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An Investment Framework: Surveying the Landscape

Funding gap

The funds and funding gap and why they create opportunities in early stage companies

~By Michael Schmanske

Most startup founders have or will become familiar with the idea of the “Funding Gap.” It’s not complicated, but if you are an entrepreneur and are not familiar with the term you are either very lucky or still too early to know what’s about to happen to you.  Even writing this I am wracked by mixed feelings of envy and pity for you.

Simply put, company funding moves in phases:

  • Self-funded: The company operates on owners’ capital, sweat equity and/or some mix of research grants and or institutional support.
  • Friends and Family:  Your mom, best man at your wedding, college besties, and working peers that respect and know you step up to help get the company off the ground.  They believe in You, so they see your Vision.
  • Seed Stage:  The first Stranger Funding Round.  “Here be Angels.”  With some initial milestones met, you head out to find your first “Real” investors.  They don’t know you, they are here to vet your product and company.
  • Series A:  The first big money.  More milestones have been met and to take you to the next level you need some bigger checks to scale, finalize and go to market.
  • Series B:  More track record, more milestones.  You might be in-market or generating revenue.  If you are a speculative product like an oncology therapeutic you’re probably at Phase 2 trials, but at the very least you have strong visibility to an exit and your earnings projections are based on reality not imagination.
  • Yada, yada, yada. Rounds C, D, pre-IPO, IPO, etc…

What is the most difficult stage?  Trick question—it’s actually a blend of two: seed through Early Series A.  From a credibility standpoint it makes sense.  You are transitioning from faith and belief to hard facts and delivered outcomes.  Angel investors live on faith and belief which is why they live in that zone.  It is also why most Angel investors don’t actually do that well if you compile all of their investments.  It is easy to get distracted by the vision of the emerald city when you should be keeping your eyes on the road.

That sounds great and it is the reason most experts or consultants in Private Equity give for the gap.  But that is dismissive of the REAL reason the funding gap exists.  Buckle up, we are going to discuss some light math.  Because of the structure of the Institutional Asset Management profession there is little appetite for $250,000 to $2,500,000 checks. Most of those sizes come from family offices and high net worth individuals.  (See sidebar at right)

Family Offices are groups of one or more wealthy families that manage their assets like an established hedge fund or other Asset Manager. They probably support a series of trust funds and/or charities. Think about the Waltons from WalMart, the Koch Brothers, or Mark Zuckerberg’s private accounts.  Now scale down to the local property developer or Mall owner. Family Offices may be anywhere in the range of $50 million to $5 Billion AUM. Even that range is somewhat arbitrary. They are different from private endowments or foundations primarily in their internal structure.  They answer to a small board of family members or an individual rather than a larger group of more conservative executors who themselves normally hire an external consultant for Plausible deniability if an investment goes south.

The Funds Gap

Consider the structure of an Institutional Asset Manager.  They charge 2% on Assets Under Management (AUM).  So a $250 million fund generates $5 million/year in fees. Operational and fundraising expenses take away ~ 40% of that leaving $3 million for compensation.  An institutional PM doesn’t get out of bed for less than $1 million /yr and they need a research and support team that costs ~half of their pay.  So with $3 million of net fees available for compensation expenses we have two teams at $1.5 million each that we can support.  How many companies can each team cover?  It depends on their philosophy.  Some funds have adopted a scattershot approach, let’s say they can cover 100 mostly hands off investments.  Liken them to the Skinny Syndicate from my earlier posts.  A hands on team might focus on a more manageable number like 25.

OK skinny syndicate fund.  $250 million AUM, 2 teams, 100 companies each = $250 million/200 yields an average check size of $1.25 million.  Investors do not like that format.  The scattershot approach means very little direct support or management interaction with the portfolio companies.  Add in the 2% per year management fee to sit and watch and that is a big performance drag.  Exits are ~ 5 years for many early stage companies and could be as long as 10 years.  That’s 10-20% off the top for a hands off strategy.  No thanks, I’ll take the monkey and the dart board again.  As a result, while these structures do exist they are primarily Family Office operations that have launched a coinvestment fund to try and cover a share of their sunk costs.

What about that more closely watched and held Managed Fund? $250 million in AUM, 2 teams, 25 companies each = $250 million/50 or an average check of $5 million.  You see where I’m going with this.  Even the skinny fire-and-forget fund writes checks between $1 to $2 million.  The managed fund won’t get involved until $5 million.  The biggest reason that checks do not get easily written in the $250,000 to $2,500,000 range isn’t the companies’ fault.  It is because there is little or no Institutional appetite for that size of investment.  There are also style and ego components, but we’ll save that for another day.  (Asset Managers are people too.)

AngelMD loves Seed through Early A. In healthcare, we see the most companies and products, we are best situated to filter the wheat from the chaff, and we have the greatest resources to support these early stage companies. Because of the Funding Gap, we also are investing at a time when capital is most dear. When investment dollars are desperately needed, investors get the best entry point as measured in a risk-return metric. Further, if you can eliminate 50% of the poor investments your portfolio returns become much much better than “average.”

But. But. But. I mentioned High Net Worth and Family Offices. Unfortunately these groups still obey the same economics as the funds. Generally speaking they do not have the internal resources to fully research and understand specialty fields. There is a reason they are not particularly active in Life Sciences.  Healthcare is hard.  To get around it they often invest in packs to share the burden of analysis and support.  Theranos didn’t get funded in a vacuum.  It took a village to mess that decision up so completely.

There’s the economics of the matter.  Pretty obvious when you know how to look at it.  If you’d like to learn more on these and other finance topics, check out my upcoming AngelMD Academy courses coming in the Spring of ‘23.  Or request a  specific topic by filling out the form (button below).

In the meantime I will cover AngelMD’s solution to this in my next post.  Here’s a hint:  We rely on  “The Four S’s.”  We Source, Select and Support companies at Scale.

Michael Schmanske is a 24-year Wall Street veteran with experience on trading desks and asset managers. He graduated with degrees in Aerospace Engineering from MIT and a Masters from Princeton University. Mike is the Managing Director for AngelMD Capital and runs research and Analytics at AngelMD where he is happy to exercise his inner nerd on a regular basis by supporting the most innovative entrepreneurs and cutting-edge medical startups.

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