Investors are a funding source that business owners may consider at various stages of their company’s life span, from the first days to the last. But not all investing is alike and companies are suited to different types of investment firms, based on their product or service, needs as a company, industry and other factors.
Below, a venture capital investor and a private equity investor share in separate conversations about how these asset classes compare and their roles in the innovation ecosystem.
Responses have been lightly edited for clarity and length.
Eric Engelmann
Eric Engelmann is general partner of ISA Ventures, a venture capital studio based in Cedar Rapids serving Iowa-based technology companies at multiple stages of growth.
How would you describe the difference between VC and PE investing?
VCs are more focused on earlier stages, generally higher-risk investments, usually in the technology sector, which has a pretty heavy tilt that way — whereas I think private equity is generally much later stage and sometimes taking controlling interest in those companies.
Which companies are typically the best suited for venture capital investments?
Most companies are not venture bankable. There are certain attributes that make them potentially venture bankable, which is enormous scale, capital efficiency, usually technology-enabled businesses. If you’re starting a business that doesn’t meet those criteria, you’re not going to have the choice to get venture capital, generally speaking. You’re looking at other capital sources. As an entrepreneur, you’re first starting with that filter: “Am I even appropriate to go after venture capital?” And usually the answer is no. Only a tiny percentage, like 1% or 2%, probably are even appropriate. But within that, then even if you are a candidate for it, it’s a pretty significant choice. Some companies simply require it. It requires so much capital upfront, and there are no loan programs because you have no collateral. The only way to start the business is to convince an investor to help you grow. For some businesses, there’s just no alternative, the business could never start without it. But if you’re a founder, if you have the option to do either way, which some of them do, then you have to decide which path to go. You’re giving up equity in exchange for capital that reduces your personal risks and helps the business presumably grow faster than it would if you were to bootstrap it.
How do you view the growth of Iowa’s access to capital?
There’s been a lot of progress in my view in the last 10 years or so. The big things that I’ve seen are the emergence of new capital structures. ISA Ventures would be an example of that, but also a lot of the state programs have gotten bigger, the ability to approach them has gotten better defined and more consistent. A lot of what we’ve been doing is figuring out how do we bring in investors from other states to work with Iowa companies to help get them funded. We’re not big enough, there’s only a couple of venture funds in the state and each of us has a time window of dollars that come in and dollars that go out. I think we have to be careful that we don’t all run out at the same time because they’re not always active at the same time. The fund matures, your fund strategy starts to change toward protecting the bets you’ve already made, for example. Right now, Next Level and ISA Ventures are both sort of at the tail ends of their current pile of funds. … Part of the way we respond to that is to bring in other investors in this state from South Dakota, from Nebraska, from Illinois.
The capital side is where I feel like I’ve been throwing my time for the last three years — in particular, solving a capital constrained problem. But it’s sort of like whack-a-mole: There’s many problems, and we might make progress in one dimension, and then the other dimensions, they need to kind of catch up to it. I feel like universities have made huge progress in building infrastructure to facilitate research, both at Iowa State and [the University of] Iowa in particular. They’ve made a lot of progress on that front; there’s probably a lot more that can be done there to help commercialize that research more consistently and in a way that’s workable.
What does ISA Ventures look for in its investments?
We’re usually pretty early as an investor in most cases, so often there’s a lot of lack of clarity around how big [the company] could be, or how great the product could be. We’re betting heavily on a person. The first filter to go through is, is this person someone we want to be involved with for a decade? And do they have the qualities we would look for — the grit to get through things, a broad industry perspective, the ability to learn quickly, adapt to new information? Ideally, the experience of having done some of this role before, innate leadership skills. They’re hard to find in the general population. Those are an unusual combination of skills. Then if they even get that far, then you can look at the product in the market and everything else.
Certainly we’re looking for signals of traction. Depending on the stage the company’s at, it might be early sales. How easy is it for them to sell it? How aggressively does the customer want it? Because the pain they feel is so bad, and their product solves that pain. For example, will they pay for it before it’s even done? Because they want it that bad. Or we’re looking for customer indications of interest in some way of if we don’t have a sale, then we’re looking for things like letters of intent, or some kind of expression from real customers that they want to buy it, which is interesting because a lot of founders come to us, and they don’t have any of those things. They have an assertion that they think people will pay for it with no real data other than assumptions.
What does it look like to create more VC funding opportunities in Iowa?
Last year, we did a trial run of an event with alumni on the set of EntreFest in Iowa City. We brought about 50 investors in; this year the goal is to bring about 100. We do a little showcase of some of the ones we’ve invested and other ones in the state of Iowa. The purpose of that is to say, “Hey, look, there’s really cool opportunities here that are worth a look.” It resulted in at least one or two investments in Iowa companies, from people from investors who are not in Iowa, so we want to scale that up a notch. So that’s certainly a piece of it. The other piece of it would be people who are here. We have a vested interest in the growth of our state and the people here, and that’s what gets me up every day and excited is knowing that it’s contributing to the forward motion of Iowa. Generally speaking, people who raise a fund, the next time they do it, they’re going to raise a bigger one, because they learned more, they know more, they know people, they’ve built those relationships and hopefully trust from investors that makes it possible to raise more money.
John Mickelson is managing partner of Midwest Growth Partners, a private equity fund manager based in West Des Moines. The firm makes individual equity and debt investments and focuses on rural and underserved areas across the country.
What is Midwest Growth Partners’ investment thesis?
[Midwest Growth Partners] really got founded with the thesis that there are nice little businesses spread out through small towns across Iowa, across the Midwest, across the nation, that unless they’re a certain size, they don’t attract a lot of attention from institutional capital providers. And eventually, one day, the owner decides they want to retire or they have a health issue or they die or something happens where there needs to be a succession planning event. Some of them are fortunate enough that they have family that are interested and capable of stepping into that role and some of them have brought employees along that effectuate the buyout. But many of them don’t. If they decide they want to retire and it’s a large business, they can sell it to a private equity fund in New York or Chicago or whatever. But if it’s smaller, there’s just not a lot of options. … We focus on growth capital investment and succession planning investment for companies in smaller towns that are maybe a little smaller in size than the typical institutional investor will target.
How would you describe the difference between VC and PE investing?
People frequently get [VC and PE investing] confused and just assume they’re the same thing, and they’re definitely not the same thing. VC, typically they have very early-stage companies, typically not profitable. And then typically they have groups that come together to do a fundraising round. You might have four or five, six, seven investors in each round for each investment. In growth investing for private equity funds, typically it’s just us, or us and one other group. Then when we say growth investment, what that means is typically we’re buying less than 50% of the business, so we’re not buying control of the business, but our partner is physically the CEO. He or she would own majority control of the business, and they’re also operating the business. Normally, it’s where the business owner says, “Hey, I’ve got this great idea. I want to add on to my facility” or “I want to buy a competitor, I want to start a product line. But I’m 60 years old, and I don’t want to borrow a bunch of money to go out and try this new thing.” So they might sell us 40% of the business and then use our capital to execute it. We’re typically very involved. We’ll vet the idea pre-close. Then after the transaction we’ll be involved helping them execute on that growth plan.
What is the difference in risk tolerance between VC and PE?
The risk tolerance is just radically different. In VC, if you fund 10 transactions, your check size is probably a little bit smaller each transaction, but you’re hoping that one or two of them are home runs and then you expect the rest of them to either fail or just be OK. In PE, we don’t expect any of our businesses to fail. These are businesses that are profitable, they’ve been around a long time, they’re established. There’s just a reason for there to be a new owner. We’re not trying to invent the next Facebook, we’re just trying to help grow an already established and profitable business.
Does MGP search for investment opportunities or do companies find you?
It’s a mix of both. Last year, we looked at 800 investment opportunities, and did three. Of those 800, probably 60% have come from intermediaries. They’re business brokers or investment bankers that had been hired by somebody to go out and raise capital or sell their business. Then the other 40%, we call them proprietary, but you might say, “Hey, my uncle’s got a nice business.” And so the other 40% just comes from conversations. Once [people] figure out what we do, they’re like, “My family member wants to sell their business.”
What are some of the biggest opportunities you see for Iowa in the risk capital space?
I started this fund 10 years ago. I would not have had that opportunity to do it in Chicago or New York. If I was in Chicago or New York, I would be working for a larger fund rather than starting one. The entrepreneurial environment here, I would say the bar is not as high as elsewhere just because it’s lower cost of living, it’s easier to get connected to the right people with one or two phone calls. Whereas if you’re in New York, it’s impossible to get tied into the right folks. Ten years ago, we had nothing, we were nothing and a lot of people took time and, you know, had lunch with us, and talked to us, and provided us mentorship and guidance. I don’t think that happens in the major metropolitan areas where finance is more prevalent.