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A Value Proposition for Venture Capital

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Is Kentucky finally becoming a startup capital destination for entrepreneurs used to flying over to the East and West Coasts? The best answer is, “We are trying very hard,” according to private investors and government officials.

Kentucky is not going to be Silicon Valley, or an East or West Coast, said Warren Nash, executive director of the Von Allmen Center for Entrepreneurship at the University of Kentucky. However, a value proposition is emerging.

“But if you raise a dollar here, and you can get it done here,” Nash said, “that dollar will go a hell of a lot further than in Boston or in San Francisco.”

Kentucky dollars, meanwhile, are more readily available because of sudden growth the past three years in the number of individual private investors and investment firms, also known as angel investors and venture capitalists.

For example, 70 more angel investors registered with Kentucky just this year, making for 344 added since 2015. At least four new angel funds, in which private investors pool their money, were formed since 2015. Kentucky’s reality version of “Shark Tank,” the popular television show about venture capitalists making deals with startups, is growing an audience for its entrepreneurial ecosystem.

“It was tough to talk about angel investing 10 years ago in Kentucky,” Nash said. Many entrepreneurs “wouldn’t have had the courage” to try to raise funds here then, he said. And while “Shark Tank” gets people talking today about start-up investing, he shrugged, “it is not what happens in Kentucky.”

Many have been working for years to build an innovation ecosystem. However, the recent surge in investment capital is adding energy to Kentucky small-business development programs that are 15 years old.

“It’s many pieces that are coming together, and it takes time,” said Nash. “I think we are on the cusp of many things happening.”

Outsiders are taking notice. Alejandro Cremades, author of “The Art of Startup Fundraising” and executive chairman of Onevest, a leading startup investing platform, spent two days at The Kentucky Angel Investor & Entrepreneur Summit last October in Lexington.

“I am convinced from what I heard here that there are great minds, and a great team of individuals who are executing this,” Cremades said. “I think in 10 years that I’m going to hear that this is a hub for real entrepreneurs.”

The nine people sitting on a panel at the October summit made for a historic moment, Nash said, because they were the largest gathering ever of Kentucky angel investors and regional VC firms on a single program event. Of the nine funds represented, four were created since 2014. In describing their firms and funds, the panelists spoke of investing over $450 million in start-ups (in Kentucky and elsewhere).

The startups’ new investor support can be defined broadly, said Nash, and vary by region.

Startups that get private investors talking are ones with a unique, new idea that could disrupt the old ways in an industry or business sector, then grow to employ from 50 to 100, maybe thousands. They talk about “scalability,” the potential for rapid growth. They want innovation that creates a new technology, process or invention yielding a unique product, device, scientific procedure or software. Startup founders who’ve created intellectual property protected by patent, copyright, trademark, etc., might need to get out of the way of the stampede of investors.

Ideally a startup can steer a community towards huge economic growth, like the now-iconic firms in Silicon Valley. In the past 25 years, firms less than five years old accounted for all net new U.S. jobs, according to the Kauffman Index of Entrepreneurship, whose in-depth economic research has been published for more than 10 years.

Kentucky targets startup company support in five categories that have demonstrated potential for scalability and innovation: bioscience; environmental and energy technology; health and human development; information technology and communications; and materials science and advanced manufacturing.

“Why should anyone care about startups, innovations, and the funding for research and development that powers them?” asks the Kentucky Annual Economic Report. “The answer is simple: Over the long term our collective standard of living will likely depend on it.”

Local funds sprouting around state

What has kick-started this sudden surge of private angel and VC fund investment in Kentucky startups?

The attraction “is the combination of building jobs, building the technical community and solving real-life problems,” said David Goodnight of Lexington, a retired Lexmark executive and a six-year investor in startups through the Bluegrass Angels funds.

Notice he didn’t specifically include making money. Cash returns are part of the attraction, but investors again and again first stress that building an innovative and entrepreneurial spirit in their communities ranks ahead as a reason for the recent growth in their ranks. They want to support local talent who have great ideas, solve problems and want to keep the companies and jobs they create in Kentucky.

“It’s all about developing that (entrepreneurial) spirit in your community,” said Jim Fugitte, president of the Lincoln Trail Venture Group in Elizabethtown.

In 2008, community leaders wanted a fund in which 100 investors from around Elizabethtown committed $10,000 each. That would, Fugitte said, “allow us to say to entrepreneurs that if you want to work and grow your company in Elizabethtown, then we have $1 million of private startup capital.”

Lincoln Trail Venture Group’s 40 current members have invested to date in 10 companies, such as Jail Tracker, a database management system built specifically for managing jails that has been acquired by a larger company. They meet regularly and listen to pitches, then make personal investments.

This happened recently in Owensboro also. Marshall Ventures raised a $2 million fund in 2015 from 14 investors in less than 30 days, said founder John Moore.

“People were looking for something like this,” Moore said. “People really got behind what we were doing, and that was pretty cool.”

They have invested in five deals so far, most in the $200,000 range, he said.

Its portfolio includes eCoach, which offers a commercially available app and platform to “connect athletes of all ages and skill levels to experts in their respective sports through state-of-the-art video analysis coaching software.” Also, there is Nectar Technologies, a clean-coal technology company based in Henderson.

On the east end of Kentucky, Ashland joined the community-based angel investor fund trend when Tri-State Angels formed in 2015 and raised a $1.2 million fund from 22 members, including two institutions. It has invested in six companies, said Chairman Don Perry.

“Things are really moving well for us. It is a new group, and we are very active,” Perry said. “We are very fortunate to have good members who are really interested in spurring economic development. That was one of the main goals, as well as to make money along the way.”

In Northern Kentucky, Covington’s Connectic Ventures raised a $5.6 million fund in 2015 with 54 Angel investors, 90 percent of them from Boone, Campbell and Kenton counties, said cofounder Brad Zapp.

“Our goal is to help you start a business so you can change the world,” its website declares. So far, the fund has made 30 investments, nearly half with minority-owned companies, and counts 230 jobs created.

Connectic Ventures’ portfolio includes ConnXus, a cloud-based supplier management portal, and SuperFanU, a fan loyalty and engagement platform presented in a customizable mobile app for colleges and universities.

In Lexington, members in one of Kentucky’s oldest angel investing funds, the Bluegrass Angels, volunteer and work to grow the entrepreneurial community spirit. They raised the first $3 million fund in 2004, and followed with two funds that total more than $6 million. Many of the Bluegrass Angels’ 52 members serve on the boards of the companies they invest in and volunteer their time.

“It’s part civic duty because banks don’t lend to startups,” said Chris Young, volunteer chair of the board of managers for Bluegrass Angels Venture Funds II and III. “We don’t want to lose these businesses to other areas.”

Being a mentor to entrepreneurs offers a lot of satisfaction.

“It is fun to get involved with companies and help them along,” said Young, who shares his experience in the entrepreneurial culture of San Francisco and Silicon Valley, where he cofounded an internet jewelry company and another involving corporate communication and packaging files for executive or sales teams.

Living in Lexington since 2004, he is general manager of Overbrook Farm and vice president of W.T. Young Storage, a public warehousing company. In 2008, he began volunteering with the Bluegrass Angels, and now is one of nine fund managers.

Joining that system is relatively easy, Nash said, and new members are needed from all regions of Kentucky to grow the total capital available for startups. However, he believes there is a need for expertise as much as a need for money. Without expertise in the ideas startups pitch, funds and investors have to pass on making a deal.

He encourages anyone interested in becoming an investor and mentor to contact the nearest Kentucky Innovation Network office (kyinnovation.com), join the state’s virtual angel investor network (kyangels.net) or contact any individual angel or VC firm. There is also information at the Cabinet for Economic Development’s ThinkKentucky.com website.

The language of investings

Helping to grow your community’s entrepreneurial spirit is all well and good, but the spirit to make money is a second key reason to invest. There have been many success stories that could be driving Kentucky’s influx of new angel and VC investors.

Moore, from Owensboro’s Marshall Ventures fund, said Kentucky’s entrepreneurial ecosystem especially needs those successful business owners and community members who have stock portfolios.

“There is real good reason to have 5 percent of that portfolio in startup companies,” Moore said, suggesting they should invest as individuals or put money into funds of at least $2 million that make startup investments.

There have been several success stories in Kentucky, and fund members need to tell this story because “not enough people know about it,” he said.

Angel investing has its own language. Investment decisions are called a “deal,” or referred to as a “bet,” reflecting the risk involved. A “term sheet” is the legal document defining what investors and entrepreneurs must do.

Making money requires an “exit.” One form is when a larger company within the startup’s industry acquires for cash and investors get dividends in proportion to the amount of their bet. Exits can involve convertible debt, revenue-sharing, sale of the business, or the rare but very profitable initial public offering (IPO) of a portion of ownership to the stock market. Early investments become stock shares whose value is set by the market, with prudent cashouts typically taking another five to seven years.

Exits return money to investors in term of “2X, 3X, 4X,” etc. – e.g., a $25,000 investment returning $50,000 is a 2X return. Rates of return are not published, but everyone interviewed for this article expects to make money.

“We say that we will make ‘10 bets’ and hope that one is a 10X return,” said Brian Luftman, a former Chicago Mercantile Exchange floor trader who is now a fund manager for the Bluegrass Angel Venture Funds.

“Every deal I invest in, at the time, I expect a return of five to 10 times my money. But I know that half the companies I invest in will fail,” Luftman said. “I am willing to make those bets because I know there will be ones that turn out truly great, and make up for all the others and then some.”

New investors most often join a local venture club, such as the Bluegrass Angels private investor group in Lexington. Members pay $1,000 in dues and attend regular meetings to hear about startup businesses. Some members become accredited and invest individually, while joining the fund requires a minimum commitment of $25,000 for three years.

Young stresses that becoming an investor in startups is serious business for all of Kentucky’s angel and VC funds, whose members put in a great deal of effort and due diligence to be successful.

“This isn’t just ‘let’s pretend that we are doing ‘Shark Tank’ and throw some money at some kids trying to start a business.’ We are trying to do things very diligently and very intelligently,” Young said. “We try to make sure we invest in the right people and the right deals. We have learned a lot of hard lessons about what not to do. We have come a long way in our sophistication.”

‘Tax credit math is pretty cool’

To encourage activity, Kentucky in 2015 introduced a tax credit that stimulated more than $25 million individual investments in its first three years. Individuals investing in qualified startup companies can receive a 40 to 50 percent state tax credit (higher for investments in economically depressed regions).

“The tax credits are such an important thing here,” said Marty
McClelland, chair of the Enterprise Angels Fund of Louisville which raised $4.6 million in 2014. “All the investors out there understand tax credit math. Tax credit math is pretty cool.”

Enterprise Angels Fund had one of its investments of $200,000 fail in 2016, getting only $90,000 back, McClelland said.

“In tax credit math that is a slight profit,” he said. “It really makes a compelling case for investing in this class of companies. All our investments are in Kentucky, in part for that reason.”

The tax credit is a huge draw, said Young of Bluegrass Angels. “We only look at Kentucky deals because of it,” he said, adding that the credits have enticed many out-of-state businesses to relocate in Kentucky.

The tax credit pool is limited to $3 million a year, however, and available to investors accredited by Kentucky who submit applications in December. In 2015, credits were exhausted in eight months, then within three months in 2016, and in one month this year, according to Casey Barach, director of the Northern Kentucky Innovation Network office and the key driver of getting legislators and the business community throughout Kentucky to support the angel tax credit.

“There is no doubt that the angel tax credit is driving deals in Kentucky,” Barach said.

Kentucky’s return on investment is $3.50 in increased tax revenue for each $1 in tax credits, according to research from Northern Kentucky’s Tri-County Economic Development Corp.

Tri-ED’s data also shows growth in the tax credit program:

• 344 angel investors were registered in 2017, up from 274.

• 28 companies were funded in 2017, with the three-year total at 81 companies.

• 80 individuals were approved for credits in 2017, with 381 individual investments gaining credits over three years.

• 307 small businesses are qualified for tax-credit investments.

Since the tax-credit program’s launch, Barach said, the following funds were created:

• Kentucky Angels (statewide)

• Tri-State Angel Investment Group (Ashland)

• Marshall Ventures (Owensboro)

• The CONNETIC Fund (Northern Kentucky)

• Northern Kentucky Growth Fund (expanded due to anticipated increased demand).

The new incentive is in addition to an older tax credit that applied only to money deposited in venture capital funds. Since 2015, another $5.8 million was invested from these funds to qualify for a 40 percent tax credit under the Kentucky Investment Fund Act, according to KIFA’s most recent annual report.

Another reason Kentucky’s entrepreneurial investor ranks are growing is that Kentucky matches Phase II federal innovation and technology transfer grants for startups, said Young, of the Bluegrass Angels. Each phase has eligibility requirements for the grants, which can total millions of dollars.

Since 2006, the Kentucky SBIR/STTR Matching Funds has awarded $61.4 million to 251 companies, which leveraged $112.6 million in federal funds.

The commonwealth has consistently lagged behind on investments for matching grants, but that appears to be changing, according to the 2017 Kentucky Annual Economic Report: “Kentucky’s $93 per $1 million in state gross domestic product during 2013-15 is converging on the competitor state average of $108; the U.S. average, while declining, is still significantly higher at $133,” the report states.

An online state angel network

The virtual Kentucky Angel Investors Network created in November 2013 is also growing the number of private investors for startups in communities all over the commonwealth. With 84 accredited investors from nearly every region, the online network “gets more knowledge out into the state about angel investing,” Nash said.

Most members telecommute into its regular meetings to hear the “pitches” then take surveys to express whether they are interested; Nash connects those who are with the entrepreneur. Kentucky Angel members involved in the other funds may invite entrepreneurs they hear to pitch to them too.

Entrepreneurs giving pitches are required to have worked with one of the 12 Innovation Network offices. Kentucky Angels and the Innovation Network both are programs from the Office of Entrepreneurship in the Kentucky Cabinet for Economic Development.

“It’s all about the community, the ecosystem of giving back,” Nash said. “It’s about the community being supportive, whether it’s a breakfast, or getting together to compare the trials and tribulations, or someone who has been successful and now comes back to be a mentor, or come and judge a pitch competition, or sit and talk to an entrepreneur. I think we have grown that support system.”

Is growth in capital enough?

Despite the geographically expanding efforts, the new funds and tax credits, a big difference between Kentucky and the coasts remains the total private capital available. Commonwealth investors talk millions of dollars in deals, while their counterparts in Boston, Colorado and Silicon Valley often discuss billions, amounts that can launch companies capable of growing into Apples and Googles.

Most Kentucky funds range from $1 million to $6 million, the exceptions being the few VC firms that invest in several states. The tax credit programs account for projected investments of $7-$12 million annually. Beyond the tax credit programs, actual amounts invested in Kentucky are known only when companies self-report their activities.

Companies in the seven-county Central Kentucky region reported to the Innovation Network that private equity raised in FY 2015 was over $26 million, and in FY 2016 over $40 million, Nash said.

Although growing, the amount of private capital in the state “is disproportionately tiny compared to what is going on in the rest of the country,” said Kelby Price, director of the Kentucky Enterprise Fund.

A state-sponsored, venture capital-like fund, KEF invests in Kentucky-based seed and early stage technology companies with high growth potential. Companies may apply for a $30,000 grant or initial investment of up to $250,000. It is one of several programs out of the Kentucky Science and Technology Corporation.

“Some of the companies in the past few years that we’ve invested in are doing really, really well. It’s exciting.” Price said. “We should celebrate that, but at the same time look at the bigger picture.”

“The Midwest has less capitalization relative to the economic activity that is bubbling up,” said Don Aquilano, managing partner of Allos Ventures, a Midwest-focused, early-stage VC firm. Allos has about $55 million in active investment from about 100 successful high-tech entrepreneurs, founders of companies, and university and institutions.

Aquilano was on the Entrepreneurial Summit panel in October, and Allos has funded some Kentucky start-ups.

Now that Kentucky has more, but relatively small, angel investment firms, they will need to collaborate on deals and invest in start-ups in other parts of the commonwealth, said Perry, of Ashland’s Tri-State Angels.

“That is key in regards to any Kentucky angel group. No one angel group can typically fund the needs of one company,” Perry said, “so it takes a number of us to come together.”

Moore, from Owensboro’s Marshall Ventures, agreed.

“I think it is going to be hard for any of us to just invest in our region and make this thing work,” Moore said. “The key is for us to all work together and prime the pump, and try to make the big numbers work. The pump gets primed, and we make more deals that people are talking about, then that will spike interest, I’m sure, in individual investors.”

More individual investors would greatly change Kentucky, said McClelland of the Enterprise Angels Fund of Louisville.

“We really need $25 million angel funds to make the economics work,” he said. That would support larger deals and allow funds to hire and keep full-time, professional managers.

Young, from Lexington’s Bluegrass Angels, said there also is a problem of “deal flow,” meaning a more consistent availability of deals instead of up-and-down cycles. But he said the quality of innovative ideas being pitched to investors is definitely growing.

“We are always looking for new members, new deals,” he said. “We want to get people knowing that we exist. We don’t want accolades – we want more deals, better deals, all the deals we can find, and we want more members who will give their time, treasure and talent.


Mike Agin is a correspondent for The Lane ReportHe can be reached at [email protected]

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