US venture firm targets gap funding

Bill McCullen is a rarity in a tight money market: his venture capital company is actively seeking innovative start-ups that need gap funding.

McCullen is director of the Boston office of LaunchCapital LLC, a Cambridge, Massachusetts, venture capital firm charged with providing up to $200,000 in gap funding to start-ups.

What distinguishes Launch is its focus on seed funding and its goal of making funding decisions within 10 weeks. One side effect of the current anaemic funding environment is that other venture company deals, which typically had taken several months, now can linger for six months or longer. “It’s taking longer and it is harder to raise money,” said McCullen.

“We’ve stayed pretty close to the 10 weeks,” McCullen told Science|Business in his sparse new office in a Harvard Square building shared with Federal Express and Kinko’s copy shop.

Family ties

LaunchCapital invests $30 to $50 million from its limited partner, a “family office” entity that manages a wealthy family’s investments. McCullen would not reveal the family’s name. However, a member of the family is a Yale University graduate with ties to Elon Boms, founder and managing director of Launch and himself a Yale graduate. Launch also has offices in New Haven, Connecticut, and in Silicon Valley in California. There are no immediate plans for overseas offices. The company was formed in February 2008, but made its debut this February.

Launch’s investments average $150,000 and are targeted at companies with strong growth potential but that are capital efficient. So far, its investments have focused around software and Web-based companies that don’t need large infrastructures or plants. Among its 20 investments to date are Promethegen Corp, a biofuels technology company based on molecular engineering developed at MIT; RateItAll, a distributed consumer rating community where visitors can find and share opinions on various topics; and FMP Products, which offers laboratory solutions in the fields of imaging, sample processing, and liquid handling.

While Launch may be somewhat unique on the US East Coast – McCullen said the West Coast has had a more developed environment for funding early-stage companies – the seeds for smaller investments are starting to sprout. In late March, Spark Capital launched a seed funding programme aimed at the entertainment, media, and technology sectors. Funding reportedly is up to $250,000. And TechStars, a mentoring and seed-funding programme, plans to expand from Colorado to Boston this summer.

Still enthusiastic

The poor economy, it seems, has not dented the enthusiasm of entrepreneurs or their backers, and the quality of entrepreneurs remains high. Launch’s McCullen has seen steady start-up deal flow from before the economic downturn last fall straight through it, including now. “I see about six to ten deals a week,” he said. His goal is to complete 10 deals in the Boston office this year. Launch aims to complete 10 deals in each of its three offices per year.

For most of its deals, Launch has syndicate partners, including larger venture capital firms and angel investors. McCullen sees his firm sitting in between those two types of investors, cooperating rather than competing with them.

The down economy and tight fists of larger venture capitalists have benefited Launch in several ways. It not only gets top students from MIT, Stanford University, and Yale to perform due diligence; with extra time on their hands and a desire to supplement their income, entrepreneurs, former investors and other highly qualified people are available to perform due diligence. “It’s a reflection of the current economic environment,” said McCullen. He also is seeing some deals that in better times would have gone to larger venture capital firms.

Another thing that has changed with the economic downturn is the rising prominence of follow-on funding sources and exit strategies on Launch’s radar. “Funding sources for the next round have risen to the top of the list for our evaluations of companies,” McCullen said.

That’s even true for portfolio companies with strong intellectual property positions, like Promethegen Corp, a biofuels conversion company that uses metabolic engineering to turn a higher percentage of biomass into alternative fuels like ethanol. Bob Johnsen, CEO of Promethegen, co-founded the company with MIT Professor Greg Stephanopoulos using technology licensed from MIT. Promethegen raised $750,000 in seed money from eight investors including angels and LaunchCapital from last April through January of this year as it organise itself. It wasn’t easy raising the money, Johnsen said.

“There’s been a different mindset over the past few months, and it got more difficult as we went through the summer into the fall,” said Johnsen, whose company is about to close a Series A round of $7-8 million with two or three investors so it can buy lab equipment. “A different amount of liquidity is required. The investors asked more questions. Institutions [VCs] that would have invested in a Series A round are now waiting to invest in Series B.” He added that investors are asking for a budget of two years rather than 12 to 18 months, so their portfolio has enough money in the bank if the market remains troubled. One of the potential investors is from Europe, and is interested because there is a market in Europe for Promethegen’s technology.

Exits for venture-backed companies remained problematic in the first quarter of 2009, according to Thomson Reuters and the National Venture Capital Association http://www.nvca.org/. There were no venture-backed IPOs in the United States for the second consecutive quarter. In addition, no companies with US venture financing went public on foreign exchanges in the first quarter. Twenty-six venture-backed companies currently have IPO filings with the U.S. Securities and Exchange Commission. M&A exits as of the last day of the quarter came to only 56 transactions, 13 of which had disclosed volumes totalling $645 million, or an average of $49.6 million per deal.

A positive is that Launch is positioning its exits – most likely M&A – five to seven years out. “You need to be an optimist about the direction of the economy,” McCullen said. “Now is a good time to invest in companies that have a five- to seven-year horizon.”

Bright spots

There are additional bright spots for start-ups seeking money. The Obama administration’s stimulus plan is starting to filter down to the US states, and the Small Business Innovation Research (SBIR) programme—which has been essential for funding early-stage companies and which was slated to end in mid March—was extended temporarily until 31 July  2009 by the US Senate.

Promethegen’s Johnsen is looking to both programmes for more money. “While the availability of Series A money is smaller, the availability of government money is higher,” he said. Promethegen plans to request an SBIR loan, and look for money from the economic stimulus package.

But there could be an unexpected gap left as smaller venture firms take a larger role in funding innovative companies. The larger venture capitalists that have extensive enough staffs of experts to help start-ups are holding back investments right now. “Venture capitalists who put money out should appreciate and understand the opportunities and risks attendant to the life sciences, biotechnology [and other fields],” Johnsen said. While he has strong backing with MIT technology, and has two previous biofuels start-ups under his belt, other start-ups looking for support from their venture partners may come up short.