and computer training in an enterprise called Taction University to train recruits for jobs at Taction. A task force, which included Mr. Flory and CEI, established the program's plan, which is still in effect today, brought in a training consultant and negotiated the agreement for this work. Since 2001, Taction has obtained grant funding sufficient to provide over 4300 hours of classroom training in topics such as grammar, new supervisor training, computer foundations, and the use of email, Internet, and Excel and Word.

Taction's employee retention rate is now significantly higher than the industry standard, helping the company to remain cost efficient, and the company expects revenue growth of 15% in 2003, following a very successful 2002. Over 30 new people have been hired in the past several months and Taction expects to add an additional 24 positions during the remainder of 2003. "Tac tion represents an excellent example of an investment that provides both a financial and a social return on investment. The dual-purpose nature of the ROI in Taction makes the investment very rewarding," says Mr. Flory.

[1] Jeffrey Sohl, Ph.D., Press Release,"The Angel Investor Market in 2002: Investment Activity and Growth Prospects," The Center for Venture Research, June 11, 2003. 2 Ibid. 3 Id. 4 Sohl, "The Private Equity Market in the USA: Lessons from Volatility," Venture Capital:An International Journal of Entrepreneurial Finance, Vol. 5, No. 1, 2003.

[2] Brian Schmidt, Ph.D., Director of Research, CDVCA,"Traditional Venture Capital Missing in Most of the Country," Ventures, Fall 2002.